China's real credit risk lurks in shadow finance – Financial Times

The downgrading of the world’s second-largest economy’s sovereign debt rating should rank as an important event. But financial markets greeted China’s downgrade last week by Moody’s, the credit rating agency, with their version of a nonchalant shrug. Chinese domestic bond prices remained steady and Hong Kong’s main stock index actually rose during the week.

But the non-event should not lull observers into complacency. China not only has one of the most highly leveraged corporate sectors in the world — with company debts equivalent to about 170 per cent of gross domestic product — it is also engaged in risky manoeuvres to cut an overgrown shadow finance sector down to size.

Indeed, the market’s shrug says more about the structure of China’s financial architecture than it does about the very considerable risks that lurk within it. The truth is that foreign rating agencies have little influence over domestic bond investors and foreign ownership of Chinese bonds amounts to just $61.5bn, or 4 per cent of the total.

In any case, China’s outstanding foreign debt stood at a modest $1.42tn — or just 13 per cent of GDP — at the end of 2016. Beijing’s huge stash of foreign exchange reserves, which currently stands at $3tn, makes it highly unlikely that the country would default on its sovereign bonds.

Nevertheless, the one-notch relegation of Moody’s rating to A1 should encourage observers to delve into the strange nature of Chinese financial risk. Although the downgrade puts China on a par with Israel, Saudi Arabia and the Czech Republic, there is almost no equivalence between the challenges it faces and those of these countries.

The risks inherent in China’s system derive mainly from the regulatory disobedience of a state-owned phalanx of banks and companies that have reaped handsome returns from a booming netherworld of shadow finance. This twilight domain has tripled in size over the past five years to be worth $9.4tn, or about 87 per cent of GDP, at the end of last year, according to Moody’s estimates.

In recent months, the China Banking Regulatory Commission (CBRC) and other official bodies have sought to re-impose Beijing’s authority by cracking down on a long list of irregular but commonplace financial dealings. Guo Shuqing, the CBRC chairman, has been quoted as saying he would rather resign than see the banking system become a “complete mess”.

But the crackdown is creating collateral damage. A squeeze on the money market, a font of shadow finance liquidity, has driven short-term interest rates higher, raising the costs of funding not only for irregular dealings but also for legitimate mid-sized banks and companies that rely on such funding to manage stretched balance sheets.

Bond market defaults are relatively new; the first one was permitted in 2014. But this year there have been 13 defaults so far, the most recent in late May when Dalian Machine Tool Group — one of the world’s largest machine-tool companies — failed to repay the principle and interest on debt issued.

The potential for debt default contagion is huge, due to a widespread practise of companies guaranteeing other companies’ loans. Nearly half of the lower-rated companies in China have extended loan guarantees of more than 30 per cent of the value of their equity, according to Everbright Securities, a Chinese brokerage. Thus while the Moody’s downgrade may not signal a clear and present danger, it should alert investors to the myriad credit risks within China’s opaque economy.

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