Throughout 2021, China’s financial markets were rocked by a series of high-profile regulatory interventions in the country’s rapidly-growing technology and education sectors.
At the same time, the financial struggles of Evergrande — China’s largest real estate developer — became the focus of considerable concern, as the firm was caught out by the shifting regulatory sands.
These policy-induced shocks have sparked soul searching around the risks of investing in China. Some people argue that domestic and global politics lie at the heart of these regulatory changes, as the ruling Chinese Communist Party (CCP) seeks to consolidate its power at home and overseas. More sympathetic observers see legitimate attempts to tackle market competition issues, fix systemic risks and deal with concerns around growing social inequality.
Chinese bond issuers that are rated single B — from B+ to B-, or their equivalent — are trading at spreads of some 3,500 basis points. This means investors are demanding yields of 35 percentage points more than those paid by comparable government bonds to compensate them for the additional risk.
The magnitude of these bond spreads implies a default rate of 50%, a one-in-two chance that an issuer will fail to repay its debt. This translates to a 15% default rate for Asia’s high-yield market, which is even higher than the 10% that we saw during the 2007-2008 Global Financial Crisis.
We’re surprised that things have been allowed to get this far, given what a property-fueled recession would mean. President Xi Jinping’s push for "common prosperity" is one reason why the authorities have pressed ahead. Perceptions of inequality — including housing affordability — are a potential threat to social stability.
Actions against financial technology (fintech) firms fit with policymakers acting to avoid the same mistakes that allowed "shadow" banking to thrive unregulated throughout the 2010s.
Policymakers are also clipping the wings of many technology companies because, like their counterparts elsewhere, they’re worried that internet platforms are concentrating economic power in the hands of a few firms, which will ultimately undermine innovation.
Meanwhile, geopolitics is an issue. A new Data Security Law introduced security-related classifications that restrict the transfer of data overseas, alongside measures to safeguard personal data.
Companies deemed to be Critical Information Infrastructure Operators must also store their data domestically, or they must undergo an assessment if they want to send any data offshore.
New academic tutoring firms will not be approved, while existing companies are being forced to convert into non-profit entities. Tutoring firms can't raise money on the stock market, or accept any foreign investment.
Looking through the prism of common prosperity, the regulatory shock to education can be seen as an attempt to solve a social issue that ties in with related concerns about high housing costs, long work hours and lack of proper childcare — all factors that have been blamed for falling fertility rates that are exacerbating China’s aging-population problem.
It is, however, not clear whether these steps are enough to address the root causes. There are no signs yet of changes to China’s tough university entrance exams, for example.
These policy-induced shocks have sparked soul searching around the risks of investing in China. Some people argue that domestic and global politics lie at the heart of these regulatory changes, as the ruling Chinese Communist Party (CCP) seeks to consolidate its power at home and overseas. More sympathetic observers see legitimate attempts to tackle market competition issues, fix systemic risks and deal with concerns around growing social inequality.
Bond market blues
The risk of a property-led systemic crisis are most acutely reflected in Asia’s "high-yield" offshore credit market — sub-investment grade bonds issued by Asian companies, often in US dollars.Chinese bond issuers that are rated single B — from B+ to B-, or their equivalent — are trading at spreads of some 3,500 basis points. This means investors are demanding yields of 35 percentage points more than those paid by comparable government bonds to compensate them for the additional risk.
The magnitude of these bond spreads implies a default rate of 50%, a one-in-two chance that an issuer will fail to repay its debt. This translates to a 15% default rate for Asia’s high-yield market, which is even higher than the 10% that we saw during the 2007-2008 Global Financial Crisis.
Safe as houses?
As reflected in the bond market, the process of reducing real estate risk is not without danger. Property is an important economic driver and sits at the heart of a network that links local governments, banks and homebuyers.We’re surprised that things have been allowed to get this far, given what a property-fueled recession would mean. President Xi Jinping’s push for "common prosperity" is one reason why the authorities have pressed ahead. Perceptions of inequality — including housing affordability — are a potential threat to social stability.
Politics or competition?
China has also cracked down on its technology companies which appears to reflect a combination of financial stability, competition and political drivers.Actions against financial technology (fintech) firms fit with policymakers acting to avoid the same mistakes that allowed "shadow" banking to thrive unregulated throughout the 2010s.
Policymakers are also clipping the wings of many technology companies because, like their counterparts elsewhere, they’re worried that internet platforms are concentrating economic power in the hands of a few firms, which will ultimately undermine innovation.
Meanwhile, geopolitics is an issue. A new Data Security Law introduced security-related classifications that restrict the transfer of data overseas, alongside measures to safeguard personal data.
Companies deemed to be Critical Information Infrastructure Operators must also store their data domestically, or they must undergo an assessment if they want to send any data offshore.
Hey teacher, leave those kids alone!
The education arms race that many parents feel obliged to join in order to give their children the best start in life spurred a major intervention by the authorities. This has effectively shut down the US$70 billion tutoring industry that specializes in extra-curricular classes to prepare children for school and university entrance.New academic tutoring firms will not be approved, while existing companies are being forced to convert into non-profit entities. Tutoring firms can't raise money on the stock market, or accept any foreign investment.
Looking through the prism of common prosperity, the regulatory shock to education can be seen as an attempt to solve a social issue that ties in with related concerns about high housing costs, long work hours and lack of proper childcare — all factors that have been blamed for falling fertility rates that are exacerbating China’s aging-population problem.
It is, however, not clear whether these steps are enough to address the root causes. There are no signs yet of changes to China’s tough university entrance exams, for example.
Our sense is that we are on a path toward some degree of stabilization and an easing of the regulatory pressures.
Looking ahead
Our sense is that we are on a path toward some degree of stabilization and an easing of the regulatory pressures.
With respect to the property sector, we’ve seen regulators at all levels attempt to reduce the pressure over the past two months, as the financial stresses and risks to the economy have risen. The People’s Bank of China and key government officials have attempted to restore access to funding for some developers and to project confidence to the markets. Notably, we’ve seen reports of the domestic interbank bond and asset-backed securities markets being reopened to builders. Regulators have also increased engagement with important stakeholders.
Lastly, we have seen builders increasingly helping themselves by raising equity, selling assets and other corporate actions, as well as embarking on liability management exercises, such as renegotiating debt repayment schedules. Hopefully this momentum will be sustained.
US-050122-163562-1
IMPORTANT INFORMATION
Property investments may carry additional risk of loss due to the nature and volatility of the underlying investments and may not be available for investment by investors unless the investor meets certain regulatory requirements. In considering the prior performance information contained herein, potential investors should bear in mind that past performance is not necessarily indicative of future results, and there can be no assurance that such investments will achieve comparable results.High yield securities may face additional risks, including economic growth; inflation; liquidity; supply; and externally generated shocks.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.