Onshore Bond Default Is A Worrying Sign For China's Economy

Includes: FXI, FXP, GXC, PGJ
by: Terracotta Capital


I have underweighted China over the next 12 months as I believe that more corporate bond default may happen.

In the near term, perhaps stimulus policy is unlikely to be introduced.

A lackluster PMI trend and continued slowdown in retail sales growth also paint a bearish picture.

I think growth deceleration is a probable scenario for China's economy over the next 1-2 years. The market has been concerned about the risk of a prolonged slowdown and a looming credit crisis (fueled by increasing local government debts and liquidity crunch even in the shadow banking system). Last month, China's government set its official GDP growth target for 2014 at 7.5%. The key question is how achievable the target is. Fortunately, China's government has a decent track record in delivering its promises (see table below). As renowned short-seller Jim Chanos interestingly commented in his CNBC interview, "China is the only major economy that knows its GDP for the year on Jan. 1."

China GDP target
Actual Target Achieved or missed?
2010 8.0% 10.4% Missed
2011 8.0% 9.3% Achieved
2012 7.5% 7.7% Achieved
2013 7.5% 7.7% Achieved
Source: CEIC

In my view, a 7.5% GDP growth, if achieved, is not bad at all. Some may rightly contend that the robust GDP growth is not consumption driven. Rather, it is a result of concerted government efforts to invest in infrastructure. I tend to be cautious on China's economic growth over the longer term, and I think that those who are bearish on China have raised valid concerns, particularly with regards to the credit system.

No more bail-out for distressed companies

Solar-cell maker, Shanghai Chaori Solar Energy Science and Technology Company (002506) announced last month that it would be unable to pay the full interest on its bonds. This is the first case of default in China's onshore bond market. China, after all, is Asia's biggest bond market outside of Japan. Any more corporate bond defaults may put pressure on the stock market.

A more market-oriented attitude

I think the government's tolerance for the default is a signal that regulators would allow more ailing companies fail, and that they are adopting a more market-oriented attitude towards financial reform.

Near-term, economic activities remain muted

The latest manufacturing PMI data for the month of March from the National Bureau of Statistics was 50.3, almost flat from 50.2 in February. In my view, perhaps a flat month-over-month PMI is better than a material fall amidst the uncertain environment.

Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14
NBS PMI 50.1 50.3 51.0 51.1 51.4 51.4 51.0 50.5 50.2 50.3
Source: CEIC

Domestic consumption growth continues to slow

According to the National Bureau of Statistics, China retail sales grew by 11.8% for the month of January and February 2014. This is a sequential slowdown from 13.6% in December 2013. With a softer domestic consumption pattern, perhaps strong stimulus policy is needed to reverse the trend of slowdown. I think that in the near-term, the government is unlikely to introduce any strong stimulus policy like interest rate cut.

In conclusion, I think it is time for China bulls to reassess their medium-term investment outlook, and invest only in the high quality corporates, rather than investing solely based on top-down sector selection.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.