Trade disputes between China and US have contributed to a volatile start to the year for global markets, and investors continue to worry about a further escalation in the tension.

To make sense of this trade war and to understand its future evolution, it is important to separate the mercantilist from the structural views. The mercantilist view focuses on the trade deficit, analyses the reasons for it and proposes solutions accordingly. The structural view tries to understand the forces behind the evolution of trade between the two countries and examines the longer-term factors that are likely to shape it in order to find solutions.

The mercantilist complaints essentially arise from the large trade deficit that the US has built up against China over the years. President Trump often takes a mercantilist stance when he complains that China (and other trading partners, including Canada, Mexico and the EU) has taken unfair advantage of the US in trading.

A frequent mercantilist complaint is that China has manipulated its currency to gain a competitive advantage in trade. While China maintained a fixed exchange rate from 1995 to 2005 (five years before and after its entry into WTO), it then allowed its currency to appreciate by 27% over the next eight years. More recently, China has struggled to keep the renminbi from sinking, and even the Trump administration has refrained from labelling it a currency manipulator.

The other causes cited by the mercantilists for the trade imbalance include China’s reluctance to open many sectors of its economy to imports and foreign investment, and the support extended to several industries through state-directed lending policies and a low cost of financing.

In fact, one of the key reasons for China’s trade surplus is the massive pool of low-cost labour that could be moved to the urbanized coastal regions to support a huge build-up of manufacturing facilities, lifting over 500 million people from poverty in the process. The mercantilist complaint also ignores the fact that western consumers have benefited from lower inflation and higher consumption in the process. While it is true that American workers have suffered from Chinese competition in some industries, we must also remember that the overall unemployment rate in the US is now close to historical lows.

Some of the solutions that result from a mercantilist analysis are purely short-term and unsustainable. For example, last year China promised to purchase more agricultural products from the US in order to level the trade balance, but such a rebalancing does nothing to alter the longer-term direction of the two economies and the trade between them.

Even if tariffs succeed in reducing the trade deficit with China, inherent differences in cost mean that other low-cost countries will be ready to take its place, simply shifting the trade balance from one country to another.

TO UNDERSTAND THE longer-term trajectory, we must instead turn our attention to structural issues. At a fundamental level, China is itself at a critical juncture as it faces rising costs, an aging population and the need to rebalance its economy towards domestic consumption. As a result, it is doubtful if it can rely on exports to the same extent in the next 10 to 20 years as it has done in the past.

As the Chinese economy matures further, it is only natural that it would want to focus on services, higher-value exports and domestic consumption as drivers of growth. After all, how long can it keep manufacturing cheap plastic products for the world? The government’s “Made in China 2025” plan is just a reflection of this desire to shift to higher-value and more advanced products.

It is in this quest for greater value addition that China is running up against US concerns related to intellectual property. The US has argued that China seeks to obtain technology and intellectual property by unfair means, including forced technology transfers to Chinese partners, making technology sharing a precondition for market access and even outright theft of technology.

While the US (and other western countries) cannot expect China to give up on its longer-term goals, China must also recognize that it needs to form fair partnerships with the western countries in order to transform its economy further. One of the key elements of the longer-term solution will be to understand that a more prosperous China would offer an attractive market for western products and technologies. As the negotiations proceed, the US and other western countries should lay greater stress on appropriate institutional mechanisms for an orderly sharing of technologies and benefits.

The two points of view, mercantilist and structural, are not necessarily exclusive. For example, mechanisms to ensure access to Chinese markets for western companies would also help rebalance trade over time. But drawing a clear distinction between the mercantilist and structural views makes it clear that tariffs are not a long-term solution.
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The future of the China-US economic relationship depends on how successfully such structural issues are resolved in the longer term, and not on how quickly trade can be rebalanced in the short term.

​Since Deng Xiaoping’s famous Southern Tour in 1992, when China’s paramount leader rekindled the country’s economic reforms, and particularly since China’s entry into the WTO in 2001, American consumers have gained significant purchasing power from low-cost imports from China. At the same time US manufacturers have lost competitiveness and market share against Chinese suppliers. Although this conflict often colours views of the recent rise in trade tensions between the two countries, it represents just one facet of a complex trade relationship.
 
For much of the past two decades, the spotlight was on China’s exchange rate policy. Despite repeated complaints, particularly from the US, China kept the renminbi-US dollar exchange rate fixed for 10 years until 2005. Throughout this period, the renminbi was widely assessed as undervalued and China’s exports gained considerable advantage in the years leading up to and following its entry into the WTO. That said, China also won much praise for keeping its currency steady during the Asian financial crisis when other Asian currencies were devalued substantially.
 
Successive American governments threatened to designate China a currency manipulator, but none of them carried out the threat. Eventually, China allowed a gradual appreciation of its currency from 2005 to 2014, raising its value cumulatively by 27%. This deflated much of the earlier criticism and many observers, including the IMF, concluded that the renminbi was no longer significantly undervalued. Last year, even the Trump administration refrained from labelling China a currency manipulator. In fact, during much of 2015, 2016 and even 2017, China struggled to keep its currency from sinking as its foreign-exchange reserves declined by nearly a fourth from US$4tr to US$3trn. Thus, on the charge of currency manipulation, we can argue that, whatever advantage China might have gained from its exchange rate in the past, it is no longer guilty.
 
What, then, accounts for the massive and repeated trade surpluses that have turned China into the ‘factory of the world’ and inflated its massive foreign exchange reserves? The main reason is straightforward: China simply had a massive low-cost labour pool that could be moved to the urbanised coastal regions to support a huge build-up of manufacturing facilities. To that extent, it was a fair deal that lifted millions out of poverty in China and benefited western consumers through lower inflation and higher consumption. However, this cost advantage is no longer a given as rising wages in coastal areas and stricter implementation of environmental regulations have started denting China’s competitiveness. Although the country still rules global manufacturing with entrenched advantages, particularly of scale and infrastructure, its cost advantage is no longer formidable.
 
Beside low labour costs, China has been accused of tilting the competitive field in favour of its own companies in a variety of ways. At a macro level, it has kept its financing costs low by trapping the savings of households at a low return. Through its dominant state-owned financial institutions, it has directed credit to sectors based not just on their intrinsic viability but on the need to generate growth and employment. Over time, these practices have bestowed a fairly big advantage on its manufacturing industries, sometimes leading to overcapacity, as in steel.
Again, any complaints on that score must be balanced against the praise China earned when the same state-directed lending fuelled the building of infrastructure in the years after the global financial crisis, adding to global demand when there was a dire need for it. It may also be argued that it is the Chinese banks, government and people who will eventually pay for supporting unviable industries and the accompanying build-up in debt to the extent of over 300% of GDP.
 
Another common charge is that, while China has been eager to tap foreign markets for its exports, it has been reluctant to open up its own markets to competing goods and services, particularly in financial services, insurance and technology. Meanwhile, it has been aggressive in mandating partnerships with local companies and pushing for technology transfers, enticing foreign companies with dreams of access to its massive domestic market. As a result, China is now on the threshold of becoming a global competitor in some high-tech industries, such as high-speed railways. Still, it is not easy to measure to what extent these practices have resulted in an unfair advantage and to put a dollar value on them.
 
What is indisputable is that China has emerged as a manufacturing powerhouse, before subsequently losing some competitiveness because of various factors. Its current-account surplus, which rose rapidly from 2% of GDP at the time the WTO entry to a peak of over 10% in 2007, has now fallen below 1.5%.
 
What has brought trade issues to the fore is the Trump administration’s focus on the loss of American manufacturing jobs, which it has blamed mainly on the trade deficit with China (and within NAFTA). Although US unemployment is at a 17-year low of 4.1%, lost trade has hit some sectors and geographies particularly hard and given the political impetus to threats of tariffs against a range of Chinese products.
 
Many of the criticisms against China, including undervaluation of currency, have lost their vigour, whether through change of circumstances or passage of time. While other complaints, particularly those related to the opening up of its markets, tilting the playing field through directed credit and aggressive acquisition of technology, have a kernel of truth, tariffs are a blunt instrument in seeking redress. It would be far better for the US administration to address these issues on a sector-by-sector basis, establish a system to filter technologies open for sharing, and adopt a firm stance in seeking access to the Chinese domestic market against transfers of technology. Such targeted measures, implemented in coordination with Europe and other countries, would be fairer and be more successful in nudging China towards being a more balanced and cooperative trading partner.

This is the reproduction of an article in IFR Asia magazine.

In the face of formidable uncertainties this year, investors may still seek the comfort of fixed income, says Dilip Parameswaran

Despite all the misgivings at the beginning, last year turned out to be a good one for fixed-income investors. Asian dollar bonds ended the year with a return of 5.8%, composed of 4.5% for investment-grade and 11.2% for high-yield bonds, according to JP Morgan Asia Credit Index data. We are beginning another year full of uncertainties. What does 2017 hold in store for fixed-income investors?

The first big uncertainty relates to the path of US interest rates. The Fed has begun raising rates and has signalled that three rate increases are in the offing this year and three more next year. A sustained period of job growth has brought US unemployment down to 4.7%, but more importantly the pace of wage increases to 2.9% per year. While these numbers underpin the Fed’s planned rate increases, the key unknown is the impact on any potential fiscal stimulus on growth and inflation.

That brings us to the second key uncertainty: the Trump administration’s plans for the economy. It is widely understood that the next administration intends to provide fiscal support through a cut in taxes and an increase in infrastructure spending, but the extent of the stimulus and its potential impact are unknown. If these plans start nudging inflation up to a level higher than the Fed’s current expectations, the Fed might have to respond by raising rates faster.

Another unknown is the extent to which the Trump administration’s policies on trade and the dollar will influence key economic variables. Mr Trump has espoused various protectionist views and may tolerate a weaker dollar. While a weaker currency might push inflation higher, the final impact of protectionist trade policies, particularly on growth and employment, is uncertain.

China is the other piece in this moving puzzle. At the beginning of last year, worries about China’s economy dominated the markets, but as time went on, growth began to stabilise and greater uncertainties – including the US presidential election – took over. This year too, the markets are resting on the comfortable assumption that China would manage growth of about 6.5%.

But China still faces a myriad of economic issues, all of them carried over from the last year. While economic growth last year was propped up by continued flow of credit to the economy, the total debt in the system has reached close to 300% of GDP, according to various estimates. China also faces the challenge of rising capital outflows in response to slowing growth and a depreciating currency. While property construction was a key support for the economy last year, property prices in many cities have risen to such unsustainable levels as to prompt a round of regulatory constraints. The government may provide a measure of support to the economy through an expanded fiscal deficit, but it would exacerbate the challenge of managing the total debt in the economy. On top of all these domestic economic issues, there is the added challenge of a strained trade and political relationship with the US. China may yet emerge as one of the key trouble spots this year.

Where does all this leave the fixed-income investor in Asia? We believe that Asian dollar bonds could again produce positive returns of 2%-3%, without leverage.

One key driver of the returns is, of course, US Treasury yields. Based on the current expectations for the Fed rates, we believe the 10-year yields could rise by about 50bp over the year to reach close to 3%.

The spreads on Asian dollar bonds narrowed by about 25bp last year for investment-grade and 130bp for high-yield bonds, according to the JACI data. This year, we expect investment-grade spreads to finish flat and high-yields bonds to widen by 50-75bp. This is primarily because the positive performance last year has left Asian spreads somewhat tight by historical standards and in comparison with US spreads.

Credit defaults are unlikely to turn into a big issue for Asian bonds. Moody’s expects that, after a temporary pick-up in the early part of the year, the global high-yield default rate will edge down from 4.4% to 3% over the year. In Asia, defaults have always been episodic and not systematic. Given the prevalence of family ownership, government connections and bank support, Asian issuers have averted defaults in many difficult situations.

The technical factors for Asian bonds were strong last year. Nearly three-quarters of Asian bond issues were placed within Asia, up from 63% the year before. Support from Chinese investors in particular has been one of the contributing factors. We expect these factors to continue supporting the market this year as well.
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While some market players expect a wholesale shift of funds to equities this year, the so-called “great rotation” has so far proved to be the wolf that never came. With major uncertainties confronting the economic world this year, investors might yet prefer the cosy comfort of fixed income for a while yet.

Asian USD bonds have exceeded all expectations by producing a total return of 9% in the first eight months of the year, driven by the search for yield, reasonable macro environment and supportive technical factors. At this stage, the bond yields for both investment-grade and high-yield bonds are approaching the tightest levels in the last five years. However, Asian bonds still offer a higher yield than the US domestic bonds.

As concerns over China’s growth have abated to some extent and India’s growth has picked up, Asia’s growth is forecast to exceed that of other regions and to stay stable for the next three years. Yet, concerns are rising over the increased leverage on corporate balance sheets and the excess of rating downgrades over upgrades. Looking ahead, technical factors are likely to continue to support Asian bonds. They will continue to present an attractive opportunity to global investors, particularly against the preponderance of negative interest rates elsewhere.

To download full report, click here.

This is the reproduction of an article in IFR Asia magazine.

One of the key constraints for the Indian economy is the accumulation of non-performing loans in the banking system. Recent figures from the IMF show that, at 5.9%, India’s gross non-performing loans as a share of total loans are the highest in Asia. Including restructured loans, the figure exceeds 14%.

As banks groan under this burden, they are unlikely to be able to support the lending growth required for the economy to pick up. The Reserve Bank of India has taken the first step towards a solution by conducting asset-quality reviews and insisting that all the non-performing loans be recognised for what they are. It has imposed a deadline of March 2017 for the banks to properly classify loans and make provisions.


While this may increase the stress on the profitability and capital ratios of the banks, it is better to accept the truth than to brush it under the carpet. The capital ratios of Indian banks are already among the lowest, according to IMF, and will come under further stress as the banks go through the inevitable pain. While the government has allocated some funds to recapitalise banks, this is by no means sufficient.

Apart from pushing for greater transparency, the RBI has allowed banks to convert loans into equity with a stipulation that they have to find a buyer for the shares within the next 18 months. The challenge for the banks is to convert the debt to equity at a high valuation, manage the companies in the interim, and identify a buyer. The RBI permits the banks to sell as little as a 26% stake while holding the rest, but potential buyers may not like keeping the banks as co-owners for an extended period.

The RBI has also allowed banks to refinance loans to the infrastructure sector for 25 years with refinancing or restructuring every five years. The question is whether banks will apply this option to viable loans or to mask problems.

However, none of these solutions is a genuine attempt to improve the viability of troubled borrowers. If India’s bad loan problems are to be resolved in a meaningful way, a host of supporting systems need to be developed. The recently enacted bankruptcy law goes some way in offering solutions for the resolution of insolvent companies, but more changes are required.

First of all, banks need the freedom to deal with problem loans in the best way possible. Currently they are averse to writing off loans or to sanction additional credit for troubled companies for fear of being accused of underhand dealings. The current RBI regulations are far too constraining for them to try to revive distressed borrowers, as they impose a time limit on re-sales of equity shares acquired through debt swaps, lay down the equity valuation method, and specify the minimum percentage to be sold.

India also needs to develop a strong culture of evaluating credits before the loans are sanctioned and for monitoring the borrowers for early-warning signals of trouble. In this context, it is interesting to note that it is not small-scale industries that have led to this massive accumulation of bad loans, but the medium and large-scale borrowers. So the question can justifiably be asked why the banks tolerated the build-up leverage and not take action sooner.

The concept of independent insolvency professionals introduced in the new bankruptcy law is a positive move, but they need to come from a variety of industrial management, finance and turnaround backgrounds, rather than merely the legal profession. This will happen only if banks are willing to entrust management of troubled industries to turnaround professionals rather than lawyers with expertise in dissolving companies, backed by appropriate incentive structures. For example, banks may agree on an incentive compensation based on an objective measure of improving the value of the borrowers’ business such as a multiple of Ebitda or on specific actionable measures such as completion of specific projects.

Although asset reconstruction companies have existed in India for many years, they are modest in size compared to the scale of the problem. They have also enjoyed a favourable system of putting up a cash outlay of only 5% (recently increased to 15%) and charging a management fee of 1.5%-2% of the asset value. In addition to this model, other models of outright sales, incentive payments and sharing of recovery values would encourage reconstruction companies to maximize recoveries. Unlike China, India could also consider investing public funds in asset reconstruction companies in order to provide a speedier resolution to the problem.

​Any amount of tinkering with rules on recognition of problem loans and provisioning is not likely to lead to a genuine revival or resolution of bad loans. To achieve that, the mindset has to change across the entire range of stakeholders, including banks, turnaround funds, professionals, and even the government.

This is the reproduction of an article published in the IFR Asia magazine.

Asian bonds are yet again likely to generate positive returns this year and provide a measure of stability to investors’ portolios, says Dilip Parameswaran

The year has not exactly started well for many asset classes. Oil has sunk to prices not seen in the last 12 years. With another sudden downward lurch in its currency, China has injected more concerns into the market about its economy, dragging other commodities further down. Equity markets have taken fright, with the Dow already down 9% since the start of 2016.

Against this background, there is one question on the mind of every investor: “With the Fed poised to raise again this year, what does the future hold for fixed-income investments?” In our assessment, the answer is not as negative as you might think: US dollar bonds from Asia can generate a total return of 2%–4%, without leverage.

Last year, Asian bonds generated a total return of 2.8%, split into 2.2% for investment-grade and 5.2% for high-yield bonds, according to JACI index data. This year’s returns are likely to be on a par with those.

When considering the outlook for this year, the first point to appreciate is that Asia is still an attractive growth story. China’s economic slowdown being partly compensated by India’s pickup, Asia ex-Japan is still set to grow at 5.8% this year and next, according to the IMF’s forecasts. This stands in stark contrast to the outlook for other emerging markets, which are suffering from a mix of problems, including low commodity prices.

THIS YEAR’S EXPECTED total return from bonds depends on many moving parts. The first is, of course, the likely increase in the Fed funds rate and the medium-term Treasury yields. Economists hold different views on how much the Fed would raise the target rate. Some point to the persistently low inflation, others talk about falling unemployment, and some highlight the potential for global issues (including China) to slow the pace of rate increase. But overall, the Fed funds futures are currently pricing in a Fed funds rate of 0.6% for the year-end. That indicates the potential for medium-term Treasury yields to rise less than expected, perhaps by 50bp.

The second key element is the credit spreads. According to the JACI data, the average Asian bond at the end of 2015 traded at 293bp over swaps, broken down into 222bp for investment-grade and 596bp for non-investment-grade. These spreads are eight times the pre-crisis levels for investment-grade and over six times for non-investment-grade. Although one may argue that the pre-crisis levels reflected unjustified and unsustainable exuberance, the current levels are still higher than the post-2009 average spreads by about 25bp for investment-grade and 140bp for non-investment-grade.

Compared to the US credit markets too, Asian bond yields are still higher, by about 90bp for investment-grade and 50bp for high-yield.

In our view, the current spreads reflect neither a significant overvaluation, nor undervaluation. Consequently, they indicate the potential for the spreads at the year-end to stay close to their current levels, perhaps within 20bp.

The third determinant of returns is defaults. At a global level, high-yield default rates are likely to pick up: Moody’s expects the global high-yield default rate to reach 3.7% by November 2016, a level that is higher than the 3% for last year, but still lower than the longer-term average of 4.2%. In Asia, most of the defaults have been triggered by the crash in commodity prices and the economic slowdown in China. These factors are likely to keep Asia’s default rates elevated, but should not lead to a spike.

THE TECHNICAL FACTORS for Asian bonds are likely to be supportive this year. Already, many major issuers have turned to Chinese domestic bonds instead of US dollars, as it offers them cheaper funding and reduces their currency risk. This year’s supply of new bonds is also likely to be restrained by the same trends, particularly in the China high-yield sector.

At the same time, the demand for bonds has remained strong, in particular from the institutional investors in the region, who picked up 63% of new issues in 2015, up from 58% in each of the three years prior to that. For most investors, Asian bonds have become a mainstream asset class, rather than a frontier asset class; and they are likely to maintain their presence in Asian bond markets in the medium- to long-term.

Based on these factors, we expect Asian bonds to generate total returns of 2%-4% if five-year Treasury yields rise by 50bp. Even if the five-year rates rise by 75bp, which seems aggressive given the uncertainties surrounding further rate increases, Asian bonds can still generate positive returns in the range of 0.7%-3%.

Given the higher yields and lower duration, high-yield bonds on the whole are likely to generate higher returns than investment-grade bonds by about 200bp in the base case. However, the challenge for investors is likely to be one of avoiding the potential defaulters. That is no easy task, since the defaults are triggered not only by economic, but sometimes by political factors as well. Another challenge of investing in high-yield is the lower liquidity due to the shrinking capacity of banks to hold inventories and make markets.
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In an environment of so many uncertainties – including those around the Chinese economy, commodity prices and geopolitical risks – we believe investors should maintain a reasonable allocation to fixed income to provide stability to their portfolio returns.

This is the reproduction of an article published in IFR Asia.

We are now firmly in the midst of a commodity downturn. From its peak in June 2014, the S&P Commodities Index has lost over half its value. Industrial metals and agricultural products have been bleeding slowly since 2011, but they have slid more rapidly in the past 12 to 15 months, shedding about a third of their value. Energy prices have declined by a shocking 60% in the same period.

This has affected the prices of both shares and bonds issued by commodity-related companies. Noble and Glencore have each lost about three quarters of their market capitalisation since mid-2014, while other publicly traded commodity firms have lost 18-38%. Noble’s bonds maturing in 2020 are trading at about 75 cents, yielding 1,300bp over Libor.

How did these masters of the universe fall from grace? Commodity traders used to take pride in their ability to make money, irrespective of the commodity cycle. After all, they buy commodities and sell them for a profit, and it should not matter to them whether the underlying price was going up or down. That was exactly the argument given to me by a past CFO of Noble Group several years ago.

But, on closer examination, this argument turns out to be illusory. First of all, there is the volume effect. In a downturn, trading volumes decline, leading to a corresponding decline in profits. Even if the trader manages to keep up both volumes and its percentage margin, the total dollar amount earned declines as the underlying price falls.

WITH GREATER AVAILABILITY of information over the years, generating a profit from pure trading has become increasingly difficult. After all, if a trader is just buying and selling commodities, how does he justify a fat margin? In their quest to improve their razor-thin margins, trading firms have to take on some risks: some traders enter politically difficult countries; others take on price risk over time by stocking up on inventory or entering into forward markets.

Either way, higher margins come with higher risk. Hedging may not be available for many commodities or may be very expensive. There is also the temptation to cross the line from using derivatives as hedging instruments to using them as profit generators.

In that sense, a pure trader’s business is by definition a high-volume, low-margin business. Over time, as traders grow bigger, they take on a very different kind of risk in a bid to improve profitability. They start to acquire long-term assets, instead of just trading short-term. Such assets could be related to logistics (such as warehouses) or processing plants to add value to the commodities, but still in line with the underlying trading nature of their business.

As a further step, commodity firms acquire long-term assets, which could be stakes in the source mines or advances to mines against guaranteed offtake contracts. These investments are often justified as guaranteeing access to the commodity. But that argument bears close questioning. After all, the best way to guarantee access to a liquid commodity is to be prepared to pay the market price for it.

This is the evolutionary path that Noble Group took during the 1990s and the 2000s to go from asset-light to asset-heavy.

INVESTMENT IN SUCH long-term assets changes the nature of the trader’s business significantly. Now the trader faces a different set of risks. By investing in the source mines, he has tied up a part of the costs, leaving his margins more vulnerable to a commodity price slump. He has also made his balance sheet asset-heavy and less liquid in a downturn.

Along with the asset-heavy balance sheet, the nature of financing for the trader also changes towards a greater proportion of longer-term debt, which may often be unsecured or secured by the underlying mines. In a down cycle, the long-term assets decline substantially in value, leaving the long-term lenders severely exposed. As the commodity borrowers scramble to sell assets in order to cut leverage, they are confronted with crashing valuations and liquidity for their assets.

Short-term lenders, by contrast, can count on the short-term trading inventory as security and can revalue such assets in the course of the trading cycle with greater frequency. This is not to say that short-term lending to commodity firms, secured by inventory, is free of risks – as last year’s Qingdao warehousing fraud illustrated.

High liquidity, particularly in the form of readily marketable inventory, is supposed to be another credit support for traders. In fact, rating agencies often cite liquidity in the form of such inventory and committed undrawn bank lines as support for their ratings. Therein lies the irony that the three – inventory values, bank lines and credit ratings – are linked to each other. Banks may use inventory values and ratings as inputs in deciding whether to renew the trading lines; and ratings depend on inventory values and bank lines!
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In fact, one of the most difficult challenges in analysing commodity companies is to disaggregate the risks of trading versus long-term investments. As commodity firms grow, their bankers come under increasing pressure to finance all parts of their business. Often they extend loans based on “relationship” reasons or on the basis that they are secured, only to expose their vulnerability in a downturn. As Warren Buffett once said, “Only when the tide goes down do you realise who is swimming naked.”

This is the reproduction of a recent article in IFR Asia.

While the world’s attention was focused on Greece’s negotiations with its lenders, another crazy spectacle was unfolding on the other side of the world. After running up 150% in the 12 months to June 12, the Shanghai stock market plunged by nearly a third in the next month.

There had been no fundamental reasons for the exuberance. China’s economy had in fact been slowing, with GDP growth at 7% in the first two quarters, down from 7.4% for the last year. The property sector, an important contributor to the economy, had also been struggling, with both volumes and prices showing a marked slowdown. Corporate profitability had been squeezed and unofficial estimates of non-performing loans in the Chinese banking system had been rising. The central bank only started cutting rates in November 2014, by which time the rally was already in full swing.

On the contrary, the run-up had been related primarily to a significant flow of financing to the stock market through a variety of channels: margin financing, collateralized lending, shadow financing through trusts, and direct peer-to-peer lending. While the overall value of borrowed funds in the stock market is difficult to judge, some estimates put the value as high as a third of all floating shares.

This diversion of funds could be in part a result of cooling property markets. As the property markets began to cool, the private savings that had been invested in it through shadow-banking channels began to be diverted to lending against stocks, in search of returns in the high teens.

Retail investors got caught up in the frenzy in the late stages of the rally, helping push the markets even higher. According to reports, more than 80 million retail broking accounts were opened towards the end of the rally.

As the market crashed, there was panic all around. Listed firms chose to suspend trading on their shares (nearly 50% of the Shanghai index was suspended at one point), and investors tried to cash out. But regulators panicked too. They organised a coordinated rescue by injecting Rmb120bn, first tightening and then relaxing the rules for margin financing, stopping IPOs, and changing the rules for opening of trading accounts. The central bank also announced another cut in interest rates, and authorities are now looking for foreign funds that might have shorted the market (and have started suspending some trading accounts of foreign fund managers). The stock market then went through several days of further volatility, but the precipitous crash had been arrested.

WHAT IMPACT IS the recent stock volatility likely to leave in its wake – assuming that the worst is indeed over for now? First of all, there is no doubt that faith of the common man in the stock markets has again been shaken, making Chinese investors question the viability of the equity market as a repository for their savings, at least in the medium term.

What China needs in the long run is to develop the equity market as a stable avenue for financing for businesses, particularly private-sector companies and small and medium enterprises. At the end of 2014, China relied on bank credit to finance its private sector to the extent of 142% of GDP, far higher than the ratio of 50% in the US, according to the World Bank. Conversely, China’s stock market capitalization was only 44% of GDP versus 116% in the US in 2012, again on World Bank data.

This reliance on bank credit leads to distortions in the allocation of capital to the most profitable and deserving businesses. Developing domestic stock and bond markets is a key necessity in improving the efficiency of capital. This year’s stock volatility – and another IPO freeze – is a setback in that process.

The government’s actions have also given rise to a version of moral hazard. There is already a persistent belief in the bond markets that the government will rescue troubled companies, leading to mispricing of risk. Last month’s intervention has created a similar belief among equity investors.

Individual investors, who account for a large proportion of equity trading volumes in China, are only likely to have been left with a confused impression of equity as a method of savings.

FOREIGN INVESTORS HAVE also been caught in the maelstrom, with monthly net purchases of mainland stocks under the Shanghai-Hong Kong Stock Connect scheme turning negative in July for the first time since the scheme was launched last November. Investors also found that some of the eligible Chinese stocks had been suspended from trading. In fact, 10 of the SSE 180 index stocks, all of which are eligible for Stock Connect, were still frozen at the time of writing.

In the coming months, we will know if the crash has dented consumer confidence and retail sales, but it is still too early to see the impact on the real economy. For the property sector, on the other hand, the crash may turn out to be a blessing, since savers may turn back to buying property as their preferred saving method. Already, there are mounting signs of stability in the property market, and the stock crash may further help strengthen the sector.

In February this year, US academics published a paper for the National Bureau of Economic Research arguing that “China’s stock market no longer deserves its reputation as a casino”.

The authors measured the ability of market valuations to differentiate between firms that will have high profits in the future from those that will not, concluding that “the informativeness of stock prices about future corporate earnings [in China] has increased steadily, reaching levels that compare favourably with those in the US.”

Had they sought to measure the rationality of the overall market valuation (as opposed to the ability to differentiate between firms), I wonder if they might have reached a rather different conclusion.

This is the reproduction of a recent article in IFR Asia.

Holders of Kaisa’s offshore bonds face an uncertain future after Sunac abandoned its takeover offer for the troubled Chinese­­ property company. While the negotiations rumble on, investors should be paying close attention to the issue of structural subordination in US dollar bonds from Chinese businesses.

In every jurisdiction, whenever a holding company raises debt, it is structurally subordinated to the operating subsidiary’s liabilities. Two of the most important remedies for structural subordination are a guarantee from the operating subsidiary and a charge on the operating company’s assets.

But Chinese holding companies are often incorporated outside China, and when they borrow offshore, the onshore operating companies are not allowed to provide guarantees or pledge their assets as security.

From the early days, nearly 15 years ago, investors have accepted structural subordination in offshore Chinese bonds. Many companies have issued – and have successfully refinanced – offshore bonds. Rating agencies notch down the offshore debt if the onshore debt exceeds a certain level (15%–20% of assets, or 2x Ebitda). And life goes on.

SEVERAL PROBLEMS ARISE from this structure. One issue is that the onshore creditors of the operating subsidiaries get priority in a distressed situation. Onshore debt is often substantial, particularly for Chinese property companies, since they take large construction loans from onshore banks by pledging different properties. That is why several onshore banks have been able to file suits to freeze Kaisa’s assets, while offshore lenders have been left watching powerlessly.

Second, the ability to refinance offshore debt becomes crucial. The offshore issuers are able to pay interest out of dividends from their onshore subsidiaries, but are dependent on refinancing for the repayment of principal, since repatriation of equity funds from onshore subsidiaries requires a lengthy and difficult approval process.

The third problem is that offshore lenders are exposed to subsequent financing decisions, since companies may be able to raise the share of onshore debt in their capital structure and push the offshore lenders deeper into subordination.

Another structure has emerged to allow China-incorporated companies to raise offshore debt without needing the approval of China’s foreign exchange regulator. In this case, the onshore holding company signs a “keepwell” deed, promising to ensure that the offshore SPV that raises the debt will have enough liquidity to service its obligations. It may also sign an equity interest purchase undertaking, promising to purchase some onshore equity interests in order to transfer enough money offshore to pay back the bonds.

However, the robustness of this structure has yet to be tested in practice. Investors’ ability to enforce these agreements is subject to several regulatory approvals from China and hence may fail when the time comes. In any case, claims under these agreements will be subordinated to the onshore company’s secured borrowings.

Last year, China opened a window for onshore companies to provide guarantees or pledge security for offshore debt, but this was subject to a restriction that the funds must be used offshore. Perhaps because of this requirement, there has been a very limited take-up of this structure, even though it is more secure for the offshore investors.

The structural problems assume an added importance when we consider that China has become a much bigger part of Asia’s US dollar bond market. In the closely followed JP Morgan Asia Credit Index, China’s share was in the single digits until 2010, but has soared in the last four years to 34% of all outstanding bonds. In terms of new issues, China’s share used to be 5%–10% between 2005 and 2009, but has since exploded to 55% last year, according to our database. That leaves a large chunk of every investor’s portfolio exposed to the structural subordination issue.

DO WE HAVE any practical means of alleviating these concerns? One useful idea would be to incorporate an offshore reserve account with a portion of the bond proceeds, to cover perhaps six months of interest payments. This would enable a stressed company to continue servicing the bonds without triggering a default, giving an opportunity for potential bidders for the business to emerge. In a situation where competing bidders may raise the recovery value for the bondholders, this period may prove invaluable. We have seen such reserves previously in Indonesian deals: why not bring them to China?

Financial covenants could also be tightened. The terms of offshore bonds usually restrict the amount of onshore debt that can be raised by subsidiaries to 15% of total assets, but the definition of debt often excludes bonds, debentures and other capital-market instruments. This exclusion leaves room for large onshore subsidiaries to raise debt from the onshore bond market, raising the level of subordination for offshore creditors.

Other potential areas for tightening could include the maintenance of a company’s listing status, and the ability to declare default in case the stock is suspended from trading for a prolonged period.

While no lending structure can remedy underlying weakness in the business or corporate-governance failings, investors should not give up on hope of better structures. As long as we are concerned by the structural subordination problems in China, it is time to think about potential solutions, too.