Speaker 1: Hello, Welcome to The Credit Edge, a weekly markets podcast.
Speaker 1: My name is James Crumbie. I'm a senior editor at Bloomberg.
Speaker 1: This week, we're very pleased to have on the show
Speaker 1: Cat Hidalgo, who covers private credit for Bloomberg News in London.
Speaker 1: How are you, Kat, I'm well.
Speaker 2: Thanks so much for having me on, James.
Speaker 1: We're very excited to get your take on the markets.
Speaker 1: Thanks very much for joining. We're also delighted to see
Speaker 1: Andrew Chan, a credit analyst with Bloomberg Intelligence in Hong Kong.
Speaker 1: We'll be coming back to Andrew a bit later in
Speaker 1: the show to talk about the brewing mess in Chinese
Speaker 1: debt markets. So do stay with us. But first, Cat
Speaker 1: Hidalgo with bloom Bloomberg News, You've been all over the
Speaker 1: private debt story. The deals are getting bigger and bigger,
Speaker 1: breaking all records. There's a five point three billion dollar
Speaker 1: loan package in the market right now. At the same time,
Speaker 1: fundraising is ramping up. Oak Tree looking to raise eighteen
Speaker 1: billion dollars for a single private debt fund, which would
Speaker 1: make it the largest ever, and pensions are being urged
Speaker 1: to allocate more to the strategy, which is enjoying what
Speaker 1: Blackstone has called a golden moment. However, we're starting to
Speaker 1: see evidence of growing risk, similar to the signals we've
Speaker 1: been getting from the public bond and loan markets. There
Speaker 1: are risky companies obviously involved in this private credit market,
Speaker 1: and they're borrowing a lot of money where there's a
Speaker 1: lot a lot of transparency or regulation. Rates of sword
Speaker 1: earnings are slowing as recession looms. Some of those borrows
Speaker 1: just can't keep up. What's the situation, cap How bad
Speaker 1: is it out there? When we look at private credit defaults.
Speaker 3: Well, it's a really interesting situation. The problem is that
Speaker 3: we don't really know. It really is a very opaque
Speaker 3: and private market. So we can rely on some surveys
Speaker 3: and a bit of data here and there. For example,
Speaker 3: pros Goauer, which is a law firm, releases a private
Speaker 3: credit default index, and their Q two.
Speaker 2: Iteration, which came out recently.
Speaker 3: Shows that there was actually a decrease in the number
Speaker 3: of defaults, and that's amongst US companies. But that was
Speaker 3: after two consecutive quarters of an increasing rate. Right now
Speaker 3: their default rate is at one point six y four
Speaker 3: sent and so that's in the US, and that is
Speaker 3: still considered quite low. But other than that, we really
Speaker 3: just have to rely on the anecdotes and things like
Speaker 3: the general default rate, which you mentioned is kind of
Speaker 3: ticking up, and these things do indicate that there is
Speaker 3: more stress in the market, but not by an overwhelming sum.
Speaker 3: And there's also a difference between loss rates and default
Speaker 3: so there's a lot of different things happening. What I
Speaker 3: can say is that what we're gathering from the people
Speaker 3: that we speak to, from fund managers and investors in
Speaker 3: those funds, is that there has been a noticeable increase
Speaker 3: in stress, but it's not dramatic or worse than other
Speaker 3: parts in the market. The kind of the typical thing
Speaker 3: that you'll hear from a fund manager is that they'll
Speaker 3: say they're hearing other portfolio struggling, but that their portfolio
Speaker 3: is doing great.
Speaker 4: Right.
Speaker 1: As you mentioned, we just don't know in some cases,
Speaker 1: so it's very difficult to actually measure this stuff, and
Speaker 1: that from markets is problematic. Usually, is there something you
Speaker 1: think that that's you know, we're just not able to
Speaker 1: track that that you know could be worrying. Is there
Speaker 1: something blowing up somewhere that we just can't see.
Speaker 3: I think it's again I mean, it's really difficult to
Speaker 3: say there's a there's a possibility of that, but one
Speaker 3: hopes that most of these funds are small enough and
Speaker 3: the allocations that pension funds and insurance companies have to
Speaker 3: these funds are small enough that if there was to
Speaker 3: be a major blow up, we wouldn't see too much
Speaker 3: systemic risk.
Speaker 2: But you know, we're keeping our eyes out for it.
Speaker 3: And and I don't I don't want to call out
Speaker 3: and say that I'm sure there's nothing nothing huge or
Speaker 3: wrong in the market. It's something that we're following very closely.
Speaker 1: So based on what we can see and what we
Speaker 1: can measure, what kinds of companies are struggling at the moment,
Speaker 1: and why are they struggling now.
Speaker 3: So I think one interesting area is actually that businesses
Speaker 3: that suffered in COVID are falling out of favor. Of course,
Speaker 3: they just can't handle the amount of stress that they've
Speaker 3: had over such a long period of time, but also
Speaker 3: that businesses that might have done really well in COVID,
Speaker 3: that kind of really enjoyed those tailwinds that they saw
Speaker 3: out of COVID are now no longer enjoying them and
Speaker 3: struggling as a result. I think also the other trend
Speaker 3: to watch out for is that you're also more likely
Speaker 3: to see assets that have been held onto for a
Speaker 3: long time by their private equity firm that probably should
Speaker 3: have been sold off previously and been able to refinance
Speaker 3: their debt, but because of the slowdown in M and
Speaker 3: A and refinancing, because of higher interest rates, they no
Speaker 3: longer have access to those lifelines. So it's those kind
Speaker 3: of older businesses.
Speaker 1: Are they in any particular sector and are they particularly
Speaker 1: kinds of businesses that we've we're more focused on, are
Speaker 1: they I mean the ones that did well in COVID
Speaker 1: are the ones that we were using because we were
Speaker 1: all locked in our house and we couldn't get out.
Speaker 1: But what kinds of When we talk about the kinds
Speaker 1: of company, what sectors are they and what kind of
Speaker 1: businesses are they?
Speaker 3: So there's the usual suspects. We've retail businesses, the obvious ones,
Speaker 3: things like casual dining. But what's interesting about private credit
Speaker 3: is that they really don't focus on those on those sectors.
Speaker 3: You know, we've got the odd specialized fund and the
Speaker 3: odd investment in most funds, but typically a private credit
Speaker 3: fund will focus on things like technology and healthcare, which
Speaker 3: is why I thought that this one example that we
Speaker 3: tracked down of a business being taken over by its lender.
Speaker 3: It's called Enva, it's a care home or operator in Germany.
Speaker 3: I thought this one was really interesting because people have
Speaker 3: written ad nauseum about how bets in the healthcare space
Speaker 3: could go billy up, But it would be actually really
Speaker 3: detrimental to see a whole sale shift in the credit
Speaker 3: quality of healthcare businesses on the private credit industry, just
Speaker 3: because they're so exposed.
Speaker 2: After technology.
Speaker 3: It's the biggest area of focus for private credit funds,
Speaker 3: and we know that sector is getting squeezed by labor
Speaker 3: inflation and regulation. We've just got to see what happens
Speaker 3: there and see if it becomes a wider vider trend,
Speaker 3: because we've really only seen of this one example, maybe
Speaker 3: a couple of others in the past, but it would
Speaker 3: have a very interesting impact if that became more serious.
Speaker 3: I guess the country to focus on is that we've
Speaker 3: noticed the larger concentration of depth F equity swaps in Germany,
Speaker 3: but we haven't yet been able to discern if that's
Speaker 3: because the situation is generally worse out there, or there
Speaker 3: are specific dynamics there, or if it has to do
Speaker 3: with technical factors in the market, kind of surrounding reporting
Speaker 3: that allow us to actually pick them up more more
Speaker 3: easily than we could elsewhere. Obviously, PMI came out yesterday
Speaker 3: with really bad numbers for the sector in manufacturing sector
Speaker 3: in Germany, and there was a recession recently there, So
Speaker 3: it kind of could be either factor.
Speaker 1: One thing that jumps out there when you're talking debt
Speaker 1: for equity swaps, what is that? Why are we talking
Speaker 1: about that in this context?
Speaker 3: So debt for equity stops is a kind of a
Speaker 3: method of last resort for a private credit fund. They've
Speaker 3: got all of these leaders that they can pull when
Speaker 3: a portfolio company is under stress. But the final thing
Speaker 3: that they'll do is they'll have a conversation with the
Speaker 3: private equity sponsor.
Speaker 2: The sponsor will.
Speaker 3: Say, we're not willing to put any more money into
Speaker 3: this business, so we're going to hand over the keys
Speaker 3: to you, and you can exchange all of the debt
Speaker 3: that you're owed into equity and now you private credit
Speaker 3: fund are the sole of this business. And we wrote
Speaker 3: my colleague and I Silas Brown wrote a piece about
Speaker 3: seeing a couple a few more examples of this happening,
Speaker 3: and it's an indicator of serious stress in the market.
Speaker 2: So that's why we're talking about this.
Speaker 1: So the debt side, that's when a private lender will
Speaker 1: give money to a private company in a bilateral sense,
Speaker 1: almost like privately negotiated deal that is alone, but because
Speaker 1: this company can't pay the money, but they end up
Speaker 1: just owning the company exactly.
Speaker 3: Yeah, it doesn't necessarily happen on a bilateral basis every time.
Speaker 3: Sometimes you've got maybe three lenders, which is what happened
Speaker 3: in a case called Unza in Germany recently. But yeah,
Speaker 3: that's pretty much the principle.
Speaker 1: That's the idea a bank or a lender, they don't
Speaker 1: generally want to own a business. They don't want to
Speaker 1: operate a healthcare company or a retail company or a
Speaker 1: fine dining establishment. What happens in this case, I mean,
Speaker 1: do they just suddenly shift their business model or what
Speaker 1: do they do with the assets?
Speaker 2: It's a really interesting area.
Speaker 3: Can I give you a bit of context on this actually,
Speaker 3: just to kind of flesh out my answer, So we
Speaker 3: could do a whole podcast just on the.
Speaker 2: Dynamics of these arrangements.
Speaker 3: But what's interesting to me is that there's this narrative
Speaker 3: emerging when we speak to direct lenders and private credit
Speaker 3: for managers that it's not necessarily bad to have a
Speaker 3: debt for equity swap. That because you know, the fund
Speaker 3: is now the equity owners of a business that has
Speaker 3: no debt because it's all been shifted into equity. There's
Speaker 3: huge potential for upside, much more so than when you
Speaker 3: were just debt holders with an expected yeald. The flip
Speaker 3: side of that, of course, is that you know, this
Speaker 3: is not what private debt funds were created for. Kind
Speaker 3: of to answer your question, many of them aren't equipped
Speaker 3: to deal with a large number of restructuring And while
Speaker 3: there is that potential for upside that's being talked about
Speaker 3: more and more, there is huge potential for downside. They
Speaker 3: could lose their entire investment, and most funds wouldn't be
Speaker 3: able to make a profit if they had even two
Speaker 3: or three situations where they couldn't recover their money. The
Speaker 3: entire fund would not make a profit if that happened.
Speaker 3: But you know, it depends on the fund, and there's
Speaker 3: a huge amount of variation on this topic. Typically larger
Speaker 3: funds have a more substantial restructuring or workout department. We've
Speaker 3: definitely seen some major funds hiring more and more in
Speaker 3: this field recently. I can't speak to whether they actively
Speaker 3: want to own these funds. No one's ever said that
Speaker 3: to me. You know, I actively want to own these
Speaker 3: portfolio companies, but we sorry not funds portfolio companies. But
Speaker 3: we do know that some of these larger funds have
Speaker 3: taken over the keys to more and more businesses, and
Speaker 3: they are this idea about their being potential for upside
Speaker 3: is is kind of on their radar. Smaller funds would
Speaker 3: struggle more in the area. But I think what the
Speaker 3: final thing that I'll say on this is that at
Speaker 3: the end of the day, big or small, these funds
Speaker 3: were not made to own and operate the companies that
Speaker 3: they lend to. That's not what was pitched to investors,
Speaker 3: and it offers a completely different risk profile, much closer
Speaker 3: to something like a special situation sund But.
Speaker 1: It's interesting in that, you know, they're on the one side,
Speaker 1: they're lending this money at very high rates, they're making
Speaker 1: a good return there, and then when things go bad,
Speaker 1: they're actually you know, potentially making even more money because
Speaker 1: they're becoming equity owners. So so sort of win win situation.
Speaker 1: But at the same time, I mean I do worry
Speaker 1: because you know, we see this all the time in
Speaker 1: the public markets. There is a you know, the risk
Speaker 1: of complete wipeout in some of these firms, right, I mean,
Speaker 1: you must have to risk losing all your money.
Speaker 3: Absolutely, that's that's that's completely the case. And I think
Speaker 3: we're in private equity funds, you've got the potential for
Speaker 3: huge upside on every one of your investments, and you
Speaker 3: only need a couple of winners, of big winners to
Speaker 3: make the whole fund profit overall. But that's just not
Speaker 3: the case in private credit funds. That's not the way
Speaker 3: that the dynamics work. And so if you do, if
Speaker 3: you do not recover any of your money on a
Speaker 3: few investments, it can be really detrimental to the returns
Speaker 3: of the entire fund.
Speaker 1: So looking back to where we started this conversation, you know,
Speaker 1: there are more defaults, We are seeing more problems in
Speaker 1: private credit. What is the outlook for more of this?
Speaker 1: You know, do we expect a big default wave to happen?
Speaker 3: Right, So that we've mentioned we've mentioned that the bulk
Speaker 3: of these deals are done the laterally. I think you
Speaker 3: said that, but you know so, So a direct lending
Speaker 3: fund might be the only lender to a company. So
Speaker 3: when we talk about a big wave of defaults, we
Speaker 3: have to contextualize that in the relationship aspect of these funds,
Speaker 3: they really kind of focus on their relationship based culture.
Speaker 3: They talk about how that's very much in place, and
Speaker 3: so what this means is that they pride themselves on
Speaker 3: their ability to negotiate and provide flexibility to borrowers. So
Speaker 3: a wave of defaults will always be tempered by the
Speaker 3: funds trying to manage these situations more so.
Speaker 2: Than a bankuard, for example.
Speaker 3: So market participants have told us that this could be
Speaker 3: a factor and why we've seen so few defaults in
Speaker 3: the space so far. But just to give you an
Speaker 3: idea of what these funds can do there, they can
Speaker 3: wave covenants, they can extend maturity, they can negotiate with
Speaker 3: sponsors to provide more equity. As we said, they can
Speaker 3: take keys to the business without it being public or
Speaker 3: calling it a default. So the possibility for a huge
Speaker 3: wave of defaults is definitely tempered by that. What would
Speaker 3: really trigger wave would be a shift in risk appetite
Speaker 3: for these funds where they were no longer willing to
Speaker 3: kind of provide that flexibility. They were more keen to
Speaker 3: kind of crack the whip and be more stringent about
Speaker 3: terms and conditions. And then, of course these companies, we
Speaker 3: can't forget are in the real economy, and if we
Speaker 3: had an overall macroeconomic decline, that could push many of
Speaker 3: these businesses over the edge.
Speaker 1: So it's more like getting a loan from my friend
Speaker 1: rather than having to go and beg the manager of
Speaker 1: Buckley's Bank to better terms and a few more days
Speaker 1: to pay my loan.
Speaker 2: Is that right?
Speaker 3: They might not be quite as nice as your friend,
Speaker 3: but that's definitely kind of the idea that they're going for.
Speaker 2: Yeah.
Speaker 1: Interesting, Okay, So it's still fairly new market though private crediting.
Speaker 1: It's seen such a boom, as we've discussed over the
Speaker 1: last few years, but it's still fairly new. How does
Speaker 1: the current default situation compare to history in terms of
Speaker 1: the level of worry out there right now?
Speaker 2: It's interesting. Again, we do have very little data to
Speaker 2: go off.
Speaker 3: We really can only talk about what we see in
Speaker 3: surveys and anecdotes. Another prosaur report from April showed that
Speaker 3: one hundred and fourteen out of one hundred and fifty
Speaker 3: private credit executive surveyed they expected the faults to rise
Speaker 3: in their portfolios in the next year, which is the
Speaker 3: highest level in the past five years from the survey.
Speaker 3: But that's kind of what makes this phenomenon so interesting
Speaker 3: is that private credit has never been for a proper
Speaker 3: recession before. This is this is uncharted territory. We can't
Speaker 3: we can't really say. I mean, we definitely know that
Speaker 3: we're seeing more defrequity swaps than ever before, more defaults
Speaker 3: than ever before. So and certainly it feels like people
Speaker 3: are worried. This is something that most people that you
Speaker 3: speak to bring up, and it's it's something that people
Speaker 3: watching closely.
Speaker 1: So before we talk to Andrew Chann at Bloomberg Intelligence,
Speaker 1: how do we reconcile that with all the fundraising, all
Speaker 1: of the billions in dry powder being raised for the strategy,
Speaker 1: and the ever increasing scale of some of the loans
Speaker 1: that are getting done.
Speaker 2: Yeah, that's a really interesting question.
Speaker 3: Does feel like a paradox, doesn't it, But the two
Speaker 3: aren't actually mutually exclusive. So yes, private credit is raking
Speaker 3: in records terms of dry powder, especially in Europe. But
Speaker 3: the data shows that more money is going to fewer funds,
Speaker 3: So that kind of implies that investors are plowing money
Speaker 3: into a select few of.
Speaker 2: The largest funds. So this would show that.
Speaker 3: There is a fear among these investors, these pension funds,
Speaker 3: these insurance companies that invest in private debt, but that
Speaker 3: they are they do believe in the asset class, they're
Speaker 3: just a bit more wary of it now, so they're
Speaker 3: more wary of the smaller firms that they would suspect
Speaker 3: would be more susceptible to the fullests that had smaller
Speaker 3: restructuring teams that are less equipped to deal with stress.
Speaker 3: And I think the larger loans are a symptom of
Speaker 3: the same trend. The funds are fearful of stress and
Speaker 3: are relying on larger companies investing more in them because
Speaker 3: they see those as as safer option. So that's kind
Speaker 3: of how I see it in my head. Does that
Speaker 3: make sense, James to you?
Speaker 1: Absolutely yes, We'll look forward to reading more of your
Speaker 1: analysis and coverage. Thank you so much. Kat Hidelgo from
Speaker 1: Bloomberg News and of course to listeners read all of
Speaker 1: Kat's scoops on the Bloomberg terminal and at Bloomberg dot com.
Speaker 2: So you're going soon, Kat, Thank you, James.
Speaker 1: Moving on to another big topic. As I mentioned earlier,
Speaker 1: we're very fortunate to have with us Andrew Chan, who
Speaker 1: covers credit for Bloomberg Intelligence based in Hong Kong. How's
Speaker 1: it going over there, Andrew.
Speaker 4: Great, Well, I guess like exciting for a SOLS.
Speaker 1: So there's a ton of anxiety right now in markets
Speaker 1: about the state of China's economy, which has a significant
Speaker 1: repercussion for everyone else in the world. The eighteen trillion
Speaker 1: dollar economy is decelerating, the property crisis is deepening, consumers
Speaker 1: seem very beat, exports as struggling, and more than one
Speaker 1: in five young people are out of work. And as
Speaker 1: we talked about last week on this show, Country Garden,
Speaker 1: a company with about three thousand pending property projects up
Speaker 1: and down China, is on the cusp of default on
Speaker 1: its debt. And also at the same time, protesters gathered
Speaker 1: at one of the biggest shadow banks demanding their money
Speaker 1: back as payments were halted. So a lot of issues
Speaker 1: you know across China right now. You know great to
Speaker 1: have you on the show, as you know, as an
Speaker 1: expert based there, and we've we've we've been looking at
Speaker 1: this from different angles on this podcast. But but we
Speaker 1: want to drill down a little bit now into what
Speaker 1: we're calling local government financing vehicles, which is another part
Speaker 1: of this sprawling debt mess you know in China. Can
Speaker 1: you start, Andrew by telling us what these entities are?
Speaker 1: You know, what is what we're calling an lg FV
Speaker 1: and how do they work?
Speaker 4: Yeah? So, right now, the LGFE definition is pretty blurred
Speaker 4: because a lot of these entities they used to provide
Speaker 4: some sort of public service or build some type of
Speaker 4: infrastructure for the local government. But once that purpose was finished,
Speaker 4: I mean, its existence was in doubt, and many evolved
Speaker 4: by foraying into like other businesses, some profit orient mostly
Speaker 4: profit oriented, but they largely still remain in an extension
Speaker 4: of the local government.
Speaker 1: So just but in basic terms, they are entities that
Speaker 1: are phoned to fund infrastructure, schools, that sort of thing
Speaker 1: in China, Is that right?
Speaker 4: Yes, that's correct, not necessarily a school, but definitely like
Speaker 4: public services.
Speaker 1: Okay, so why do they have to set these vehicles up?
Speaker 1: Like don't they just borrow money directly.
Speaker 4: Ah, So say, for example, like I want to build
Speaker 4: a subway, and so they would set up like a
Speaker 4: subway LGFE, so to say, And so it's like somewhat
Speaker 4: run like more on co marcial terms rather than being
Speaker 4: built say by the local government.
Speaker 1: Okay, but who is responsible for that debt?
Speaker 4: Then?
Speaker 1: If you if you're burrowing through through a special purpose
Speaker 1: vehicle like this is, does that mean that you're you know,
Speaker 1: kind of distancing yourself from the ultimately from repaying that debt.
Speaker 4: So the debt is definitely belongs to the LGF, which
Speaker 4: again is an extension of the government, and a lot
Speaker 4: of the lenders that lend to the LGF, whether it's
Speaker 4: like say through offshore notes, on shore notes, or through
Speaker 4: bank lending, they understand that there's some sort of implicit
Speaker 4: government support to this SPV so so to say, or LGFF.
Speaker 1: Okay, And by government you're meaning you're meaning the federal government,
Speaker 1: not not the local or the state government, right, Oh no,
Speaker 1: the local government okay. Okay, So it doesn't necessarily roll
Speaker 1: up to the federal level.
Speaker 4: No, not to the central government level.
Speaker 2: Okay.
Speaker 1: So just to like put this in perspective, I mean,
Speaker 1: it's a we're hearing huge numbers. How much debt do
Speaker 1: they actually have?
Speaker 4: Okay, So using the termino, we actually use the bottom
Speaker 4: up approach to estimate this China LGF debt, which could
Speaker 4: be around like nine point eight trillion US dollars based
Speaker 4: on the latest available financial data of more than three
Speaker 4: thousand lgfs.
Speaker 1: So to put that in perspective, Andrew, how much debt
Speaker 1: are we talking about here?
Speaker 4: Yeah, So using the terminal, we use a bottom up
Speaker 4: approach to estimate China's LGFF debt which could be around
Speaker 4: nine point eight trillion US dollars based on the latest
Speaker 4: available financial data for more than three thousand lgfs and
Speaker 4: local soees. Now, looking at the overall financing structure, around
Speaker 4: seventy percent of this is funded by financing other than bonds,
Speaker 4: such as bank loans, while around twenty nine percent is
Speaker 4: onshore bonds and another one percent are offshore bonds of
Speaker 4: around one hundred billion US dollars.
Speaker 1: So this is a lot of it is actually sitting
Speaker 1: with foreign investments, is that right?
Speaker 4: Not as much so one percent of their total loans
Speaker 4: or so? Okay, And so the remaining ninety nine percent
Speaker 4: is on shore bank loans or onshore bonds.
Speaker 1: Okay, so mostly held by should I mean is it
Speaker 1: mostly Chinese banks that are that are holding this debt? Yes,
Speaker 1: it is, and then most of those banks actually stay
Speaker 1: owned a majority okay, yes, interesting, So the anxiety has
Speaker 1: been around a default by one of these local government
Speaker 1: financing vehicles. What other chances of that happening and what
Speaker 1: would what would that mean for China?
Speaker 4: Yeah, so I think your question can be rephrased to like,
Speaker 4: what type of debt are we talking about that is
Speaker 4: to be defaulted?
Speaker 3: Now?
Speaker 4: In our view, no LGF wants to be the first
Speaker 4: to default on its offshore or on shore notes. I mean,
Speaker 4: considering the relatively small offshore amount and small proportion in
Speaker 4: their total death structure. I mean, there could be very
Speaker 4: low incentive for lgf's to default because should there be
Speaker 4: a default of a high profile LGF, I mean, investors
Speaker 4: would likely reassess China's SOE and LGF issuing universe on
Speaker 4: a standalone basis without state support. I mean that could
Speaker 4: create a lot of unintended consequences, mainly because there would
Speaker 4: be substance a huge, substantial repricing in risk and subsequent
Speaker 4: refining refinancing risks for not only offshore but likely onshore too.
Speaker 4: I mean, that could lead to a lot of rating downgrades,
Speaker 4: which could transpire to, in a worst case scenario, systemic
Speaker 4: risk for the financial system. I mean, right now we
Speaker 4: calculate around twenty trillion US dollars equivalent of outstanding bonds
Speaker 4: could suffer from some form of repricing risks because a
Speaker 4: lot of investors really when they price these state owned
Speaker 4: bonds or state affiliated bonds, they factor in a form
Speaker 4: of state support.
Speaker 1: Okay, and what right now do you think is the
Speaker 1: probability of one of those government financing vehicles defaulting?
Speaker 2: Is it?
Speaker 1: Is it a high likelihood or is it very very small?
Speaker 2: Do you think?
Speaker 4: Uh, very small for the time being. And it goes
Speaker 4: back to the point that no one wants to be
Speaker 4: the first one because obviously these local governments they have,
Speaker 4: they operate independently, and so if say one province defaults,
Speaker 4: then that pretty much spills over to a read across
Speaker 4: to all the all the other provinces as well because
Speaker 4: of the reassessment of state support. That's why in the
Speaker 4: past actually earlier this year, we saw one example. It
Speaker 4: was called Junyi Road and Bridge Construction in Gueijo Province,
Speaker 4: which is one of the poorest provinces in China. I
Speaker 4: mean they abruptly restructured, and a lot of the debt
Speaker 4: was actually restructured on the bank loan side. But if
Speaker 4: you look at say they're onshore bonds and their offshore bonds,
Speaker 4: they remain close to par.
Speaker 1: Okay okay.
Speaker 4: And of course if we look at say some of
Speaker 4: the old if you've been following the sector, you might
Speaker 4: recall some names such as chun Ching Energy, Beijing, High
Speaker 4: End State owned Assets, Investment in UNN, Health and Culture.
Speaker 4: I mean all of them had offshore dollar notes, and
Speaker 4: despite all of the tight liquidity and the very volatile
Speaker 4: bond prices, a lot of them, I mean all of
Speaker 4: them actually repaid their offshore dollar debt without issuing new
Speaker 4: dollar debts. So the local government came out step, stepped
Speaker 4: up and helped them, and in particular, one notable example
Speaker 4: is chum Ching Energy, which actually repaid all outstanding on
Speaker 4: shore and offshore bonds before filing for bankruptcy.
Speaker 2: Okay.
Speaker 4: So that shows you, like the importance of any local
Speaker 4: government to not be the first to default on a
Speaker 4: public note.
Speaker 1: Obviously that it want to, but they might ultimately be
Speaker 1: forced to because of maturity walls or you know, lack
Speaker 1: of liquidity or whatever. I mean, what can the actually
Speaker 1: what can the government to prevent this happening? How can
Speaker 1: they help out here?
Speaker 4: Yes, and so I think the key backstop will be
Speaker 4: the state owned banks, and so they've done most of
Speaker 4: the lending for it, and so, of course the exact
Speaker 4: answer to this question like how much bad loan losses
Speaker 4: can China's banking system absorb, that's for another podcast and
Speaker 4: for the banking team. But again, if we look at
Speaker 4: say the overall picture, the total assets of FI in
Speaker 4: China according to the China Banking and Insurance Commission, I mean,
Speaker 4: is around fifty seven trillion US dollars, with shareholder funds
Speaker 4: of close to five trillion dollars. So again, depending on
Speaker 4: your own NPL assumption, I mean, there appears to be
Speaker 4: a decent capital buffer. Now, of course, the banks would
Speaker 4: likely need to raise additional capital somewhere somehow, but again
Speaker 4: that's another question for the banking experts. But the key
Speaker 4: point remains, and that is the banks can act as
Speaker 4: a temporary backstop. Should lgfs need to urgentily structure their loans,
Speaker 4: of course, such actions will need to be coordinated by
Speaker 4: the local and central government.
Speaker 1: Do we expect losses to those banks? I mean, is
Speaker 1: there going to be a haircut on that debt?
Speaker 4: There will likely be a haircut for that. And so
Speaker 4: it depends on how the banks classified these loans. And
Speaker 4: so say, for example, the Jini example I just gave out,
Speaker 4: it's been restructured, and the principle everything has been extended
Speaker 4: by another twenty years now that can be may not
Speaker 4: necessarily be considered a bad loan in Chinese accounting, so
Speaker 4: to say. And so as long as the LGFE continues
Speaker 4: to pay their interests, I mean, it's considered a performing loan.
Speaker 1: What analogies can we drove between this and the property
Speaker 1: crisis in the sense that, you know, the Chinese government
Speaker 1: right now doesn't seem to be doing much to support
Speaker 1: the property developers, and in fact, it seems that the company's
Speaker 1: party doesn't really you know, want to support them to
Speaker 1: the extent that they want to, you know, bail out.
Speaker 1: You know, there's a moral hazard issue. They didn't want
Speaker 1: to bail out excesses that have gone on in the
Speaker 1: in the real estate market. Is it the similar situation
Speaker 1: for the local government financing vehicles?
Speaker 4: Is it a similar situation? I guess that question is
Speaker 4: more is more interconnected? And now why I say that
Speaker 4: is because if the central government is not helping out
Speaker 4: the property developers and they end up defaulting, I mean,
Speaker 4: I think that sends the wrong message to the entire sector,
Speaker 4: and so pretty much all the home buyers will will
Speaker 4: likely shun future home purchases of state owned developers and
Speaker 4: non state owned developers, and so that will have a
Speaker 4: trickle down effect, which is the property developers they won't
Speaker 4: be buying land from the local government. The local government
Speaker 4: won't have any money to provide support to the lgfs.
Speaker 4: So I mean a lot of this is really hinged
Speaker 4: upon the central government's decision to allow a big player
Speaker 4: like Country Garden to default, And to me, I think
Speaker 4: it just really sends the wrong message because this vicious
Speaker 4: cycle will just not be broken until something substantial comes
Speaker 4: out from the central government. So again, home buyers aren't buying,
Speaker 4: developers aren't buying land. Local governments become poor, they can't
Speaker 4: support their local government lgfe's and again that's the house
Speaker 4: of cards there we're talking about.
Speaker 1: So ultimately, do you think this ends with government bailing
Speaker 1: everyone else and everything just you know, coming back to
Speaker 1: normal again.
Speaker 4: It will be very difficult. And now I say that
Speaker 4: is mainly because looking at Evergraham, which defaulted two years
Speaker 4: ago already, I mean, this messis continues to drag on.
Speaker 4: So I think they're in my opinion, there may have
Speaker 4: been some bureaucratic miss and hopefully the Chinese government can
Speaker 4: try to reverse this, so to say, because the property
Speaker 4: sector has just been dragging everything down, and if you
Speaker 4: look at say the second order, third order effect coming
Speaker 4: from it, I mean, property accounts for a quarter of
Speaker 4: GDP and if that's dropping, you can't meet your five
Speaker 4: percent target. You're starting to see rising unemployment in the sector,
Speaker 4: not only on the terties on the property level, but
Speaker 4: all the ancillary sectors as well. So it can be
Speaker 4: your cement, your white goods, electronics, and so a lot
Speaker 4: of bad debt will start to pile on the supplier side,
Speaker 4: construction companies with razor razor thin margins, and of course
Speaker 4: you have the declining housing prices which will lead to
Speaker 4: negative wealth effect again, which isn't good, and so everything
Speaker 4: is really hinged upon the central government's actions.
Speaker 1: Now, okay, obviously there's going to be many different parts
Speaker 1: of this and it's going to be, you know, a
Speaker 1: long drama to come. But right now, what are the
Speaker 1: key takeaways for investors?
Speaker 2: Do you think? Andrew?
Speaker 4: The key takeaway for investors. I think the first one
Speaker 4: is that the China high yield sector is unfortunately close
Speaker 4: to uninvestable, as we've seen with the property crisis saga,
Speaker 4: because I don't think we've ever seen a sector be
Speaker 4: decimated in such a way that there are over one
Speaker 4: hundred billion US dollars in investor losses and over two
Speaker 4: hundred something bonds are below ten cents, which pretty much
Speaker 4: assumes very very pessimistic recovery expectations. That's one, and then
Speaker 4: I guess on the second front is that if there
Speaker 4: are r V opportunities on the LGF side, and it
Speaker 4: goes back to our our thinking is that the lgffs,
Speaker 4: no matter what, needs to be saved because one, the
Speaker 4: toll I'm not outstanding on the offshore notes is very
Speaker 4: small in the grand picture. And second of all is
Speaker 4: that a lot of these lgfes are pricing to be
Speaker 4: rather distressed as somewhat over fifteen percent, and so on
Speaker 4: that front over there, there could be r V opportunities
Speaker 4: over there if our thesis is correct that the lgfe's
Speaker 4: will be saved.
Speaker 1: V as in relative value. Yes, okay, So just to
Speaker 1: wrap things up, what's the next big thing to watch?
Speaker 1: I mean, we're looking right now at the country God
Speaker 1: and Grace period everyone's worried about to fill. There are
Speaker 1: there any sort of triggers or any events that you
Speaker 1: think we should be looking out for in terms of,
Speaker 1: you know, the calendar coming up.
Speaker 4: Two things, I guess the first thing would be definitely
Speaker 4: like how the Chinese government is plans to deal with this,
Speaker 4: because obviously there's a spillover effect not just domestically but
Speaker 4: internationally as well. Their demand for commodities will likely be
Speaker 4: adversely affected. All your geopolitical goals such as China's One Belt,
Speaker 4: One Road initiative may definitely slow down on that front.
Speaker 4: That's more of the macro picture on the company and
Speaker 4: sector wise basis. I think a lot of investors will
Speaker 4: start to focus on the remaining survivors and even the
Speaker 4: SOOE developers because again with the country Garden debaco, I mean,
Speaker 4: it seems like no one is safe. And so those
Speaker 4: state owned developers, a lot of them still have bond
Speaker 4: prices in the eighty cents ninety cents levels, and so
Speaker 4: if one of them starts to become a bit shaky,
Speaker 4: I think that would really put the nail in the
Speaker 4: coffin for the entire sector.
Speaker 1: Thanks very much, Andrew Chan of Bloomberg Intelligence. You can
Speaker 1: read all of his great analysis on the Bloomberg Terminal.
Speaker 1: Do check it out and hope see you soon on
Speaker 1: the show again, Andrew.
Speaker 4: Thank you very much, James, and thanks.
Speaker 1: Again to Cat Hidelgo from Bloomberg. Yous read all of
Speaker 1: her great credit scoops on the Terminal and at Bloomberg
Speaker 1: dot com. I'm James Crombie. It's been a pleasure having
Speaker 1: you join us again next week on the Credit Edge.