



Asia Pacific Equity Research		05 March 2014
China Banks The first corporate bond defaults...short-term pain vs long-term gain

Shanghai Chaori Solar Energy Science and Technology Co Ltd (Chaori) announced on late Tuesday that it would not be able to pay the obliged RMB89.8 mn interest on its "Chaori-11 bond". This is the first default in China’s bond market since the first corporate bond issuance in 1983. We believe this could be positive in the long term, as the “allowed” default is the first step towards building a meaningful credit spread in China; and an improvement on the sense of investment risks for both financial institutions and investors (general public) might reduce the moral hazard issue. However, the default case intensifies concerns on assets quality, particularly on shadow banking loans, which has been the key financing source for over-capacity industries in the past three years. And banks may have implicit guarantee on some of these shadow banking products (WMP and trusts). We expect to hear of more default cases from both the bond market and shadow banking products in 2014; this could increase the volatility of bank shares.

What happened? Chaori announced default on bond interest payment, a few facts:

· The 5-year "Chaori-11 bond" was issued in March 2012 with total amount of RMB1 bn. Coupon rate of 8.98%. The company is obliged to pay RMB89.8 mn interest on 7 March 2014 but is only able to pay RMB4 mn, according to the announcement.

· Chaori’s announced default is not really “news”, as the company has warned of possible default on bond payments multiple times since November 2013 (latest warning on 26 February 2014).

· Chaori’s credit rating was AA by Pengyuan Credit Rating upon issuance. The rating was downgraded to AA- in January 2013, subsequently downgraded to BBB+ in February 2013 and further downgraded to CCC May 2013.

Background of Chaori:

· A company in an over-capacity industry: This is a privately-owned company with a principal business in the manufacturing of solar energy products, including solar module, solar cells and solar lights.

· Negative equity and EBITDA in 2013: Total assets size was RMB6.2 bn at end 2013, and its equity was negative RMB209 mn due to net loss of RMB1.3 bn in 2013.

· Key ratios: Gearing ratio (debt / equity) was 3.3x at end 2012, and interest coverage ratio was -3.5x in 2012. ROAA was -19.3 % and -22.7% in 2013 and 2012, respectively. Aside from this bond, the total debt outstanding is RMB2.7 bn bank loans. Principal bankers include ABC, China Development Bank and Cathay Bank.

Near-term implication is negative: rising concerns on defaults from shadow banking loans

· Chaori’s default on interest payment raises concern on the debt-servicing ability of China’s corporate borrowers, particularly those in over-capacity industries, which include manufacturing of polycrystalline silicon (solar energy), glasses, wind power equipment, metal cement and coal mining.

· Asset quality concern on investment and loan book of banks: Total corporate and enterprises bond outstanding at 2013 was RMB4.4 trn, equivalent to 4.2% of total banking deposits, and banks are key holders of corporate and enterprises bonds in China. We estimate total loan exposure to overcapacity industries is low single-digit to listed banks.

· Defaults and re-financing risks of shadow banking products are the key concern: We believe companies in over-capacity industries are key borrowers from shadow banking, as banks have started curbing new lending to these sectors from 2010 following the CBRC’s guideline. Therefore, we believe the concern on asset quality is mainly on banks’ off-balance sheet books, including non-standard credit assets (NSCAs) invested in over-capacity industries through banks’ wealth management products (WMPs) or trusts products facilitated or distributed by banks. As these off-balance sheet assets could be de-facto liabilities for banks due to implicit guarantee, investors are concerned that banks might experience some losses when the WMP/trusts products default. In addition, there is a lack of transparency and liquidity on shadow banking assets, making it difficult for the market to quantify the potential losses by banks. Thus, we believe the default news will have a negative impact on banks’ share prices in the near-term. (For detailed analysis on how much NPLs could increase if banks need to take up some shadow banking credits on balance sheets, please refer to China Banks: Out of the frying pan, but not into the fire...YET dated 9 February 2014.

Long-term implication could be positive: the first step to build a meaningful credit spread

· The first “allowed” default – is the government trying to address the moral hazard issue? Likely, yes! According to Reuters, Chaori avoided a default in January 2013, after the local government in Shanghai persuaded banks to defer claims in overdue loans, in order to ease cashflow pressure on Chaori, resulting in the timely interest payment on the bond. We believe the “allowed” default may result from lack of government interference on the issue this time, even though it is amid the National People’s Congress. This may be a signal that the government would like to reduce the moral hazard risks by “allowing” a default to happen. And the legal process and liquidation procedures following the defaults could provide a precedent or reference for other potential default cases to follow.

· First default could be a milestone for China to reform its bond market: Over the past 30 years, even during the SOE reforms in the late 1990s when banks’ NPL ratio reached 20%+, there has never been any default on corporate bonds. This means that the credit spread became less meaningful and credit risks could be mis-priced. For example, of the 3,398 corporate bonds and enterprises bonds outstanding in China at end 2013, 22.9% have AAA rating, 77.0% have AA rating, only 0.1% have A+ rating or below (table 2), and the difference between average coupon rates of AAA bond and CCC bond is less than 400bps. We believe that defaults can entail the re-examination of the credit spread assumptions by both rating agencies and fixed income investors, and eventually constitute a better risk-reward pricing mechanism.

· Increased sense of investment risks for WMP/trusts buyers: Although the default is on corporate bonds, this will alert some WMP/trusts investors on investment risks on such products. We believe this could be an effective measure to tame growth in the shadow banking products. A reduction of investments in WMP/trust products could also intensify the re-financing risks of shadow banking products in the near term.

· We believe that improving risk pricing by both financial institutions and general public (investors) could be the first step towards building a meaningful corporate bond market in China, which could provide solution to the shadow banking issue in China and release banks from the “liability” of implicit guarantee. Although, a lot more needs to be done by the government before we can see a functional corporate bond market.

Table 1: Key financials of Chaori Solar

RMB mn	2012	2013
Assets	7,576	6,192
Total debt	3,723	NA
Short-term borrowings	1,872	NA
Long-term borrowings	863	NA
Bonds payable	987	NA
Equity	1,112	-209

Revenue	1,638	685
EBITDA	-764	NA
Net profit	-1,676	-1,331

ROAA	-22.7%	-19.3%
ROAE	-84.8%	-294.7%
Debt / equity	3.3x	NA
Interest coverage	-3.5x	NA

Source: Company reports

Figure 1: Outstanding enterprise bonds, company bonds and short-term financing bills

Source: Wind

Figure 2: Newly issued enterprise bonds, company bonds and short-term financing bills

Source: Wind

Table 2: Overview of outstanding enterprise bonds and company bonds

Rating	Number of bonds	% of total issuance	Average coupon %
AAA	777	22.9%	5.17
AA+	1,040	30.6%	6.36
AA	1,511	44.5%	7.10
AA-	65	1.9%	7.99
A+	4	0.1%	8.62
CCC	1	0.03%	8.98
Total	3,398	100%

Source: Company reports

Table 3: WMP exposure by bank

In Rmb bn	Total	35% of	4% of	NSCA	% of Total		Total WMP as % of	NSCAs as % WMP	NSCA WMP as % of
1H13	WMP	WMPs	Assets	WMP	Gteed	Ungtd	Assets		Assets
ABC	718	251	569	230	40%	60%	5%	32%	2%
ICBC	1,200	420	749	408	18%	82%	6%	34%	2%
Boc	787	275	530	244	22%	78%	6%	31%	2%
CCB	1,016	356	594	305	48%	52%	7%	30%	2%
Bocomm	674	236	229	123	36%	64%	12%	18%	2%
Citic	417	146	137	202	21%	79%	12%	48%	6%
CMB	554	194	152	139	NA	NA	15%	25%	4%
Minsheng	300	105	136	120	0%	100%	9%	40%	4%
CRCB	28	10	20	3	NA	NA	6%	10%	1%
Huishang	9	3	16	NA	71%	29%	2%	NA	NA

Source: Company data

Banks & Financial Services

Katherine Lei ^AC

(852) 2800-8552

katherine.lei@jpmorgan.com

Bloomberg JPMA LEI <GO>

Lu Lu

(852) 2800-8592

lu.lu@jpmorgan.com

Josh Klaczek

(852) 2800-8534

josh.klaczek@jpmorgan.com

J.P. Morgan Securities (Asia Pacific) Limited

www.jpmorganmarkets.com

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