Default fuels hope for China bonds
Andrew M Johnson
When Shanghai Chaori Solar Energy Science & Technology missed an 89.8 million yuan (US$14.7 million) interest payment on March 6, China's financial system took a turn for the better. The event marked the first default of a corporate bond issued onshore since the financial system was overhauled in the late 1990s, and provided much-needed evidence that the central government is serious about implementing market-led reforms of the economy.
Chinese equity markets hardly reacted to the default as investors appear to be interpreting the Shanghai-based PV cell maker's repayment problems as the beginning of a readjustment of risk in the corporate debt market for non-financial companies listed in China and Hong Kong. That market has expanded from $607 billion at the end of 2007 to $1.98 trillion today. 
Chaori Solar in May 2012 sold 1 billion yuan of five-year bonds with variable coupon rates starting at 8.98%. The company's notes were downgraded to triple-C from triple-B+ by Pengyuan
Credit Rating in 2013, sending yields on the bonds to 22% just before trade in company's shares was halted in late summer.  Chaori took on the debt to finance its expansion from PV cell manufacturing to the capital-intensive field of solar farm construction.
The company is seeking buyers for solar farms in Greece, Bulgaria, Italy and the US, its Vice President Liu Tielong told Bloomberg on March 10, indicating that Chinese banks now "have no willingness to lend" after previously agreeing to provide 800 million yuan in loans in the event of a temporary cash squeeze.
In the Chinese credit markets, the spread between triple-A and double-A rated securities widened as a result of the default. That is an encouraging sign the bond markets are pricing in more risk. The higher cost of credit is a necessary headwind for Chinese companies that have enjoyed a pool of easy money, despite being plagued by overcapacity and illiquid inventories in the years since the financial crisis of 2008. Given the amount of leverage in the Chinese economy, it is very likely that Chaori Solar is only the first of several companies which must default on soured debt. However, an array of corporate bond defaults could be the necessary cost for the financial sector begin the anticipated reforms and necessary restructuring, which is why it is vital that Beijing remain on the sidelines throughout this process.
If Chinese policy makers are serious about emphasizing quality of growth rather than quantity of growth, they should continue to let the dice fall where they must in the corporate bond market. It is the only way for the World's second largest economy to transform itself into a free-market where interest rates are determined by supply and demand and risk premiums are allocated efficiently.
As Chinese banks slowly adapt to a system of market-driven interest rates and proper allocation of resources, lending by non-bank financial institutions - a practice known as shadow banking - has ballooned in recent years. The shadow banking system consists of trust companies, leasing firms, insurance firms, pawnbrokers, and the off-balance-sheet lending arms of large banks. Overall, new credit in China rose 9.7% to 17.29 trillion compared with a year earlier. 
JPMorgan estimates that while China's shadow banking sector is valued at at 46 trillion yuan (about $7.5 trillion), the ratio of shadow banking to total bank assets stands at 30%, which is far less than the 170% ratio for the United States banking system.  Despite the glut of spilled ink over whether China's internal credit binge could trigger a global financial meltdown, JPMorgan in a recent report concluded that "[t]he chances that a potential Chinese financial crisis in the future will become such a global systemic event seem low."  While the report points to the fact that China's shadow banking system is not systemically important to the global financial system, there is no dispute that it is systemically important to many companies in China with bleeding balance sheets.
Chaori Solar's default is encouraging from a market psychology point of view, but threats from the country's internal credit boom are still significant in the near-term. A necessary step in the long-awaited remedy to China's credit bubble and burgeoning shadow banking industry is a readjustment of risk, and the unfortunate failure of several over-leveraged companies that have bitten off more than they can chew in the credit markets. After all, capitalism is not about saving companies with pricey bailouts that introduce even pricier moral hazard into the financial system.
The Chinese government allowing Chaori Solar to default is good news; hopefully it will continue to let internal restructuring in the economy play out. This event is a key sign of financial maturity in an economy that is shifting toward long-term sustainable quality, growth, and stability.