shadow banking China

China High-Yield Debt Investing — the new China First Capital Research Report Published Today

Leave a Comment / April 21, 2015

China High Yield Investing -- China First Capital research report

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China First Capital today publishes a special research report titled, “China Debt Investing: An Overlooked Opportunity”. You can download a copy by clicking here.

This report examines some of the unique attributes of China debt investing, especially its fast-growing high-yield “non bank” shadow banking sector. Do the high yields adequately price in risk? Is this an investment class international investors should consider? Can the regulatory Great Wall be scaled to get dollars legally in and out for lending in China?

Little has been written in English about China’s huge high-yield debt market except constant predictions of its imminent catastrophic demise. Search “China shadow banking crash” and Google turns up 390,000 books and articles in English, some dating back five years now. One sample among many, a 2013 book by James Gorrie titled, “The China Crisis: How China’s Economic Collapse Will Lead to a Global Depression”. It perfectly captures the near-unanimous tenor of Western experts and analysts that shadow banking is the iceberg China has already struck. Losses will run into the billions of dollars, we are told, and China’s entire banking industry will teeter and perhaps collapse in a devastating replay of the 2008 financial crisis in the US and Europe.

Those of us in China inhabiting the world of fact rather than prediction, however, will have noticed that there is no crisis, no iceberg, no titanic upsurge of defaults in China’s shadow banking systems. In fact, it is by far the world’s largest, and using actual default statistics rather than somebody’s forecast, the least risky high-yield debt market in the world. There’s good money to be made.

Our report offers only one prediction — that as rules are loosened, global institutional capital will begin to put money into high-yield lending in China, likely by making direct loans to the best of China’s corporate and municipal borrowers. They will do so because debt investing in China offers institutional investors diversification as well as potentially higher risk-adjusted returns than private equity or venture capital.

The report examines high-yield lending in China as an investment strategy for fixed-income investors.  In that, it may well be a first to do so. Are there risks in the high-yield market in China? Of course, as there is in all fixed-income investing, including, in theory, the safest and most liquid of all instruments, US Treasury bills, bonds and notes.

Are actual default rates in China high-yield lending likely to surge above the current reported level of 1%? Yes, it seems entirely possible. But, this hardly invalidates the attractions of lending there. Instead, it means lenders, be they large credit funds or institutional investors acting directly as a source of debt capital to borrowers in China, should perfect their collateral at the outset,  do first-rate credit analysis before money moves and then, no less important, be extremely hands-on with on-site cash flow monitoring after a loan has been made.

There are 1,000 good reasons for institutional investors to consider China’s high-yield debt market. That’s because of the 1,000-basis point yield premium available in China compared to making similar types of loans against similar collateral to similarly rated companies outside China. In other words, an investor can earn far more with an intelligent direct lending strategy than is possible in all other major economies, as well as more than one can earn even in poorer domains like Indonesia and India.

The report looks at lending and credit markets in China from several different vantage points, including a few case studies. It’s a fascinating topic for anyone who wishes to learn more. Why are interest rates so much higher in China? Who are the winners and losers? Why is it there this near-unanimous view among English-speaking financial analysts and media folk that the high-yield market in China is on the verge of a ruinous crash? Do they share a common gift for doom-laden exaggeration like Nostradamus or will before very long be proven right at last?

I know which way I vote on that, that the shadow banking industry will certainly suffer some stumbles, with individual deals going sour and money being lost. But, as more money enters China for the purpose of providing debt capital, the shadow banking industry will mature, will improve its credit-analysis and credit-pricing skills, and smart investors will do well both relative to other fixed-income investment strategies worldwide as well as compared to private equity investing in China.–

 

Treating the Cancer of High Interest Rates in China — Caijing Magazine commentary

Leave a Comment / March 31, 2015

caijing

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The cost of borrowing money is a huge and growing burden for most companies and municipal governments in China. But, it is also the most attractive untapped large investment opportunity in China for foreign institutional investors. This is the broad outline of the Chinese-language essay published in this week’s Caijing Magazine, among China’s most well-read business publications. The authors are me and Dr. Yansong Wang, China First Capital’s Chief Operating Officer.

Foreign investors and asset managers have mainly been kept out of China’s lucrative lending market, one reason why interest rates are so high here. But, the foreign capital is now trying to find ways to lend directly to Chinese companies and municipalities, offering Chinese borrowers lower interest rates, longer-terms and less onerous collateral than in the Rmb15 trillion (USD $2.5 trillion) shadow banking market. Foreign debt investment should be welcomed rather than shunned, our commentary argues.

If Chinese rules are one day liberalized, a waterfall of foreign capital will likely pour into China, attracted by the fact that interest rates on securitized loans here are often 2-3 times higher than on loans to similar-size and credit-worthy companies and municipalities in US, Europe, Japan, Korea and other major economies. The likely long-term result: lower interest rates for company and municipal borrowers in China and more profitable fixed-income returns for investors worldwide.

I’ve written in English on the problem of stubbornly high borrowing costs in China, including here and here. But, this is the first time I tried to evaluate the problem for a Chinese audience — in this case, for one of the more influential readerships (political and business leaders) in the country.

The Chinese article can be downloaded by clicking here.

For those who prefer English, here’s a summary: high lending rates exist in China in large part because the country is closed to the free flow of international capital. The two pillars are a non-exchangeable currency and a case-by-case government approval system, managed by the State Administration of Foreign Exchange (SAFE) to let financial investment enter, convert to Renminbi and then leave again. This makes it all but impossible to arbitrage the 1,000 basis point interest rate differential between China domestic corporate borrowers and similar Chinese companies borrowing in Hong Kong.

Foreign financial investment in China is 180-degrees different than in other major economies. In China, almost all foreign investment is in equities, either through buying quoted shares or through giving money to any of the hundreds of private equity and venture capital firms active in China. Outside China, most of the world’s institutional investment – the capital invested by pension funds, sovereign wealth funds, insurance companies, charities, university endowments — is invested in fixed-income debt.

The total size of institutional investment assets outside China is estimated to be about $50 trillion. There is a simple reason why institutional investors prefer to invest more in debt rather than equity. Debt offers a fixed annual return and equities do not. Institutional investors, especially the two largest types, insurance companies and pension funds, need to match their future liabilities by owning assets with a known future income stream. Debt is also higher up the capital structure, providing more risk protection.

Direct loans — where an asset manager lends money directly to a company rather than buying bonds on the secondary market — is a large business outside China, but still a small business here. Direct lending is among the fastest-growing areas for institutional and PE investors now worldwide. Get it right, and there’s no better place in the world to do direct corporate lending than in China.

For now, direct lending to Chinese companies is being done mainly by a few large US hedge funds. They operate in a gray area legally in China, and have so far mainly kept the deals secret. The hedge fund lending deals I’ve seen have mainly been short-term lending to Chinese property developers, at monthly interest rates of 2%-3%.

I see no benefit to China from such deals, nor would I risk a dollar of my own money. A good rule in all debt investing is whenever interest rates go above 20% a year, the lender is effectively taking on “equity risk”. In other words, there are no borrowers anywhere that can easily afford to pay such high interest rates. Anyone who will take money at that price is probably unfit to hold it. At 20% and above, the investor is basically gambling that the desperate borrower will not run out of cash while the loan is still outstanding.

Interest rates are only one component of the total cost of borrowing for companies and municipalities in China’s shadow banking system. Fees paid to lawyers, accountants, credit-rating agencies, brokerage firms can easily add another 2% to the cost of borrowing. But, the biggest hidden cost, as well as inefficiency of China’s shadow banking loan market is that most loans from this channel are one-year term, without an automatic rollover.

Though they pay interest for 12 months, borrowers only have use of the money for eight or nine months. The rest of the time, they need to accumulate capital to pay back principal at the end of one year. China is the only major economy in the world where such a small percentage of company borrowing is of over one-year maturity. China’s economy is guided by a Five Year Plan, but it’s domestic lenders operate on the shortest of all time-frames.

If more global institutional capital were allowed into China for lending, I would expect these investors to want to do their own deals here in China, negotiate directly with the borrower, rather than buying existing securitized shadow banking debt. These investors would want to do more of their own due diligence, and also tailor each deal, in a way that China’s domestic shadow banking system cannot, so that the maturity, terms, covenants, collateral are all set in ways that correspond to each borrowers’ cash flow and assets.

China does not need one more dollar of “hot money” in its economy. It does need more stable long-term investment capital as direct lending to companies, priced more closely to levels outside China. Foreign institutional capital and large global investment funds could perform a useful role. They are knocking on the door.

http://magazine.caijing.com.cn/20150330/3851367.shtml

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