China’s Bear Stearns Moment? First Bond Default Looms

Following the bailout of a delinquent trust company late January, China’s credit markets seem to have returned to a placid state, thereby signaling a possible easing of credit woes. 

Well it turns out that such credit tranquility has only shifted the financial pressures to the currency market, the yuan.

Now even as the agitations in the currency markets remain unsettled, reports say that a debt delinquent solar company may spark a “Bear Stearns moment” with China’s first possible bond default.

From Bloomberg: (bold mine)

The growing risk of default by Shanghai Chaori Solar Energy Science & Technology Co. may become China’s “Bear Stearns moment,” prompting investors to reassess credit risks as they did after the U.S. securities firm was rescued in 2008, according to Bank of America Corp.

“We doubt that the financial system in China will experience a liquidity crunch immediately because of this default but we think the chain reaction will probably start,” Hong Kong-based strategists David Cui, Tracy Tian and Katherine Tai wrote in a note yesterday. During the U.S. financial crisis, it took a year “to reach the Lehman stage” when investors began to panic and shadow banking froze, the strategists added.

The maker of solar cells said March 4 it may not be able to make an 89.8 million yuan ($14.7 million) interest payment in full by the deadline tomorrow. As sub-prime mortgages fell amid the 2008 U.S. financial crisis, banks began hoarding cash, causing two Bear Stearns Co. hedge funds to seek bankruptcy protection. The troubled bank was sold to JPMorgan Chase & Co. in March of that year in a deal facilitated by the U.S. Federal Reserve. Six months later, Lehman Brothers Holdings Inc. collapsed in the biggest bankruptcy in U.S. history.

Chaori’s potential failure to pay investors would mark the first bond default in Asia’s largest economy, highlighting the strain in China’s $4.2 trillion bond market after a trust product issued by China Credit Trust Co. was bailed out in January. There haven’t been any defaults in China’s publicly traded domestic debt market since the central bank started regulating it in 1997, according to Moody’s Investors Service.

Will this lead to another bailout within the week?

Let me add that China’s troubles have not been entirely captured by Western media. For instance, a report just surfaced that in late January, there has been a reported “run” on three cooperatives

From the Chicago Tribune

In the run-up to the holiday in late January, word had spread that at least three rural cooperatives were running short on funds. In what the local government described as a "panic", depositors rushed to withdraw cash. Local officials say several co-op bosses fled after committing fraud…

Depositors would normally be protected by China's banking regulator, which requires lenders to keep a certain amount of cash on reserve to meet depositor demand.

But as participants in a pilot program, the depositors quickly woke up to an unpleasant reality: so-called "Farmers' Mutual Help Funding Cooperatives" aren't technically banks. Not only did they not have sufficient reserves on hand, they weren't legally required to.

Farmer’s cooperatives reportedly emerged in 2006 and ballooned fast over the years. According to the  same report

By the middle of last year, 137 such co-ops had been established in Yancheng, with total membership reaching 170,000, deposits of 2.3 billion yuan, and total loans outstanding of 1.9 billion yuan, according to figures cited by official media.

But in practice, many co-ops shifted into riskier forms of lending. Jiangsu, along with neighboring Fujian province, is known for its vibrant grey-market lending networks, serving small factory owners and real estate developers who often cannot obtain bank loans.

Informal lending generally occurs through family and friends, but the rise of farmers' co-ops created a platform for informal lenders to scale up their operations by collecting funds in a bank-like setting.

If you might notice China’s financial markets seem to have been faced with increasing frequencies of financial tremors. This may lead to a financial Pompeii.

I am not sure if Bear Stearns should even be the right parallel. That’s because all it takes is for China’s fragmented highly indebted financial system to become unglued, as the Chinese government to lose control that results to the crumbling of the castle built on the proverbial sand. 

Remember financial strains will always function as the initial symptoms. Then a liquidity squeeze follows (this is where the PBoC has been actively intervening in the hope to kick the can). After, the contagion spreads to the real economy via a financial crisis that leads to a economic crisis or vice versa.

Interesting times indeed.