China's Version of "Too Big to Fail"

MoneyShow's Jim Jubak thinks some small Chinese company defaults are inevitable, while defaults by bigger companies are not, and will be stopped by the Chinese government.

It turns out that China has its own version of "Too Big to Fail." In early March, there has been a lot of turmoil in the market and risk in the market because China had its first ever corporate bond default. They have another few companies that are talking about defaulting in different ways on bank loans, etc., and raised the sense that there is a whole lot of risk.

What is interesting is that the biggest risks in the Chinese financial system are financing companies that are affiliated with the Hu governments. The Hu governments are not allowed to borrow themselves, so they have gotten around that regulation by setting up financing arms that then finance things like shopping centers or factories. The amount of debt here is up to about $2.9 trillion, about 40% of that has to be rolled over this year, and the sense was that these entities were in deep, deep trouble. What has been interesting is that even though you have had this worry about the first ever bond default, the yield that investors have been demanding to invest in these financial entities has fallen. It is down about 70 basis points since the end of January. Investors are saying, seemingl,y to just look at that rate. They are saying these things are less-risky than before when we were not really worried about defaults. What it really seems to imply is that investors are looking at the Chinese government and saying, "Well some default is inevitable," which is what the Chinese Premier said a few weeks ago. I have decided that, yes, what he really means is that some defaults, by relatively small privately owned companies are inevitable, but that defaults by things like financing entities affiliated with the Hu governments or big state owned enterprises are not inevitable. In fact, the government is not going to let those happen. That is the consensus at the moment. That is what is driving prices in the debt market for things like bonds that are being sold by these low government entities.

Now looking at the spread between those bonds, and those issued by Beijing itself, has contracted, so there is clearly a sense that there is less risk in this than we thought, as the market consensus says, at the moment. Whether the market consensus is right or not, time will tell. I doubt that we are going to get through this without some more turmoil down the road, but at the moment, at least, China's financial markets have decided that, yes, there is a problem, but it is not where we thought the problem was and, in fact, it is actually smaller than we thought it was, and "hey, we are going to work through this and it is not going to be a big deal." I think when we get to complacency about this, that is when we then really do need to start to worry about it again.

This is Jim Jubak for the MoneyShow.com Video Network.