Forging bonds to save SMEs

The bond market in China just turned more interesting - kicked off in part by a loan default crisis in the country’s entrepreneurial hotspot called Wenzhou. If China is the world’s factory, Wenzhou is the heart of traditional Chinese entrepreneurship and birthplace of private economy. But in the last two years, this eastern China city has seen the worst side of usury rates and loan defaults. Debt-laden factory owners, unable or unwilling to pay up, fled in droves, threatening to damage the very fabric of this booming region. The advent of ‘junk bonds’, may now provide a viable alternative to this region. Chinese banks have showed extreme reluctance to lend to short and medium enterprises (SMEs), which are usually low on fixed assets and have poor credit records. To keep their businesses running, many SMEs resorted to underground usury for lines of credit that sometimes commanded annualized interest rate as high as 90 percent. Quite unsurprisingly a large number of debt-riddled businessmen were forced to ditch their enterprises and flee overnight when matters came to a head. Alarmed by this exodus, the central government quickly drew up financial reforms tailor-made for Wenzhou. The 12-point blueprint will allow residents of this city to set up loan companies legally. By bringing private money into the official banking system, policy-makers hope to give a buffer to cash-starved small businesses which play a critical role in providing employment. Under the plan, Wenzhou will allow rural financial institutions, micro-credit companies, private asset management companies and private equity fund led by the city government to extend loans. More importantly, it can help spice up the markets in future by following Shanghai and Shenzhen in issuing high-yield bonds. As part of a national attempt to let small and medium-sized enterprises gain access to funds, China has for the first time added ‘junk bonds’ - high-risk but potentially high-yield securities with low credit ratings - into the market. Last week, the first issue was made by a company called Suzhou Huadong Coating Glass, which offered RMB 50 million worth of two-year notes at a yield of 9.5 percent. The Shanghai Exchange has approved seven Chinese companies to issue such bonds by private placements to qualified investors. The bonds may be bought and sold under highly restricted conditions on Shanghai’s fixed-income trading platform. Listed companies, property developers and financial institutions strictly out of the reckoning. For the world’s second biggest economy, China has an infantile bond market. Records show that 80 percent of bonds issued since 2005 are from State-owned enterprises, government agencies or very large companies. The volume of corporate bonds, issued by these enterprises, was RMB 124 billion in 2011 while bonds issued by SMEs accounted for a mere RMB 5.2 billion. Also, total bond balance, at USD 3.47 trillion at the end of 2011, was only one-tenth of the USD 36 trillion in the United States. If the high-yield ‘junk’ bonds do take off, it will provide investors with a much-needed option. China has one of the world’s highest saving rates, but much of it remains unproductive for lack of lucrative investment products. These bonds will also bring in an element of competition. Chinese public companies are known for their reluctance to pay out dividends. With high-yield bonds coming in, they will have to pay out more or lose investors to the bond market. The move will impact the stock market in other ways too. The market will act as testing ground for selecting future IPO candidates. Having companies first issue bonds before they go public will bring in greater discipline and possibly enhance the quality of firms going public. Down-side Investors, however, are very cautious about the success and transparency of this system, given that bond derivatives turned an ugly word after the financial implosion of 2008. China’s notoriously lax implementation of laws, combined with under-educated investors could cause turmoil in the fledgling bond market. Also, an incomplete regulatory framework does not inspire confidence as of now. The domestic bond market is very much a ‘work in progress.’