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China’s first bond default was long overdue

In the vast credit universe, a minor bond default by a middling solar-equipment company would normally pass unnoticed by everyone but the investors stuck holding the paper.

But the failure of Shanghai Chaori Solar Energy Science & Technology Co. to meet an interest payment due Friday on a one-billion-yuan ($163-million U.S.) bond issue was not your ordinary case of another cash-strapped borrower missing a deadline. It marked the first time since Beijing embraced its singular capital-markets vision that any Chinese corporation had defaulted on a debt obligation, sparking fears that many more "zombie" companies could soon be marching off the same cliff.

There is little doubt that Chaori's default was not a one-off rarity but the first casualty of a deliberate change in public policy to let some of the air out of a ridiculously inflated credit bubble that threatens to tear apart the deeply troubled financial system.

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The cold splash of reality was long overdue. A more realistic pricing of credit risk should give investors a much clearer picture of the true strength of China's companies. That in turn should lower the cost of capital for the country's strongest enterprises and make it more expensive for weaker businesses to borrow.

No one could possibly believe that there wasn't a single bad apple lurking anywhere in the country's $1.4-trillion-plus corporate debt market. And now that one has finally been allowed to fall to the ground without a state-orchestrated bailout or credit extension, investors are already demanding higher risk premiums, certain that more defaults will inevitably follow.

The question is how bad things will get. "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," a trio of Bank of America-Merrill Lynch strategists warned in a note to investors. They also sounded a more ominous note, drawing a comparison between the Chinese situation and the earliest Wall Street victim of the 2007-08 financial crisis, arguing that the credit bubble has reached the stage where Bear Stearns collapsed. As the strategists remind us, it took another year to get to the "Lehman stage," when the collapse of the much larger Lehman Brothers caused global financial markets to seize up.

Other bearish analysts have warned that China's credit bubble has the capacity to do similar awful things when it explodes. I'm not convinced we're witnessing anything of the sort, at least not yet. Beijing still has plenty of firepower to keep its own financial pipelines open.

But regardless of whether the dire forecast proves true down the road, the immediate benefit of allowing a handful of defaults is bound to be a better-disciplined market that ought to reduce financing costs for stronger companies while forcing a raft of financial basket-cases to the sidelines, where they belong.

The decision to make an example of Chaori probably says more about the weak political and banking connections of the maker of solar panels and cells than its precarious finances. But on paper, it was a good first choice. It has been in arrears on its bank loans, unable to raise new capital for months and operating in an overcrowded industry where prices have only recently improved after a tough couple of years.

The only question now for investors in the world's third-largest corporate debt market (after the U.S. and Japan) is whether this will be followed by a trickle of other defaults or a veritable flood, as authorities at both the national and regional levels stop digging deeper credit holes. But China had to impose some discipline on a credit market that has the potential to make a hash of its optimistic growth forecasts. It's good to see the process is finally under way.

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More

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