Shedding Light on China’s Massive Shadow Banking Market - Landmark Corporate Bond Default - Part 1

by Dorsey & Whitney LLP


The debt level of the PRC1 is rising. It is estimated that the PRC’s corporate debt could hit US$13.8 trillion in 2014, surpassing that of the United States (“U.S.”) as the largest in the world. This has raised increasing concerns in the non-bank financial market, particularly the shadow banking market, upon which the huge growth of debt in the Chinese economy is largely centered. Shadow banking is a term for the collection of non-bank financial activities that provide services similar to conventional commercial banks, sometimes through the conventional commercial banks. In general, shadow banking takes place through three types of institutions2. The first includes third-party wealth management products and trust companies, or financial institutions without licenses and regulatory oversight. The second category is credit guarantee companies, microcredit firms, or those without licenses and partially regulated. The last type includes entities with licenses but have inadequate regulation, such as money market funds, securitized products, and off-balance-sheet products.

While shadow banking is characterized by a lack of regulatory oversight, there is no parallel lack of government intervention. In January, 2014, a default of a RMB 3 billion trust product of the shadow banking market was avoided by a bailout by unidentified parties. It was generally thought that the PRC government was behind the bailout, an event that was widely taken for granted in Mainland China3.

On March 7, 2014, the first onshore4 bond default occurred in Mainland China. The default concerned an onshore corporate bond issued by a struggling Chinese solar-equipment manufacturing company and was not a product of the shadow banking market. However, the alarm this event triggered is by no means confined to the non-bank corporate bond market, and it has forced reflections upon the threat that the non-bank financial market as a whole, particularly the shadow banking market, in the PRC is posing. This eUpdate is part 1 in a series of eUpdates on this topic. Part 1 explores and reflects upon the circumstances pertaining to this landmark default, the change it marked and the alarm it triggered for Mainland China’s non-bank financial market.

China’s First Onshore Corporate Bond Default

On March 7, 2014, Shanghai Chaori Solar Energy Science & Technology Co. (“Chaori Solar”), a Chinese solar-equipment manufacturing company, failed to meet interest payments (the “Chaori Solar Default”) of RMB 89.8 million on a RMB 1 billion 5-year bond it issued in 2011 (the “Chaori Solar Bond)5. This is China’s first onshore bond default6, and the first default on a publicly traded debt in Mainland China since the PRC government regulations began in 19997. Perhaps to the surprise of Chaori Solar and many others, there was no bailout by the PRC government, an event that was seen as a landmark for market discipline in Mainland China8. As of March 11, 2014, the Chaori Solar Bond was suspended on Shenzhen Stock Exchange9.

China’s “Bear Stearns Moment”?

A default of RMB 89.8 million is relatively small. However, in an investment environment that is confidence- and speculation-based, the Chaori Solar Default may disrupt the stability of the financial market in general and cause panic that could spiral uncontrollably, leading to a chain reaction that is potentially serious. Three companies have postponed domestic debt issues after Chaori Solar warned of its default10. The proposed deals were relatively small (ranging from RMB 300 million to RMB 1 billion), but the delays underlined the risk that an unprecedented default would make it more difficult for other companies to access capital11.

Some observers described the Chaori Solar Default as China’s “Bear Stearns moment”12. We would recall that six years ago, on March 14, 2008, when it became clear that Bear Stearns Companies, Inc. (“Bear Stearns”), an 85-year-old bank, was facing imminent insolvency, the Federal Reserve authorized the Federal Reserve Bank of New York to extend a bridge loan to Bear Stearns through JPMorgan Chase Bank, N.A. (“JPMC Bank”), to enable Bear Stearns to meet its immediate liquidity needs and to allow for time during the weekend for Bear Stearns to explore options with other financial institutions that might save it from bankruptcy13. On March 17, 2008, however, Bear Stearns was sold to JPMC Bank for US$2 per share, a price which was ultimately raised to US$1014. Six months later, Lehman Brothers Holdings Inc. collapsed in the biggest bankruptcy in U.S. history15.

The Chaori Solar Default may prompt investors to “think again” before lending money at artificially low rates to weak companies. The small- to medium-sized private companies which do not have solid fundamentals may be hit the hardest, as demands for their bonds may drop, and borrowing costs may become higher. As mentioned below, the immediate impact of the Chaori Solar Default might be limited, but a default by a financial institution or a local PRC government may easily result in a downward spiral.

A Sign of Change

No doubt the Chaori Solar Default will alert investors to reassess credit risk. However, this could be a healthy development for the financial market in the long run. The Chaori Solar Default may force a re-pricing of credit risk and a correction of credit misallocation.

Bailout Culture

In the past, the PRC government and state-owned banks often stepped in to provide bailouts or debt extensions to local entities in imminent danger of defaulting on their debts, keeping borrowing costs low for companies with high debts16. The primary reason was that the PRC government feared a systemic crisis in the financial market caused by panic outflows and loss of confidence. Chemical fibre company Shandong Hailong in 2012 narrowly avoided default on its RMB 400 million short term bond after an injection of capital from the PRC government and banks17. CITIC Trust was forced to delay payment on a wealth management product linked to a steel loan in Hubei province in 2013, but investors were eventually repaid when the PRC government apparently stepped in18. In 2013, the investors of a wealth management product sold through Hua Xia Bank were repaid – despite a default on loans – by the unwilling guarantor of the product19. Chaori Solar itself narrowly avoided a bond default in February 2013 after the PRC government persuaded banks to defer claims for overdue loans20. Most recently, in January 2014, China Credit Trust Co. (“CCTC”) was bailed out of a RMB 3 billion trust (the “CCTC Trust”).

CCTC was a trust company and part of the PRC’s non-bank financial market – to be specific, the shadow banking market21. Most CCTC Trust clients signed an agreement on January 28, 2014 to transfer their rights in the CCTC Trust to unidentified buyers in exchange for an amount equal to the product’s face value but forgoing most of 2013’s interest payments22. The offer to investors was presented on January 27, 2014, by Industrial & Commercial Bank of China Ltd., which distributed the trust product in 201123. Separately, CCTC announced that it had reached an agreement with an unidentified third party to sell the shares it had acquired in Shanxi Zhenfu Energy Group24. Despite the uncertainty of the details, this was widely regarded as a bailout by the PRC government.

The financial market in Mainland China had long assumed that even high-yielding debt carried an implicit state guarantee25. This was an unhealthy moral hazard phenomenon, when investors looked for the highest yields without considering the risks. Credit risk should play an important role in pricing, making the market more efficient in the allocation of capital. However, the Chinese market is distorted when investment decisions are influenced by whether the companies are most likely to be bailed out, rather than the performances and fundamentals of the companies. The bulk of the financial products developed under the shadow banking market, such as the CCTC Trust, were not priced according to the risk of the underlying assets26.

Pilot Project?

The Chaori Solar Default may be a “pilot project27” by the PRC government, signalling a landmark change as the PRC government takes a new stance in treating at least some corporate debt crisis according to market rules28. As an 85% majority owner of the Chaori Solar Bond’s underwriter, the PRC government appeared to have managed and even desired the Chaori Solar Default29, noting that the local PRC government and the underwriter involved had sufficient funds for a bailout30. Chaori Solar was a relatively small company that had been in crisis for years31, and was in a discredited industry suffering from overcapacity problem. There was unlikely to be any major immediate impact on the financial market. By contrast, CCTC was a major Chinese shadow bank32. It was unlikely that the PRC government would have allowed a default that would create a systemic risk for the financial market or the economy.

Alarm Triggered

The PRC government may be making a strategic decision to allow the Chaori Solar Default, which may not have a huge knock-on effect in the market33, to help accelerate the pace of market reform34. However, the landmark default made by Chaori Solar has raised an alarm in Mainland China’s non-bank financial market, in particular the less- or non-regulated shadow banking market.

The risk of more defaults in 2014 is very real. The number of Chinese companies whose debt is double their equity has surged since the global financial crisis: publicly traded non-financial companies with debt-to-equity ratios exceeding 200% have jumped 57% from 163 in 2007 to 256 in 201435; some 63 of these publicly traded non-financial companies have a debt-to-equity ratio exceeding 400%36. It is estimated that outstanding bank loans and bond debt among non-financial companies in Mainland China reached about US$12 trillion at the end of 2013, the equivalent of more than 120% of GDP37 38. It is also estimated that China’s corporate debt could hit US$13.8 trillion in 2014, surpassing that of the U.S. as the largest in the world39. Total corporate bonds outstanding increased more than tenfold to RMB 8.7 trillion at the end of January 2014 since the end of 200740. Mainland China’s renewable energy industry (Chaori Solar is a renewable energy company) alone faces a record US$7.7 billion in bonds maturing in 201441. “The domestic economy is slowing, liquidity is tightening globally and more bonds are maturing [in 2014] with greater refinancing pressure42.” There were around 28 near or technical defaults since 2012, all of which involve trust products43, the largest form of shadow banking44.

The PRC government is considering to regulate – and not merely to bailout – the non-bank financial market. The CCTC Trust crisis might have prompted the People’s Bank of China and National Audit Office to announce in January that they would begin an audit of shadow banking; the announcement followed the release of the local PRC government debt audit that showed local PRC government had become increasingly reliant on shadow banking to fund their investments45, and the State Council Document No. 107 calling for the strengthening of shadow banking regulation46.

Coming Soon…

Chaori Solar Bond is a corporate bond issued by a struggling company in a discredited sector, and not a product of the shadow banking market like the CCTC Trust47. However, some see it as a test case in a more isolated platform for the non-bank financial market in general, especially for the shadow banking market48, upon which the huge growth of debt in the Chinese economy is largely centered49. A default of a more isolated nature may not cause major immediate impact. A default to which many investors could relate by analogy, however, might precipitate fear in the non-bank financial market. The threats are real. As an illustration, more than 43% of the RMB 10.9 trillion worth of outstanding trust products fall due for repayment in 201450. More selective and managed defaults may be expected. Watch out for the headlines.

1   “PRC” in this article refers to the People’s Republic of China, excluding Hong Kong, Macau and Taiwan.
2   According to the State Council Document No. 107 released in December 2013, which did not define shadow banking, see “Fears of China’s Shadow Banking Implosion Are Overblown” by Nina Xiang, Forbes, February 18, 2014.
3   “Mainland China” in this article refers to the geopolitical area under the jurisdiction of the PRC, excluding Hong Kong, Macau and Taiwan.
4   “Onshore” in this article refers to the jurisdiction of the PRC.
5   “Chinese default landmark looms” by Jing Song, Finance Asia, March 5, 2014.
6   According to Moody’s Investors Service, see “Shanghai Chaori in Default on Bond Interest Payments” by Lingling Wei, Wall Street Journal, March 6, 2014.
7   “Chaori Solar default is a test case for China’s markets” by Linda Yueh, BBC News, March 7, 2014.
8   “Watershed moment for China markets with Chaori Solar bond default”, Reuters, Bloomberg, March 7, 2014.
9   See data from Shenzhen Stock Exchange ( and Bloomberg (
10  “China Bond Default Risk Prompts Others to Delay Fund Raising”, Reuters, March 6, 2014.
11  See footnote 10.
12  See for example “China Bear Stearns Moment Seen by BofA in Solar Default” by Justina Lee, Bloomberg, March 7, 2014.
13  “Bear Stearns, JPMorgan Chase, and Maiden Lane LLC”, Transaction Data, Federal Reserve (last updated on August 2, 2013).
14  “A Look Back At Bear Stearns, Five Years After Its Shotgun Marriage to JPMorgan” by Steve Schaefer, Forbes, March 14, 2013.
15  See footnote 12.
16  See footnote 6.
17  See footnote 5.
18  See “Latest China bailout reveals risk of local govt's hidden debts” by Gabriel Wildau, Reuters, May 7, 2013; “In China, troubled shadow bank product tests no-default policy” by Heng Xie and Gabriel Wildau, Reuters, January 16, 2014.
19  See “Guarantor repays principal on failed Huaxia product” by Daniel Ren, SCMP, January 23, 2013; “In China, troubled shadow bank product tests no-default policy” by Heng Xie and Gabriel Wildau, Reuters, January 16, 2014.
20  See footnote 8.
21  “Losing Faith in China’s Trusts?” by Shuli Ren, Barrons, February 8, 2014.
22  “China Credit Repays Principal to Bailed-Out Trust Holders” by Bloomberg News, Bloomberg, January 30, 2014.
23  “See footnote 22.
24  “China Trust Default Avoided… What Comes Next?” by Oliver Barron, Forbes, January 27, 2014.
25  See footnote 8.
26  “Trust bailout highlights massive growth of China’s ‘shadow banking’” by Oliver Campbell, World Socialist Web Site, February 6, 2014.
27  “China’s first bond default is no Bear Stearns moment” by Jamil Anderlini, Financial Times, March 6, 2014.
28  “China’s Chaori Solar Energy Not Counting on a Bailout” by Wynne Wang, Wall Street Journal, March 6, 2014.
29  See footnote 27.
30  See footnote 12.
31  See footnote 27.
32  See footnote 26.
33  “Chaori Solar in landmark Chinese bond default” by Kim Gittleson, BBC News, March 7, 2014.
34  “This is huge: China may allow its first-ever corporate bond default” by Gwynn Guilford, Quartz, March 5, 2014.
35  “Chaori Can’t Make Full Payment in China’s First Onshore Default” by Bloomberg News, Bloomberg, March 7, 2014.
36  See footnote 35.
37  GDP means Gross Domestic Product, the market value of all officially recognized final goods and services produced within a country in a year, or other given period of time.
38  According to Standard & Poor’s, see footnote 10.
39  According to Standard & Poor’s, see footnote 40.
40  “Shanghai Chaori in Default on Bond Interest Payments” by Lingling Wei, Wall Street Journal, March 6, 2014.
41  “Zombies Spreading Shows Chaori Default Just Start: China Credit” by Bloomberg News, Bloomberg, March 7, 2014.
42  According to Zhang Yingjie, Beijing-based deputy general manager in China Chengxin International Credit Rating Co., Moody’s Investors Service’s joint venture in Mainland China, see footnote 41.
43  According to Nomura, see “Fears of China’s Shadow Banking Implosion Are Overblown” by Nina Xiang, Forbes, February 18, 2014.
44  “Rating agencies criticize China’s bailout of failed $500m trust” by Josh Noble, Financial Times, January 30, 2014.
45  See footnote 24.
46  See footnote 24.
47  See footnote 7.
48  See, for example, footnote 7.
49  See footnote 26.
50  See footnote 34.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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