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Bond default a "moment of reckoning for the Chinese government"

Aaron Task
Daily Ticker

Bond default a "moment of reckoning for the Chinese government”

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Until recently, few investors outside China had ever heard of Shanghai Chaori Solar Energy Science & Technology Co. But the maker of solar cells is now the talk of the global financial community amid fears it could be the proverbial butterfly whose flapping wings cause an earthquake in China's $1.4 trillion credit market.

Last week, Shanghai Chaori Solar said it was unlikely to be able to make a roughly $14.7 million debt payment by Friday's deadline, putting it on track to be the first corporate borrower to default in China.

“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,” write Bank of America strategists David Cui, Tracy Tian and Katherine Tai, suggesting this event could prove to be a "Bear Stearns moment" for China.

In the summer of 2007, two internal Bear Stearns hedge funds collapsed due to bad bets on subprime mortgage-backed securities. Their failure was a harbinger of both the end of the credit boom and the ultimate collapse of Bear Stearns itself, which was consumed by J.P. Morgan (JPM) in March 2008 in a deal facilitated by the Federal Reserve. At the time, many thought the "rescue" of Bear Stearns signaled the end of the crisis and financial markets rallied; but Bears' demise was merely a prelude to the collapse of Lehman Brothers in September 2008, and the financial chaos which resulted.

To be sure, Bank of America's (BAC) strategists aren't the first -- nor likely the last -- to warn that China's debt boom is going to end badly. Last summer, Fitch analyst Charlene Chu generated headlines by warning about China's overall debt market, specifically its wealth products. From 2008 to 2013, China's debt-to-GDP levels jumped 75 basis points to 200% vs. a 40 basis point rise in the U.S. in the five years ending 2007, Chu noted, prompting her to warn: "This is beyond anything we have ever seen before in a large economy. We don't know how this will play out. The next six months will be crucial."

Again, that was roughly 10 months ago, suggesting today's warnings about Shanghai Chaori Solar missing a $14.7 million debt payment should be taken with a grain of salt, especially given the context that China's corporate bond market is $1.4 trillion and the nation's foreign currency reserves topped $3.8 trillion in December.

"I think people underestimate the scale of things that happen in China," says Dan Colarusso, executive editor of Reuters Digital. "The real 'Bear Stearns moment', if there is going to be one -- and it's a frightening specter -- is if [a default] happens in a consumer-lending area like real estate or a bank where hot money flows through quickly."

Unlike consumer-based firms, where a lot of so-called shadow banking occurs, Shanghai Chaori Solar operates in a regulated industry that is not dissimilar to the U.S. utility industry, he notes. "Maybe the government feels there's a glut and it may be time to take in some capacity" and so is willing to let market forces work vs. stepping in to rescue the firm (and its debt holders).

 Related: Fear the dragon: China could be next global headwind

Colarusso's forecast is that Chinese authorities will let the Shanghai Chaori Solar default play out "and see how the world reacts." With other solar players like LDK Solar fighting with creditors and myriad companies in the coal, wind and steel industries struggling as well, Shanghai Chaori Solar could prove to be a good test case for Chinese authorities to weigh the impact of letting the 'free market' work. On the other hand, Chinese officials declared this week they will allow a freer flow of credit in order to meet the nation's 7.5% GDP growth target.

"More than a 'Bear Stearns moment', it's a real moment of reckoning for the Chinese government," which seems to want to have its cake and it eat it too, Colarusso says.

Aaron Task is the host of The Daily Ticker and Editor-in-Chief of Yahoo Finance. You can follow him on Twitter at @aarontask or email him at altask@yahoo.com.

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