How Bond Defaults Are Changing China's Markets

Tracy Alloway (0:10)

Hello, and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:15)

And I'm Joe Weisenthal.

Tracy Alloway (0:18)

So Joe, you know I just came back from Beijing.

Joe Weisenthal (0:21)

Yes, and we haven't even talked about it yet, but I saw all of your pictures, and I'm extremely jealous.

Tracy Alloway (0:29)

Yeah, the food was very good, and you should be jealous because you missed out on quite a lot. But you know, I hadn't-

Joe Weisenthal (0:35)

You had some lamb thing, like a big gigantic barbecued lamb that just looked like the best thing I've ever seen. Is that right?

Tracy Alloway (0:42)

It was so good. It was amazing. It was like a Mongolian barbecued leg of lamb that you grill at your own little table, and then you dip it into crushed peanuts and salt, and it was good.

Joe Weisenthal (0:56)

I'm allergic to peanuts, but everything else sounded amazing.

Tracy Alloway (1:00)

All right.

Well, next time you come, we will have that without the peanuts. But you know, I hadn't been back to Beijing for like 13 or 14 years, and there were so many changes to the city, like really big ones. Whole areas of it are just unrecognizable to what they looked like in 2005, 2006

Joe Weisenthal (1:21)

I feel like we should do a whole episode at some point, just like you comparing Beijing over 13 years. I bet people would be interested in that.

Tracy Alloway (1:29)

I don't think I was as financially minded back in 2005 and 2006, but I was gonna say, one of the biggest changes in that time period has of course been to China's capital market. So 13 years ago, China didn't really have much of a corporate bond market.

And now it has a pretty big one, both domestically and dollar denominated offshore bonds as well. But most importantly, China's corporate bond market has had a number of defaults in recent years. And that's a really big change because historically, it was kind of uncertain that the authorities in China would allow companies to default. So you can imagine, Joe, that makes for an interesting bond market, given that bonds are of course supposed to reflect investors' perception of default risk.

Joe Weisenthal (2:20)

Yeah, I remember, I guess, what was it, 2014 or 2015, the first ever Chinese bond default.

And I remember thinking, how is this possible? How could you have the first ever bond default? And I almost thought I was misreading the article as this idea that there had never been a defaulted bond before. But obviously, we sort of take for granted the maturity of the US bond market, the US corporate bond market, and then defaults even in good times. They happen from time to time with low rated companies. We sort of take for granted that not all markets are as mature and sort of market regulated the way the US one is.

Tracy Alloway (3:01)

Yeah, totally. And I mean, I remember in 2015, analysts over at Bank of America, Merrill Lynch, they published a note that was basically a history of Chinese corporate bond defaults. And there were like two things on there.

It was a pretty short note, as you might imagine. But it raises all these interesting questions about how do you actually develop a corporate bond market almost from scratch? And what sort of distortions or unique characteristics are introduced when you have a big question mark over whether or not defaults will be allowed? And I should just say, one of the defining features of China's sort of business system as a whole is the division between private companies and state owned enterprises. So SOEs, these big state run conglomerates that are often thought to be government backed or even government guaranteed.

Joe Weisenthal (3:57)

Right. Well, I'm interested in learning more about this topic.

Tracy Alloway (4:02)

All right. So we actually have the perfect guest to talk about all of this. It's someone who's done a lot of academic work on exactly this topic, as well as a lot of other stuff.

It's Jun Pan. She is a professor at the Shanghai Advanced Institute of Finance at Shanghai Jiao Tong University. So Jun, thank you so much for coming on.

Jun Pan (4:23)

Well, thank you so much for the invitation. It's exciting to hear what you and Joe just talked about. It's really an interesting topic for me at the moment.

Tracy Alloway (4:35)

Right, so you actually just published a paper where you were looking at this exact topic, and specifically, you were looking at whether or not spreads or risk premiums on China's corporate bonds actually reflect the health, the financial health of its companies. But before we dive into that, I wanted to sort of ask you a broader question about how China's financial markets are currently structured. So corporate bonds are supposed to be market-based versus the sort of traditional bank-based system of lending in China. And what I mean by market-based is investors are setting or influencing funding costs by demanding a certain level of compensation for perceived risk.