One default, but not yet a solution for China´s financial stability – Sara Hsu

The default of the Chaori Corporate Bond might signal a change in China´s approach of shadow banking, more structural measures are needed to guarantee the country´s financial stability, writes financial expert Sara Hsu in The Diplomat.

Sara Hsu:

China continues to lag behind in risk rating and pricing of the corporate bond market and until these issues are addressed, it will continue to do so. Although some analysts believed bonds were making strides in pricing risk before the Chaori failure, the fact that many bonds are rated as AA- or above even though the interest coverage ratio (using EBITDA) is negative or less than one, revealing a weakness in ability to pay the bond coupon, shows that China’s corporate bond market is less resilient than it appears.

What does this mean for the rest of the financial economy? While some have predicted that the Chaori event will result in a revelation of risk exposure and correction across the board, it seems unlikely that this will be the case, in part due to the issues presented above. Other financial sectors of the economy have responded to risks in different ways, some with local government bailouts, as in the case of trusts, some with central government bailouts, as in the case of banks, and some with failures, as in the case of private finance. This can be attributed to the high degree of segmentation in China’s financial economy, in which the activities of financial instruments may not move in tandem, and to a lack of financial marketization, in which financial activity is not governed by interest rates or other strong market forces.

Without some fundamental, institutional changes in China’s financial economy, “market forces” will continue to be prevented from taking shape. While the Chaori incident may improve risk signaling in the non-state owned portion of the corporate bond market, it will by no means be a catalyst for positive change in the rest of the financial economy. Major reform must take place before Chinese finance relies on the natural forces of exchange rather than artificial forces posed by state owned institutions, regulated interest rates, and automatic bailout mechanisms.