The legacy of the soon-to-retire PBoC governor, Zhou Xiochuan, will be that in sharp contrast to his western brethren, he warned that China’s credit bubble would burst before the fact. Two weeks ago, Zhou warned during the Party Congress that China’s financial system could be heading for a “Minsky moment” due to high levels of corporate debt and rapidly rising household debt (see here).

“If we are too optimistic when things go smoothly, tensions build up, which could lead to a sharp correction, what we call a ‘Minsky moment’. That’s what we should particularly defend against.”

Perhaps sensing that nobody in the Middle Kingdom was paying attention, we noted two days ago his lengthy essay published on the PBoC website. It contained another warning that latent risks are accumulating in the Chinese system, including some that are “hidden, complex, contagious and hazardous.” He also highlighted “debt finance disguised as equity” as a concern. Talking of which, there’s a new growth market in the gargantuan Chinese corporate debt market – we are referring to perpetual notes. Are you ready for the clever part about perpetual notes - they are debt but it’s permissible under Chinese accounting regulations to classify them as “equity” - et voila, corporate gearing has fallen. According to Bloomberg.

Under pressure to trim borrowings, China’s companies have found a way to reduce their lofty debt burdens -- even if some of the risk remains. Sales of perpetual notes - long-dated securities that can be listed as equity rather than debt on balance sheets given that in theory they could never mature -- have soared to a record this year as Beijing zeros in on leverage and the threat it poses to the financial system. The bonds are so popular that issuance by non-bank firms has jumped to the equivalent of 433 billion yuan ($65 billion), more than seven times sales by companies in the U.S.

 

“Chinese issuers love perpetual bonds because they are under great pressure to deleverage,” said Wang Ying, a senior director at Fitch Ratings in Shanghai. “Sophisticated investors should do their homework and shouldn’t be misled by the numbers in accounting books.

Unsurprisingly the state-owned companies have been gorging themselves on perpetuals, accounting for more than 60% of issuance. In the state-owned sector, perpetuals are the perfect source of financing for companies that are unlisted and need to raise financing without damaging their pro-forma gearing level. As Bloomberg notes.

While many state-owned or connected companies are trying to deleverage, actually reducing debt can be tough, says Ivan Chung, head of Greater China credit research at Moody’s Investors Service in Hong Kong. A lot of firms aren’t listed so can’t raise cash by issuing shares.

 

“By selling perpetual bonds under Chinese account treatment they can present lower debt ratios to SASAC,” Chung said, referring to the State-Owned Assets Supervision and Administration Commission of the State Council.

 

SASAC generally uses the ratio of total liabilities to total assets to measure the leverage of China’s state-owned enterprises against their performance, according to Christopher Lee, managing director of corporate ratings at S&P Global Ratings. That means perpetuals wouldn’t appear as part of the tally.

Don’t mention the war perpetuals. Bloomberg’s efforts to engage regulators and corporates in a discussion of perpetuals was spectacularly unsuccessful. To wit.

Two calls to SASAC weren’t answered and the body didn’t respond to faxed questions about why perpetual sales were increasing and whether the practice helped SOEs to conceal their true leverage burdens. State firm China Datang Corp. has sold 15 billion yuan of the securities this year, making it the country’s top non-financial issuer. The company also didn’t respond to emailed questions on the sales. Local issuance of perpetual notes only started in 2013, while offshore dollar-denominated perpetuals from China dates back to 2010. The finance ministry didn’t issue the regulation saying accountants can classify the securities as equity until 2014.

Besides facilitating more debt equity to be piled on to China’s debt mountain, there are two further downsides to the rapid growth in perpetuals issuance:

  • Perpetuals are more expensive than plain vanilla debt during the five years following issuance. Bloomberg estimates the average coupon on perpetual notes is 5.83%, about 20 basis points higher than a 5-year note; and
  • The coupon on perpetuals typically rises after 5 years, often by 100-200 basis points or more. Consequently, Chinese corporates need to be in a position to refinance them within that period.

With respect to the latter, Bloomberg notes...

Rating firms sometimes classify perpetuals as debt when assessing Chinese companies’ creditworthiness. Fitch does this if the call date on the note is within five years of issuance and the coupon step-up is 100 basis points or more. S&P does the same if the jump in the coupon is at least 200 basis points. But because of the way they work, perpetuals can pose particular problems for firms facing financial difficulties, said Tan Chang, an analyst at China Chengxin International Credit Rating Co.’s research institute in Beijing.

 

“If a company faces capital shortages on the call date and can’t redeem the bonds, they must accept a surge in future interest payments,” she said. That “may worsen the company’s financials and increase credit risks.”

…which is reminiscent of adjustable rate mortgages.

We have to credit (intended) China’s corporate sector with “pushing the envelope” in terms of finding ways to extend its debt binge. Last week we highlighted the debt-laden and corruption-tainted conglomerate, HNA, which issued dollar bonds with less than a year to maturity in order to circumvent restrictions on outbound investment. The only problem was the coupon of 9%. PBoC Governor, Zhou, must be coming to the realisation that nobody is going to listen to him and he might as well trudge off into the sunset and leave China Inc. to its fate. Nobody likes a smart ass anyway.