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The unexpected failure of this seemingly healthy company shows what can go wrong when you invest in China

The Chinese property developer Kaisa has run into financial problems that have yet to be satisfactorily explained. Despite, or perhaps because of, these unanswered questions, the episode sheds an interesting light on the possible contagion — and other — risks of investing in China.

Kaisa's failure to make a $23 million bond coupon payment in January came as a shock to investors, given that the company had appeared to be in reasonable financial condition and was considered to be among the better governed and relatively less leveraged private Chinese developers.

Trouble began in December when three senior managers — including the chairman and founder, Kwok Ying Shing — resigned after local authorities blocked sales of the company's apartments in new housing projects in Shenzhen. The company denied rumors that Kwok Ying Shing was being investigated by the government as part of its anti-corruption campaign.

As the crisis deepened, the value of Kaisa's securities in debt and equity markets fell, causing considerable pain for investors — many of whom held Kaisa shares and/or bonds directly as part of their core exposures to the property sector.

As the end of the 30-day grace period loomed, relief came in the form of a loan repayment waiver by HSBC and the announcement that another developer, Sunac China, would take a 49.3% stake in Kaisa. Since then, however, it has been revealed that Kaisa's debt is much larger than previously disclosed — a development that could complicate negotiations with banks, bondholders, shareholders, and Sunac.

What seems clear from our perspective is that a restructuring for offshore bondholders is likely. As another litmus test of the subordination risk in China's debt markets, the market will carefully review how onshore and offshore debt holders will be treated. This episode has brought into focus a number of issues of concern to investors.

Political and policy risks

Why, for example, did an apparently healthy company suddenly become financially distressed? Many investors suspect that politics played a role, based on the Shenzhen government's intervention in apartment sales and rumors that the company chairman was being investigated.

While not making any assumptions about the specifics that might have applied in Kaisa's case, our view is that political and policy risks in China these days are moving increasingly to the upside. This is because the government's reform program is taking China's economy in the right direction by making it more open, balanced, and efficient.

Increasing risks

There is one issue, however, that we regard as more problematic.

This is the contagion effect: Trading in Chinese property bonds and equities paused when the news of Kaisa's problems broke. This typically does not happen in mature capital markets. The property sectors of China's capital markets have now largely returned to normal but remain vulnerable to contagion from similar episodes in the future.

This vulnerability is to be expected in the current stage of development of China's capital markets, and, unfortunately, several corporate collapses may be necessary before the markets learn to take them in stride. Only after a number of these issues occur will investors gain confidence in the ability of the country's legal system to resolve them in an orderly manner.

Time will tell, as the potential for defaults in China seems to be increasing. The country — as well as, indeed, Asia as a whole — is at a late stage in the credit cycle. Slowing credit growth, driven in no small part by government efforts to rein in expansion, is putting pressure on private companies and state-owned enterprises across all industries.

Diversification is important

There are two actions corporate bond investors can take in this environment to give themselves some measure of protection. One is to be prudent about individual security exposures, as idiosyncratic risk is now high and problems can arise unexpectedly. For this reason, it's important to diversify — for example, by investing in managed funds rather than directly in securities.

The second action is to invest in funds run by managers with strong risk-management skills. While a Kaisa-like event might detract from a portfolio's short-term performance, it needn't result in a loss if that portfolio has been properly constructed with regard to risks as well as returns.



© LEHMAN, LEE & XU 2014.
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