China's policy easing fails to whet appetite for private firms' bonds

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By Samuel Shen and Andrew Galbraith

SHANGHAI (Reuters) - China's recent moves to ease credit conditions were supposed to support struggling private firms, but investors, spurred by easier cash, are instead pumping money into low-rated bonds issued by state-backed entities.

The People's Bank of China this month injected money into the banking system and encouraged banks to buy lower rated corporate bonds as part of attempts by the government to throw a funding lifeline to the private sector in a slowing economy

However, bond markets data shows the persistence of a stubborn preference for the debt of local government financing vehicles, or LGFVs, and state-owned enterprises (SOE).

Despite government messages to contrary, investors believe such assets are less risky owing to implicit government support.

Samuel Wang, an official at China Zheshang Bank's asset management department, said bonds issued by private firms would represent just "a small portion" of the bank's portfolio.

According to the lender's disclosure, instruments issued by corporates account for merely 1.4 percent of its 562.7 billion financial investments, which are heavily concentrated in debts issued by the government and financial institutions.

Such a bias, already reflected in rapidly falling yields in LGFV and SOE bonds recently, could mean resources continue to be channeled into China's inefficient state sector at the cost of private firms that contribute to 60 percent of China's economic growth and over 80 percent of new jobs.

"It's a paradox. Private firms were hurt by the deleveraging campaign and the government wants to help them. But for market players, the rational choice is to invest elsewhere," said Zhou Li, president of the bond-focused asset manager Rationalstone Investment.

If the private sector continues to suffer from a funding shortage, China's long-term economic growth could suffer, he said. Yet Zhou's firm, which gets mandates from banks, also shuns risky corporate bonds issued by private firms.

POLICY SHIFT

Private Chinese firms have long struggled to tap the largely state-dominated financial system, and many resorted to shadow banking and other channels for funding in the past.

But the funding environment worsened rapidly in the first half of this year as Beijing stepped up efforts to reduce risky, off-balance-sheet loans. A series of defaults also soured investors' appetite for corporate bonds.

To avert drastic credit seizure in an economy already clouded by a looming trade war with the United States, the PBOC cut some banks' reserve requirements, lent to financial institutions via a medium-term facility and encouraged them to invest in corporate bonds rated AA+ and below.

A portfolio manager at the People's Insurance Co (PICC), who declined to be named, said banks and insurers would still seek bonds issued by SOEs and LGFVs because "the market still has belief in implicit government guarantees".

Last year, the authorities tightened borrowing by local governments, reiterating that LGFV bonds are not guaranteed by the state.

AA-rated LGFV bonds maturing in five years saw yields drop 44.9 basis points this month, compared with a 29.9 bp fall in other types of corporate bonds, according to official data.

There's no index tracking bonds issued by private firms alone, but the Wenzhou Private Finance Index, an official barometer of private financing cost, ironically rose to a three-week peak of 16.67 percent on Tuesday, despite recent monetary loosening.

The market for lower-rated private issuers still faces a dearth of liquidity, hampering plans to raise loans and stirring worries over the health of the sector.

"Bonds issued by private firms are not popular because they don't have government backing and endorsement," said He Yingfei, bond analyst at CITIC Futures.

Rationalstone's Zhou agreed that funding difficulties pose an existential threat to low-rated private firms. But he added the risk-reward calculus is hard to change.

"For a bank official, if you invest in low-rated bonds issued by a private firm and lose money, you risk severe punishment. So the rational choice is to invest in those issued by SOEs," he said. "You choose the lesser of two evils."

(Reporting by Samuel Shen, John Ruwitch and Andrew Galbraith; Editing by Vidya Ranganathan and Sam Holmes)