China fixed income: Dislocations create opportunities in this large and diverse market

China continues to confront a confluence of macroeconomic challenges that have resulted in a prevailing atmosphere of subdued investor sentiment both domestically and internationally. These challenges have chiefly revolved around apprehensions regarding the sustainability of debt, particularly within the real estate and local government financing vehicle (LGFV) sectors. While these concerns are warranted, it is essential to recognize that China remains a large and diverse opportunity set, as current market dislocations also offer unique investment opportunities. We believe such environments provide chances for us to lean on industry expertise and lessons learned across previous market cycles: to look through near-term noise and identify the future winners.

The Chinese property sector shows signs of stabilization after prolonged turbulence, with policy measures aiding sector sentiment. In the near term, market recovery appears promising, driven by recent demand-side policy adjustments, including the relaxation of nationwide mortgage restrictions aimed at alleviating short-term economic drag and instilling broader confidence. In the medium term, China's property sector is undergoing a structural transformation in supply and demand dynamics, as alluded to in the July Politburo meeting. This evolution will be accompanied by noticeable divergences in performance among developers and across different regions and cities.

Looking beyond short-term market cycles, we anticipate the likelihood of further defaults among privately owned enterprises (POEs) developers. For the surviving POEs, restructuring their debt-heavy balance sheets will be imperative to ensure the delivery of homes along with their long-term viability in the market. This poses potential conflicts of interest with USD bondholders, who face significant subordination risks. Conversely the emergence of "white knights," particularly from a policy perspective, represents a substantial upside scenario. Nevertheless, these factors introduce a level of binary risk, shaping our cautious and selective approach within the space.

As for the concerns of China's financial stability in LGFV stemming from the property sector, we contend that China's financial system is now better equipped to weather such stressors, thanks to improvements made during the multiyear financial deleveraging campaign initiated in 2016, which included:

• Reduction of credit growth rates and stabilization of overall system leverage as a percentage of GDP;
• Improved transparency in risk assessment and capital charges due to the transformation of risky and opaque shadow banking credit into formal loans within banks;
• Recognition of substantial amounts of bad debt, which has been an essential step in enhancing the system's resilience;
• Implementation of derisking efforts in mid-tier banks; smaller banks, though relatively weaker, generally do not pose systemic risks due to ongoing recapitalization and consolidation efforts;
• Establishment of 2018 asset management rules that have curbed leverage and duration mismatches in wealth management products by prohibiting guarantees or bailouts. These rules, targeting moral hazard and implicit guarantees, have resulted in an increase in permitted defaults across several financial instruments; and
• Execution of a significant overhaul of the financial regulatory framework, which has resulted in the establishment of a new “super regulator” with a holistic and coordinated approach to policymaking and supervision.

Over the years, Chinese authorities have proactively addressed major pockets of financial risk that had accumulated since the global financial crisis. That comprehensive approach, implemented step by step, has tackled issues ranging from shadow banking, state-owned enterprise debt, overleveraged corporate groups, fintech, and peer-to-peer lending. While property and LGFVs present some of the last remaining and most formidable financial risks, various attempts to address them have yielded mixed results, and a definitive resolution plan remains elusive.

While the presence of bad debt and restructuring is inevitable, in our view, banks should be sufficiently resilient to absorb these losses (assuming a gradual and managed approach). Moreover, the government and state-related entities are expected to share some of the loss and recapitalization burden. In addition to China's commitment to shift its economic growth model from quantity-driven factors like credit, property, and investments to quality-driven drivers such as consumption, services, and high-end manufacturing, we anticipate that authorities will be willing to tolerate lower economic growth rates provided these reduced rates do not precipitate systemic crises. This approach underscores the unlikelihood of reverting to a credit-fueled bailout, an act that could create bigger problems down the road.

Although challenges persist, China's financial system has undergone substantial improvements, which have made it more resilient to the stresses stemming from the property and LGFV sectors. We believe these challenges present opportunities for astute investors to identify mispriced assets and navigate through the evolving landscape, in conjunction with a well-informed process with deep research.