China's Move to Limit Risk Misses the Problem With Bonds

These broad changes come at a sensitive time, and raise the question of whether companies in China can cope with the dual challenge of rising interest rates and tighter liquidity.

China’s wealth-management industry may be fraught with moral hazard but it is a key source of funding for the private sector, especially when firms find themselves cut off from regular financing channels such as bank loans. Wealth management product proceeds have funded many a property project, which helps explain why shares of China Vanke Co. tumbled as much as 4% in Hong Kong on Monday.

Sudden liquidity tightening can also result in nasty surprises.

Dandong Port Group Co., which manages China’s largest trading harbor with North Korea, defaulted on a 1 billion yuan ($151 million) bond that matured last month even though it’s a profitable company with 15% operating margins. It just couldn’t refinance fast enough.

The yield on government debt due in a decade stabilized at 3.96% Monday, but that’s probably the calm before the storm. China’s debt market lacks proper credit ratings and is best described as a large sausage stuffed with good and bad meat. Of the some 1,500 notes of publicly traded companies covered by the nation’s four main credit-rating firms, 70% are scored AA or above, and 60% are AAA. As recently as June, Dandong Port was at a respectable AA.

As Gadfly has noted, China is unlikely to want benchmark yields to spike much higher. But here’s the problem with bonds: often bought with leverage, they can sell off quickly when risk aversion grips. What’s more, asset managers will have to list their WMPs at market value rather than at cost, meaning any bond-market correction could snowball into worse much faster.

With these new rules, Beijing risks opening a Pandora’s box of new problems.

— For more columns from Bloomberg View, visit http://www.bloomberg.com/view.