Failure Can Be Good
In the first week of March, Chaori Solar (a Chinese solar panel maker), became the first ever corporation in China to default on its corporate bond. Although defaults are commonplace in the U.S., China’s local governments have historically bailed out companies that are close to missing payments on loans. The reason for most bailouts is almost always politically motivated. Local officials in China often fear that a default would damage their career prospects, and the potential economic concerns surrounding unemployment from a failed enterprise in their region/district have encouraged bailouts in the past. As a result, investors have often viewed corporate bonds in China to have implicit government backing. Since many investors felt that corporate bonds were as safe as government bonds, they chased those bonds with the highest returns with no concern for default risk.
Government bailouts are almost always a bad outcome for markets in the long-run because they discourage companies from practicing financial discipline. Additionally, they also discourage investors from paying attention to the risks associated with an investment opportunity. Our Investment Committee views this default as positive for the global economy for three reasons:
- Reduces Moral Hazard: A “moral hazard” is a situation where one party takes risks because any negative outcome will not affect them. This change from China’s past behavior of bailing out companies sends a message to other firms that there will be consequences for mismanagement.
- Push-Needed Reform: This minor default will likely encourage investors and regulators to pursue reforms in investor protection via covenants and better disclosures and governance.
- The Concept of Risk Has Now Been Introduced: Lenders and investors will become more disciplined because they can now lose money. In addition, firms with less risk will pay less to borrow, and those with more risk will pay more to borrow.
The bottom line is that failure is often good for economies because the lessons learned will likely make markets more reliable. Companies must be penalized for borrowing more money than they can handle, and those firms who are in worse financial shape should be required to pay a higher interest rate if they choose to pursue more debt. Investors will likely be far more cautious the next time they are presented with the opportunity for higher returns with no regard to the risk involved.
Read this week’s Thought of the Week to learn more about corporate bond defaults in China.
Click Here for the Weekly Thought As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.