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UBS says Hong Kong traders should be worried amid China defaults

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China's state-backed companies no longer have the ironclad support of the government - and that's bad news for the equity bull market in Hong Kong, says UBS Group AG.

[TAIPEI] China's state-backed companies no longer have the ironclad support of the government - and that's bad news for the equity bull market in Hong Kong, says UBS Group AG.

Three of the seven Chinese companies that defaulted on debt repayments this year are partly owned by the state, including Baoding Tianwei Group Co. The end of implicit government support will drive up funding costs and undermine foreign investor confidence in the 20 percent rebound by the Hang Seng China Enterprises Index, said Lu Wenjie, a Shanghai-based equity strategist at UBS.

"People are realizing national SOEs can default, local government-owned enterprises can default - anything can default," Mr Lu said. "H-share investors, especially foreign investors, haven't paid much attention to this yet, so the risk isn't priced in."

Defaults are a relatively new phenomenon in China, which had its first such case only in 2014. The rising number of payment failures is reverberating across the nation's US$3 trillion credit market, with onshore junk debt heading for its biggest monthly selloff since 2014, issuers canceling bond sales and Standard & Poor's cutting its assessment of Chinese firms at the fastest pace since 2003. The widening of credit spreads from eight-year lows also threatens an incipient economic recovery, which has been mainly supported by a surge in cheap lending.

"China's credit risks haven't been entirely exposed because of implicit guarantees and bailouts," said Mr Lu, who declined to predict how far H shares will fall. "Now they're starting to be exposed, but you don't know how bad things can get."

Foreign investors have turned more optimistic about the outlook for the nation's equities than their mainland counterparts, with the Hang Seng China Enterprises Index outperforming the Shanghai Composite Index by the most in six months last week. The Hong Kong traded-gauge has pared its losses this year to 7 per cent at the end of Monday, compared with a 17 per cent plunge by China's benchmark measure, as raw material producers led the rebound.

The H-share index rose 0.3 per cent at the close, after falling as much as 1.4 per cent.

Cyclical industries seem to be showing some green shoots, but once defaults occur, you'll realize their balance-sheet risks are still very high," said Mr Lu. "Their fundamentals are not solid, so I think these stocks will suffer."

BLOOMBERG