Investors should brace themselves for rising defaults from Chinese bond issuers after the Chinese government sent a clear signal that it will reduce short-term leverage in its financial system.

Among key takeaways from the concluded 19th National People’s Congress (NPC) of China were messages relating to strengthening the financial system and the economy.

“If you read all the comments behind the Congress, President Xi is obviously much more in control of the economy than a year or so ago. The debt-to-GDP has not really changed, but that requires a long-term solution. But it’s the short-term leverage that is being taken out. It’s the leverage within the financial system which is really unnecessary,” says Sean Taylor, chief investment officer, Asia-Pacific and head of emerging markets at Deutsche Asset Management in an interview with The Asset.

Taylor admits that while the overall debt-to-GDP ratio remains an issue, Chinese authorities appear more determined after the NPC to reduce short-term leverage in the medium-term even if it means allowing defaults among poorly performing companies.

“We will see more defaults and we would welcome that because of all the differentiation that would result. The economy is in much better shape now than it was three to four years ago. Defaults were not being allowed to happen the past four years. The fact that they’re allowing those defaults to happen now is positive because they’re allowing the normal market system to work,” says Taylor.

In what could be a warning sign of more defaults, a Chinese firm missed on a bond payment shortly after the 19th Congress. Dandong Port Group failed to repay part of notes to investors. Dandong Port sold 1 billion yuan ($151 million) of five-year bonds in 2014 with an initial coupon rate of 5.86% with an option for investors to sell them back to the port company. The company has failed to honour the option payments.

Soaring borrowing costs are eroding companies’ profits, making it tougher for firms to to roll over existing debt. Already, a number of onshore bonds have defaulted this year. In August, Wuyang Construction Group Co, a builder in the eastern province of Zhejiang, defaulted on two putable notes totaling 1.36 billion yuan.

“Smaller banks and smaller institutions who have leveraged up by borrowing cheaply and leveraging their books to get profit, that’s the sort of speculation that the authorities are trying to take out,” Taylor says.

China’s efforts to reduce leverage, however is boosting investor confidence in its bond market. Deutsche Asset Management has turned more positive about allocating to Chinese bonds.

“On a bond perspective, we’re still selective. We were negative earlier in the year, but we now think that China is looking okay particularly when compared to other emerging markets like the Middle East, Brazil and Russia,” Taylor says.

In 2017, the Chinese government has managed to contain capital out-flows after some confusion over policy issues at the beginning of the year. At that time the market was nervous about the renminbi and there were expectations that a devaluation may take place.

Since then the authorities have focused on controlling capital outflows and sending a clear message that capital flight will not be allowed.

“A year or so ago it was still confusing. The PBoC (People’s Bank of China) was saying we’ve got this capital outflows, but at the same time SAFE (State Administration of Foreign Exchange) was letting big corporates in China, namely state-owned enterprises to buy into trophy assets in the US and Europe. There was conflicting policy. This year there has been a much clearer policy. That has allowed China to rebuild credibility and control its economy a lot more,” Taylor says. Speculation in the property market and the country’s long-term debt are among the biggest investment risks in China, he adds. China’s debt-to-GDP ratio stood at 327% or US$217 trillion in the first quarter of 2017.

“In the long term they still has to tackle the debt-to-GDP ratio. One way of tackling it is to get more of that debt offshore – to get foreigners to buy more of it. So the Bond Connect is an incredibly important stage in that,” says Taylor, referring to a Hong Kong bond trade scheme that links China’s US$9 trillion bond market to foreign buyers.