Signage will be illuminated at China Huarong Asset Management Co.'s headquarters on Financial Street in Beijing, China on Wednesday, May 19, 2021.
Yan Cong | Bloomberg | Getty Images
BEIJING – Vulnerabilities are emerging in China's growing mountain of debt.
Public debt has risen to nearly four times GDP, while corporate bonds have defaulted more and more over the past 18 months.
Although the recent defaults represent only a fraction of China's $ 13 trillion onshore bond market, a few high profile cases have rocked investors as the popular belief has been that the Chinese government will not fail state-backed companies.
The case of China's debtor Huarong has also scared investors and led to a market flight this year when the company failed to submit its profits on time and collapsed its US dollar-denominated bonds.
Analysts said cases like this signal how the state's so-called implicit guarantee is changing as the government tries to improve the quality of the bond market – weeding out the weaker companies and allowing some differentiation within the industry.
As China's growth slows, authorities are trying to strike a better balance between maintaining control and allowing some market-driven forces into the economy in order to sustain growth over the long term.
For the first half of this year, the total number of corporate bonds in default in China was 62.59 billion yuan ($ 9.68 billion) – the highest in the first half since 2014, according to data from Fitch Ratings at more than half that amount – about 35.65 billion yuan.
For all of 2020, bond defaults totaled 146.77 billion yuan, according to Fitch, a huge increase from 2014, just six years ago. This year, defaults were 1.34 billion yuan and there were no defaults by state-owned companies, the rating agency said.
As investor fears mount, three major developments can be observed here, say economists.
1. Bond default in a gray area of local government
An important milestone in countering the idea of an implicit guarantee in the Chinese market would be the default of a bond issued by a local financing vehicle (LGFV).
These companies are typically wholly owned by local and regional governments in China and were set up to fund public infrastructure projects. Such firms' bonds rose amid an infrastructure surge as the Chinese economy improved.
"Many LGFVs are even worse than so-called zombie companies, in the sense that they couldn't pay the interest, not (to) mention the capital alone," said Larry Hu, chief economist for China at Macquarie, in a note. Zombie companies are heavily in debt and rely on loans and government subsidies to stay alive. "They were only able to survive thanks to government support."
“2021 is a window to break the implied guarantee as policy makers needn't worry about the GDP growth target for the first time in a decade. As a result, they could tolerate more credit risk, ”Hu said. It is only a matter of time before the LGFV bond defaults.
In 2015, electrical appliance maker Baoding Tianwei became the first state-owned company to default its debt after the first default in China's modern onshore bond market a year earlier.
Nomura said LGFVs were a "major focus" of China's tightening efforts, noting that bonds issued by the sector rose to a record 1.9 trillion yuan ($ 292.87 billion) over the past year, from just 0 , 6 trillion yuan in 2018.
2. Huarong's "big overhang" in the sector
For investment grade bonds in China, an important factor in future performance is how the Huarong Asset Management case will be resolved, Bank of America analysts said in a statement last month, calling the situation a "large overhang".
China's top bad debt manager Huarong is battling failed investments and a corruption case against its former chairman, who was sentenced to death in January.
After the company missed its March deadline to release 2020 results, the company also said that auditors "need more information and time to complete the audit process." However, it added that failure to provide results does not constitute a delay.
Huarong's largest donor is the Treasury Department. China's economy needs to grow fast enough to ensure that the central government budget is not further burdened.
Should the Huarong dollar bond default in disorder, we could see a widespread sell-off of Chinese loans, particularly investment grade loans.
If government assistance resolves Huarong's case, it should boost China's wealth management sector, as well as other Chinese government-affiliated companies, says Bank of America.
However, the bank added, "If there is a disorderly default on Huarong's dollar bond, we could see a widespread sell-off in China loans, particularly (investment grade) loans."
Regulators are pushing Huarong to sell non-core assets as part of an overhaul, according to a Reuters report in early June.
If Huarong defaults, the cost of capital for other state-owned companies could "rise significantly" as "markets reassess the perception of implicit guarantees by the state," Chang Wei-Liang, macro strategist at Singapore bank DBS, told CNBC via email with. When risks increase, companies need to offer higher returns to attract investors.
Chang said China has enough money to address Huarong's problems.
"The key question, however, is whether the state will step in by providing additional capital or by first imposing losses on shareholders and debtors to strengthen market discipline," he added.
3. Vulnerabilities in some provinces and local banks
To find out where potential national bankruptcy hot spots might be, analysts at S&P Global Ratings found that small banks concentrated in north and south-central China are facing deteriorating asset quality.
"Commercial banks in urban and rural areas with above-sector problem loans would have to write off 69 billion Chinese Renminbi (RMB) in those loans to bring their quota to sector averages, with those in the northeast being hardest hit," said 29. June report said.
A fiscally weaker province is likely to be related to a less dynamic economy, (and) a weaker economy means more corporate bond defaults could occur.
senior economist Euler Hermes
This could affect the ability of small banks to support local state-owned enterprises and potentially force larger banks to step in to maintain systemic stability, the report said.
The provinces with bigger problems are the ones exposed to cyclical industries, S&P Global Ratings credit analyst Ming Tan told CNBC.
Authorities need to strike a balance between approving poorer quality loans with riskier ratings and preventing the problems from accelerating, Tan said. "There is definitely a risk of mismanagement in the future, but so far we see that this has been handled pretty well."
China's banking and insurance regulators announced last week that the banking industry had sold a record 3.02 trillion yuan – or $ 465.76 billion – in distressed assets in 2020. Other data released last week showed that China's GDP rose 7.9% year over year in the second quarter, slightly below expectations.
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Some analysts have pointed to local weaknesses. Pinpoint Asset Management's analysis found that consumption in four provincial capitals – Wuhan, Guiyang, Shijiazhuang and Yinchuan – declined in May from a year earlier.
"A fiscally weaker province is likely to be related to a less dynamic economy, (and) a weaker economy means more corporate bond defaults could occur," said Francoise Huang, senior economist at Euler Hermes, an Allianz subsidiary.
The longer-term problem is restructuring the economies of these weaker provinces so that more dynamic ones can grow, she said. "I don't think the solution would be to keep investing in these underperforming sectors just to keep them alive."