China Firms Went Deep in Debt. Here Come the Defaults

(Bloomberg) -- Chinese companies are facing a reality check after years of ramping up debt. The deleveraging campaign that President Xi Jinping began in 2016 to curb risks in the nation’s financial markets has cracked down on shadow financing and tightened rules on asset management. As a result, firms are having a tough time raising new funds to repay existing debt, leading to a record amount of bond defaults this year.

1. How big is the default problem?

There have been about 33.3 billion yuan ($4.9 billion) in corporate bond defaults so far this year, data compiled by Bloomberg show. That already exceeds the full-year record of 30 billion yuan, set in 2016. These include nine private and 25 public offerings. Strains are set to get worse if the trends of credit-rating companies are anything to go by -- agencies including Dagong Global Rating Co. have been downgrading firms by an unprecedented margin.

2. Why are bond issuers defaulting?

Chinese companies are finding it harder to get financing, while investors are demanding ever-higher interest rates. The average yield on AA- rated firms, considered junk score in China, has risen 210 basis points from a six-year low in October 2016 to 7.2 percent currently, near the highest in more than three years. In the previous default peak in 2016, most of the failures were in industries with excess capacity including coal and steel.

3. Where are defaults hitting hardest this time?

The energy sector, for one. Oil firm CEFC Shanghai International Group Ltd. and coal miner Wintime Energy Co. were the biggest defaulters, according to data compiled by Bloomberg. Last year, industrial firms saw most missed payments, accounting for 60 percent of the 2017 tally. By region, Shanxi Province took the No. 1 spot with 11.4 billion yuan of bond defaults, all of which were by Wintime Energy. It was followed by Shanghai (7 billion yuan) and Liaoning (4.95 billion yuan).

4. How did we get here?

Chinese companies have been piling on debt for at least a decade, ever since the leadership team under Xi’s predecessor unleashed a record borrowing binge in response to the global financial crisis. Corporate debt to GDP ratio surged to a record 160 percent at the end of 2017 from 101 percent 10 years earlier. Xi and his lieutenants have vowed to deflate asset bubbles by, among other steps, reining in excessive corporate borrowing. Starting last year, the government issued a flurry of directives on how money is loaned and managed, with a particular goal of curbing China’s $10 trillion ecosystem of unregulated lending, known as shadow banking.

5. What’s the impact of rising defaults?

They’ve spurred investors to reassess risks with Chinese firms amid signs that authorities are more comfortable with letting borrowers renege on payments both in the domestic market and offshore. As investors shun weaker borrowers, yields on their existing debt has been rising, which further dampens their ability to issue new debt. The average yield on dollar-based junk bonds from China has risen over 4 percentage points this year to 10.3 percent, near the highest level since February 2015. Junk bond sales in both domestic and offshore market have been slowing, indicating more liquidity strains to come.

6. Has the government done anything to curb defaults?

Yes, in hopes of keeping strains in the domestic bond market from spiraling into a broader systemic collapse. In recent months, officials have moved to inject liquidity into the financial markets by measures such as cutting banks’ required reserve ratios. They’ve also pressured creditors to negotiate with beleaguered individual borrowers. So far, they’ve stopped short of an outright bailout. Regulators this week offered banks cash and asked them to lend more, to help small firms reduce financing costs. The challenge will be encouraging market-driven efforts to resolve corporate debt issues without reinforcing the old image of a state-dominated financial system.

7. How bad will corporate bond defaults get?

Chinese companies face 2.5 trillion yuan of bond maturities in the remainder of 2018, one of the busiest redemption periods. Less market demand for corporate bonds, combined with higher bond yields, means more liquidity crunches may occur at corporations. To make things worse, many Chinese companies may be living on borrowed time with the biggest cash flow deficit in six years. Analysts expect property developers and local government financial vehicles may be riskier due to more restrictive refinancing policies. More investors are now looking at how those defaults will be resolved.

8. How is the restructuring process in China?

In the current law which has been effective since 2007, a restructuring process allows troubled companies up to nine months from when the court accepts a bankruptcy reorganization filing to agree on a plan with all parties. If they fail they can be declared bankrupt, triggering liquidation. Concerns still exist about government’s involvement in major restructuring cases, and banks’ reluctance to pursue court-supervised workouts because they don’t want to bear losses. In practice, the process can be much longer and foreign investors have had limited enforcement rights on some state-owned assets, according to Pacific Investment Management Co.

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