How ‘Bad Bank’ China Huarong Tested Too Big to Fail: QuickTake

(Bloomberg) -- What happens when a company set up by the Chinese government to help clean up toxic debt in the country’s banking system gets into trouble itself? We’re finding out now. Investors were spooked in April after China Huarong Asset Management Co., one of the country’s biggest distressed asset managers, failed to release financial statements on time. That raised questions not only about its financial health, but also whether the central government would let a state-backed institution fail. A presumed safety net has long been priced into Chinese bond values -- and a rescue package unveiled in August suggests Beijing isn’t ready to pull it.

1. What’s China Huarong?

It’s one of the four state-owned firms set up by China’s government in 1999 to help clean up a banking system riddled with bad debt. The firm was left reeling in 2018 after then-chairman Lai Xiaomin was accused of bribery and ultimately found guilty of receiving 1.79 billion yuan ($281 million) in illicit payments. Under his watch, China Huarong expanded into areas including securities trading, trusts and other investments, deviating from its original mandate. Lai was executed in January, an unusually harsh sentence for such a crime.

2. How did it get in trouble?

China Huarong failed to release its 2020 financial reports by a March 31 deadline, which prompted a trading halt in its shares and structured products in Hong Kong. Reports emerged, during weeks of near-silence from officialdom, of a potential restructuring or default. Bondholders, panicked about the prospect of losing money on their investments, confused by conflicting reports and operating in an information vacuum, spurred wild swings in the firm’s offshore and and local bonds. Finally, in mid-August the company posted a record $15.9 billion loss for 2020 and said government-backed investors would step in to replenish its capital.  

3. Why the panic?

Even though Huarong is majority owned by China’s Ministry of Finance and is a linchpin of the nation’s $54 trillion financial industry, there were doubts about whether it would be deemed “too big to fail.” Although authorities have long sought to wean investors off the belief that the government will step in to prevent defaults, nearly all bond valuations involve some assumption of state support. Any change in that would spur a fundamental reassessment of the way investors and rating companies look at the credit risk of Chinese borrowers. A restructuring or default at Huarong could put other firms at risk, since China’s local bond market is dominated by other state-linked borrowers. And the crisis coincided with a cash crunch at China Evergrande Group, the world’s most indebted property developer, which amplified market jitters.

4. How is Huarong coping?

The firm has said it has access to liquidity and it has been making local and offshore bond payments on time. The nation’s financial regulator also has said the firm has ample liquidity. Still Huarong was downgraded by the major international rating firms and is on watch for further cuts. Even with a bailout, Huarong is set to shrink: It’s said to be planning to sell nearly all its local units outside of the core distressed-debt business.

5. How deep is Huarong’s hole?

China Huarong and its subsidiaries have about $39 billion outstanding in local and offshore bonds alone. Of that, global investors have some $21 billion at stake in offshore notes. Because the company was considered a quasi-sovereign, investment-grade borrower, that debt was popular among institutional investors including BlackRock Inc., Goldman Sachs Group Inc. and Allianz SE. 

6. What happened to investors?

The lack of clarity over potential losses had left the dollar bonds in no man’s land: too expensive for distressed traders but too risky for some of its usual buyers. A rebound followed news of the bailout and potential $7.7 billion capital injection, with bonds due November 2025 trading at about 94 cents on the dollar. They had sunk as low as 61 cents in April. For some investors, though, that was too late: they’d been forced to unload or significantly cut back their holdings after incurring significant losses early in the selloff.

7. What’s the broader picture?

Chinese President Xi Jinping has dialed back support for weaker borrowers to reduce moral hazard, and even though Huarong is getting its bailout, the protracted process showed a determination to punish creditors who ignore risks. The stakes are high: State-owned enterprises had the equivalent of $3 trillion in onshore bonds outstanding at the end of last year, or 91% of the total, data compiled by Fitch Ratings show. A small but growing portion is now owned by international money managers, after a steady relaxation of China’s restrictions on foreign investment in recent years. SOEs reneged on a record 79.5 billion yuan of local bonds in 2020, lifting their share of onshore payment failures to 57% from 8.5% a year earlier, according to Fitch. The figure jumped to 72% in the first quarter of 2021.

8. What about China’s other bad banks?

The three other state-backed, distressed-loan managers are also showing some signs of strain. The industry has been facing rising pressure over the past year as the pandemic made it harder to dispose of assets. Increasing credit losses at the managers themselves are hurting profits and undermining capital strength, not to mention maturity mismatches as most of their liabilities are short-term. The four so-called AMCs have nearly $48 billion in outstanding dollar bonds, including China Huarong’s $19.8 billion and $18.5 billion at China Cinda Asset Management Co. The others, Orient Asset Management China Co. and China Great Wall Asset Management Co., had $5.3 billion and $4 billion respectively. Altogether they need to refinance or repay some $3 billion of maturing notes through the rest of 2021, according to data compiled by Bloomberg.

The Reference Shelf

• Follow Bloomberg’s China Credit Tracker for updates.
• Dan Wang at Bloomberg Intelligence examines Huarong’s white knights.
• Bloomberg Opinion’s Shuli Ren doesn’t see China picking up the tab for Huarong, while Anjani Trivedi asks, did no one see it coming?
• At Bloomberg Economics, Tom Orlik, chief economist, explains why China is the bubble that never pops, while David Qu says the credit risks are just beginning.
• A deep look inside the China Huarong saga, how the company’s plunging bonds are pointing to a market shift and a timeline of key events.
• Andrew Collier’s book, “Shadow Banking and the Rise of Capitalism in China.”

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