Why China's Bonds Are Defaulting at a Record Pace

(Bloomberg) -- Chinese companies are facing a reality check after years of ramping up debt. A deleveraging campaign that President Xi Jinping began in 2016 to curb risks in the nation’s financial markets has cracked down on shadow banking and tightened rules on asset management. As a result, firms are having a tougher time raising new funds to repay existing debt, leading to a record number of bond defaults and government moves to try to alleviate the liquidity crunch. The worsening economic climate isn’t helping.

1. How big is the problem?

It’s big, with the potential to worsen. More than 12 billion yuan ($1.8 billion) of local note defaults took place in the first two months of 2019, including four private and 12 public offerings, according to Bloomberg-compiled data. The tally last year was a record 120 billion yuan, more than quadruple the 2017 amount. Failures from private sector firms, which accounted for more than 90 percent of total defaults last year, are still the trend. Some 4.8 trillion yuan of bonds will mature in the final 10 months of 2019. To make things worse, many companies may be living on borrowed time: Cash flow deficit for non-financial firms is at the highest level in six years.

2. Why are bond issuers defaulting?

It’s that liquidity crunch, mainly. Investors and banks, which historically have favored state-backed borrowers, are still reluctant to extend credit to smaller, private companies. Although yields for AA- rated firms, considered junk level in China, have fallen from a 3 1/2-year high in September, they are still well above the three-year average, illustrating the risk aversion.

3. Where are defaults hitting hardest?

The last time they peaked, in 2016, most of the failures were in industries with excess capacity including coal and steel. This time, a wide range are seeing delinquencies. Oil firm CEFC Shanghai International Group Ltd. and coal miner Wintime Energy Co. were the biggest defaulters in 2018, according to data compiled by Bloomberg. This year, China Minsheng Investment Group Corp., a conglomerate with a wide range of assets including property, aviation and health care, came under pressure from its $34 billion debt pile. It missed payment on a 3 billion yuan note due Jan. 29 before making good on it about two weeks later.

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 went on a borrowing binge in response to the global financial crisis. That kept China’s economy chugging but at a cost. The 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 vowed in 2016 to rein in excessive corporate borrowing and financial market leverage in an effort to reduce the risk to the economy. The government issued directives on how money is to be 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. Investors have grown more skeptical about the quality of Chinese issuers’ financial reporting after some defaulters, such as Kangde Xin Composite Material Group Co. and Reward Science and Technology Industry Group Co., had earlier reported a sizable amount of cash on their balance sheets.

6. Has the government stepped in?

Yes, while stopping short (so far) of an outright bailout. Since July last year, officials have injected liquidity into the financial markets through measures such as cutting banks’ required reserve ratios. They’ve also pressured creditors to negotiate with beleaguered borrowers. Regulators have offered banks cash and asked them to lend more to help small firms as recently as February. 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 does bankruptcy work in China?

In the current process, troubled companies get up to nine months from when the court accepts a bankruptcy reorganization filing to agree on a restructuring plan with all parties. If they fail they can be declared bankrupt, triggering liquidation. Concerns exist about the government’s heavy involvement in major restructuring cases and the reluctance of banks to pursue court-supervised plans 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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