Why China’s Debt Defaults Are More Alarming This Time

Chinese companies are facing a reality check after years of ramping up debt. A crackdown on unregulated lending -- so-called shadow banking -- and tighter rules on asset management made it harder for some to borrow fresh funds to repay existing debt, leading to a record number of bond defaults in 2018 and 2019. When the pandemic put business activity on hold in early 2020, policy makers initially rushed to prevent another wave of missed payments. As the year wound down, private-sector defaults seemed to be coming down but the list of state-tied firms in distress had grown, despite signs of an economic recovery. That new source of risk has roiled China’s credit markets, prompting a renewed emphasis on financial discipline and a “zero tolerance” approach to misbehavior.

1. How big is the problem?

Chinese defaults actually dropped by 20% in the first three quarters of 2020 to 85.1 billion yuan ($13 billion), according to Bloomberg-compiled data. That was largely due to pandemic-related measures in the first half: At least a dozen companies managed to relieve pressure by delaying repayments, swapping bonds or canceling early repayment. However, short-term measures often end up just buying time, while the credit risk remains. Defaults picked up again in the second half, and investors were predicting another record year. In 2019, onshore defaults totaled more than 141.9 billion yuan, dominated by private enterprises. (The 2018 total of 122 billion yuan was itself more than quadruple the level in 2017.) By late 2020, there were signs that the stress in the private sector was bottoming out. But a string of defaults among state-linked firms, long considered to be immune from such troubles because of their implicit government backing, has shaken investors’ confidence.

2. What’s behind that?

Investors and banks historically have favored state-backed borrowers and are reluctant to extend credit to smaller, private companies. On top of that, the government’s surprise seizure of Baoshang Bank Co. in May 2019 -- the first such takeover in two decades -- cut many investors’ tolerance for risk. Meanwhile, growth in the broader economy had been losing steam long before Covid-19 emerged, and weaker companies can be subject to funding squeezes and higher repayment pressure.

3. Where are defaults hitting?

In 2016, most were in industries with excess capacity such as coal and steel. This year, transportation, tourism and retailing were especially hard hit by the pandemic. But the pain extended wider. In December Tsinghua Unigroup Co., a top chipmaker, said it wouldn’t be able to repay the principal on a $450 million dollar bond, after it defaulted on a 1.3 billion yuan local bond in November. Yongcheng Coal & Electricity Holding Group Co., a state-run coal miner, blamed tight liquidity for its November payment failure. Brilliance Auto Group Holdings Co., a state-owned carmaker linked to BMW AG, also failed to repay its domestic debt that month. Last year Tewoo Group, a major commodities trader based in Tianjin, restructured $1.25 billion of debt in an unprecedented deal in which most investors accepted heavy losses. It was the biggest dollar-bond default among state-owned companies in 20 years. Some heavily indebted companies managed to hang on, however: Property developer China Evergrande Group secured a $4.6 billion investment from state-linked companies to help shore up its finances.

4. Has the government stepped in?

Allowing the defaults by a few state-backed firms showed that it wants a market-based approach, but in an orderly manner. China’s top financial regulators, presided over by Vice Premier Liu He, in November pledged a “zero tolerance” approach to fraud and other violations in the bond market to protect investors. China’s interbank bond market watchdog also jumped to investigate banks and others linked to the Yongcheng Coal bond sales over alleged irregularities.

5. And more broadly?

China’s central bank has been providing hundreds of billions of yuan in loans, and regulators have promised speedy approvals for companies to sell “anti-epidemic bonds.” (Although ostensibly meant to fund virus-fighting efforts, a closer look early in the year showed the bulk of some bonds going to roll over old debt.) The central bank has also lowered interest rates for commercial banks to encourage more lending. For two years officials have been injecting liquidity into the financial markets through measures such as cutting banks’ required reserve ratios. They have offered banks cash and encouraged them to lend more to help small companies and to support their smaller peers, which are the main buyers of corporate debt. Nonetheless, policy makers are still keen to avoid another debt bubble like the one that emerged after the 2008 global financial crisis. Signs that they are refocusing attention on risk prevention include tighter financing rules for property firms and an announcement that the sector won’t be used as short-term economic stimulus.

6. How did we get here?

Chinese companies have been piling on debt for at least a decade, ever since the leadership team under President Xi Jinping’s predecessor responded to the 2008 crisis by going on a borrowing binge. That kept China’s economy chugging, but at a cost. The corporate debt to GDP ratio surged to a record 160% at the end of 2017, from 101% 10 years earlier. Xi and his lieutenants vowed to rein it in, issuing directives on how money was to be loaned and managed. A particular goal has been to curb China’s $10 trillion ecosystem of shadow banking. So-called local government financing vehicles, which were established to fund infrastructure projects, have already defaulted on many trust loans (which were part of that shadow system). They had yet to suffer a bond default as 2020 began, but concerns have been rising over the repayment risks for LGFVs from some provinces.

7. What’s the impact of rising defaults?

Given signs that authorities are more comfortable letting borrowers renege on payments both in the domestic market and offshore, potential investors are reassessing risks. They’ve also grown more skeptical about the quality of Chinese issuers’ financial reporting. In one case, the China Securities Regulatory Commission found Kangde Xin Composite Material Group Co., a laminating film and equipment maker in Jiangsu province, had fabricated 11.9 billion yuan of profits during 2015-2018. Meanwhile, China has seen a booming market for junk bond investors. A fast-expanding pool of souring debt and a new generation of risk hunters also helps create a more diverse market where creditworthiness is better reflected in pricing. China is seeking help on credit analysis from some of the international rating firms favored by overseas money managers, and offering U.S. investors greater access to the potentially lucrative pool.

8. How does bankruptcy work in China?

In the current process, troubled companies get as long as nine months from when the court accepts a bankruptcy reorganization filing to agree on a restructuring plan with all parties. If they fail the company 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 drag on beyond nine months and foreign investors have had limited enforcement rights on some state-owned assets, according to Pacific Investment Management Co.

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©2020 Bloomberg L.P.

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