Why China’s Debt-Loaded Companies Face a Reality Check

(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 financial markets led to a crackdown on unregulated lending -- so-called shadow banking -- and tighter rules on asset management. That 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 erupted this year, policy makers rushed to prevent a wave of missed payments while business was on hold. But with signs of economic recovery came a renewed emphasis on financial discipline, meaning more stress for firms struggling amid the fallout.

1. How big is the problem?

Chinese defaults actually dropped by 10.2% in the first half of the year to 53 billion yuan ($7.8 billion), according to Bloomberg-compiled data. That’s because as the pandemic shut down most economic activity, at least a dozen companies managed to relieve pressure by delaying bond repayments, swapping bonds or canceling early repayment. However, such short-term measures often end up just buying time, while the credit risk remains. Defaults picked up again in the second half, reaching a five-month high in August, and investors are predicting another record year. In 2019, onshore defaults totaled more than 141.9 billion yuan. The 2018 total of 122 billion yuan was itself more than quadruple the level in 2017. Private-sector firms accounted for more than 80% of defaults in 2019, data compiled by Bloomberg show. While the vast majority of defaults happen in China’s domestic, yuan-denominated bond market, offshore defaults this year have already amounted to $6.8 billion, exceeding last year’s total by 75%.

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 hardest?

In 2016, most were in industries with excess capacity such as coal and steel. This time, delinquencies have come from a wider range. The pandemic hit transportation, tourism and retailing especially hard, and some firms have warned they may struggle to repay creditors. In July, Tahoe Group Co. became the first large residential developer in China to default on a bond in five years after struggling to sell its premium properties. In February, Peking University Founder Group Corp.’s failure to make good on a local bond came after a court in Beijing agreed to a creditor’s request to put the conglomerate under debt restructuring. 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. And China Minsheng Investment Group Corp., a conglomerate with assets including property, aviation and health care, came under pressure from its $34 billion debt pile.

4. Has the government stepped in?

Yes, though with restraint. To counter the economic squeeze from the virus, China’s central bank is 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. More broadly, officials have for two years 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 financial crisis. Recent signs that Beijing is refocusing its 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.

5. 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 responded to the global financial 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.

6. 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 as part of the trade deal struck between Presidents Xi and Donald Trump early this year.

7. 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.

The Reference Shelf

• Some investors are expecting defaults to ramp up after an initial drop this year.
• QuickTake explainers on shadow banking in China, its wealth-management products and digital currency plans, what CMIG is, how its financial sector opening is going and how it got serious about financial risk.
• Bloomberg Opinion’s Andy Mukherjee examines China’s digital currency future, and Nisha Gopalan looks at Gen Z’s love affair with debt.
• Bloomberg Markets looks at “fakes” in China’s bond market.
• Bloomberg Intelligence warns of higher risk for lenders in China.
• More on the proposed guidelines for handling bond defaults.
• The riskiest sector in China: energy.
• Chinese leaders back bankruptcies for zombie firms, while creditors see strong-arm tactics from local governments.

©2020 Bloomberg L.P.

With assistance from Bloomberg