Repricing Risk At China’s SOEs The Hard Way

FOR THREE YEARS running, defaults on Chinese corporate debt have exceeded 100 billion yuan ($15 billion). Defaulters increasingly include state-owned enterprises, signalling that Beijing is no longer extending an implicit guarantee, even to its own.

The pivot towards market-based pricing of credit and away from policy lending (also known as unproductive investment) is to be welcomed. It demands better credit decisions by lenders and implies capital will go to the firms that can best use it.

However, Beijing’s new approach also entails risk, mainly if debt repricing happens too quickly, causing a domino-effect of corporate defaults that spill over into other markets.

The latest defaults show how real this risk is.

Earlier this week, a logistics subsidiary of Jizhong Energy Group, which is owned by the Hebei provincial government, missed a scheduled repayment of principal and interest on a 500 million yuan ($76 million) trust loan. Facing a potential cascade of cross-defaults on the parent company’s bonds that would have been triggered by its subsidiary’s default, the money was found to make the payment to the lender four days late, but still within a grace period.

Word is that the financing was arranged through the good offices — and no doubt hefty local arm twisting — of the Hebei provincial government, which wanted to avoid the political awkwardness that followed the surprise delinquency of the Yongcheng Coal and Electricity Holding Group earlier in the month.

On November 10, the state-owned coal miner in Henan province unexpectedly missed a repayment due on a 1 billion yuan of short-term commercial paper, despite having presented a healthy cash position in October, the very month it issued the debt. That raised some more red flags for investors about hidden risks in China’s bond markets.

Investors were already uneasy following a default late last month by Huachen Automotive Group Holdings, the parent of the Chinese joint venture partner of German vehicle maker BMW, and a AAA-rated issuer.

They were further discomforted by regulators promising to crack down on misconduct in the corporate bond market. A statement following a meeting of the Financial Stability and Development Committee chaired by Vice Premier Liu He warned that ‘acts of intentional debt evasion’ would be severely punished. Yongcheng, which was also AAA-rated, its underwriters, rating agency and accountants are now under investigation for possible wrongdoing, including fraud.

Nevertheless, the explanation may be as simple, if scarcely less reassuring, as that Yongcheng’s parent company, Henan Energy and Chemical Industry Group, was using Yongcheng’s earnings to cover losses in other businesses. The scale of the shortfalls is indicated by the fact that last year Yongcheng, which is the country’s leading producer of high-grade anthracite, contributed 995 million yuan to Henan Energy’s group profit of 38.8 million yuan. And, yes, you did read that right.

In October, the Henan provincial government provided a liquidity injection of 7 billion yuan to Henan Energy, suggesting the shortfalls were, if anything, getting bigger.

Some reports claim that Yongcheng also shuffled assets out of the reach of its bondholders ahead of its bond delinquency. That was an eerie echo of the accusation against Huachen that it had done the same with its 30% stake in Hong Kong-listed Brilliance China Automotive Holdings.

Beijing initiated a massive deleveraging in 2015 to curb excessive borrowing by local governments, financial institutions and businesses. As a result, any ticking debt time bombs within private companies have been identified and for the most part, defused. There have been defaults, and will continue to be, but not on a scale that would threaten the bond market.

The same is not true of state-owned enterprises, who are are thought to account for more than half of the nearly $4 trillion corporate bond market. Huatai Securities has calculated that the default rate for Chinese private companies rose sharply to 5.34% in 2018 from 1.83% in 2017, but defaults by state-owned enterprises remained at 0.02%.

Ten state-owned enterprises have defaulted on bonds worth a total of 54 billion yuan so far this year (out of a total of 109 corporate bond defaults), compared to 25 over the past five years, on a total of 156.8 billion yuan of bonds. This month and next could be rocky as state-owned enterprises are at risk of year-end cash crunches.

People’s Bank of China Governor Yi Gang wrote in the middle of this month that investors have to take on more risk as China moves away from implicit guarantees of the government backstopping state-owned enterprises’ debt.

For bondholders, that is coming as an unpleasant surprise — or rather a series of them.

China Allows Its First Corporate Bond Default

CHINA’S FIRST ONSHORE default since the corporate bond market was opened up in 1997 is at hand. Solar-panel maker Shanghai Chaori Solar Energy Science & Technology has technically defaulted on its 1 billion yuan ($163 million) five-year bond issued in 2012 after warning last month that it would be unable to meet in full a 89.8 million yuan ($14.7 million) interest payment due March 7. The company says it was only able to pay 4 million yuan on the due date.

By not coming to the issuer’s aid, and as they are doing with defaulting trusts, authorities are warning that the implicit guarantee that investors have assumed government gives to every issuance no longer holds true. Big money is at stake. Chinese companies had 8.7 trillion yuan of bonds outstanding as of end-January (up from 800 billion yuan at end-2007). That makes Chaori’s default a drop in the bucket, one reason that central government is letting it default. The ripple will be salutary rather than financial.

Investors have had time to prepare. Chaori’s bonds were suspended from trading last July and its equities, listed on the Shenzhen exchange, last month. Authorities, though, will be hoping now the day of default has come it does not turn into “China’s Bear Stearns moment” as analysts at Bank of America have warned, referring to the way investors reassessed credit risks when the U.S. investment bank had to be bailed out by Washington in 2008 triggering a chain of events that led to the crash of Lehman Bros. and the global financial crisis.

Another reason to let Chaori go is the dire state of the solar panel industry where the government is promoting the consolidation of weaker players to remove excess production capacity. (Another solar panel maker, LDK Solar, has previously been allowed to default on its offshore bonds and to go to the brink of bankruptcy, a precipice that Wuxi SunTech went over.) Nonetheless, four companies have scrapped bond sales that would have raised an aggregate 1.27 billion yuan while yields on Chinese junk-bonds have jumped in the wake of Chaori’s default.

Getting lenders and investors to better price risk in domestic credit markets and corporate managers to better understand what is a realistic return on their investments in plant and equipment is exactly what President Xi Jinping and Premier Li Keqiang meant when they said market forces would be allowed to play a greater role in the Chinese economy. This Bystander expects more low-key corporate bond defaults to come in other industries suffering from excess capacity such as steel, metals and shipbuilding.

Building Out China’s Bond Markets

The ambitious urbanization plans of new leader Xi Jinping will provide the next stimulus for developing China’s nascent bond market, we read in a Reuters report. Beijing has been taking ever larger steps in expanding its municipal and corporate bond markets as part of broader reforms of both the financial system and of local government finances.

The latter are teetering under the burden of more than 10 trillion yuan of debt, a large chunk of which already strained banks have recently had to roll over. Much of it is a consequence of the stimulus spending in the wake of the 2008 global financial crisis with a booster from last year’s spending to reverse the economic slowdown. Central government policy makers aren’t shy in laying down grand plans for local government to build out and pay for.

The finance ministry, which since the 1994 local government reforms has handled what bond issuance their has been on behalf of local governments, has been cautiously lifting the ceilings of permitted amounts and expanding the list of provinces that can do to the markets directly. As well as trying to let down China’s local-government debt bubble before it can go damagingly pop, an expanded muni-bond market also pushes provincial and municipal governments in three other desirable directions: less reliance of land sales to raise revenue; less need to repair to the shadow banking system to get round restrictions on official borrowings; and more transparency generally about their finances.

The scale of the proposed urbanization bond issuance is likely to be on scale unlike anything seem before, though. The current quota for local government bond issuance is 250 billion yuan ($40 billion). The domestic non-financial corporate bond market is larger; the Shanghai Securities News reported it had reached 3.45 trillion yuan for the year to date by November last year, three quarters as much again as a year earlier. The urbanization program is being pegged at upwards of 40 trillion yuan over 10 years.

Potentially doubling the size of the bond markets over that time will demand not just a fully-functioning muni-bond market, but also more robust corporate and high-yield bond issuance that can pull in foreign capital. It will also require the development of a secondary market in the issues. Otherwise, if held to maturity,  bonds become just a variant of bank lending, and will do little to divert risk from the state-owned banking system that now provides three quarters of China’s credit.

There is much other structural work to be done beyond that, including further consolidation of the three regulatory agencies that now have responsibility for various bond issuance, and a lifting of restrictions in the qualified foreign institutional investor rules that limit bond funds’ investment in bonds. Most of all it will need the government to let a few issues default so investors realize that the government won’t always bailout troubled issuers and that there is a risk to be priced in. That may be the most difficult change of all.

China’s Financial Reform: ‘Making Progress While Maintaining Stability’

There were no great expectations of the fourth quinquennial national financial work conference that has just ended in Beijing. And it seems to have met them.

These two-day meetings set broad policy objectives for the coming five years. In the past they have provided a blueprint for significant financial-system reform. But with a leadership transition already underway, the start of a new five-year plan and growing nervousness among policymakers and political leaders about the volatile outlook for the global economy and the potential implications for China’s growth, there is no great appetite for much beyond keeping a steady ship.

“Risk-aversion should be the lifeline of our financial work,” said Prime Minister Wen Jiabao, seen in the Xinhua photo above arriving for the start of meeting with the men and woman in whose hands so much rests. Wen also said that there would be greater supervision of the banks, which, he said needed to improve their governance and risk management.

Risk control and prudent macroeconomic management were the order of the day, as they were at last month’s annual economic work meeting. “Making progress while maintaining stability,” is the mantra. The emphasis is currently on the stability.

More detail about the financial work meeting will likely drip out over the coming days. The post-meeting statement dealt in generalities, but two leading topics of discussion were the currency and interest rates. Moves towards more market oriented interest rate mechanisms are necessary if China is to become more efficient at capital allocation, as it needs to be as its economy develops from its invest and export model of the past three decades. But steps have been tentative in the face of some vested interests who have thrived on cheap and ready bank loans. We expect the equally tentative steps to develop bond markets to be given priority over interest rate liberalization, with provincial and local governments being given more scope to sell bonds to firm up their finances. However, when it comes to developing a corporate bond market, don’t underestimate the political task in getting the big state owned enterprises to be supportive of a new source of credit that will be more demanding of their performance.

The internationalization of the yuan is also likely to continue at a measured pace, while the exchange rate against the dollar won’t be allowed to drift much higher. Policymakers feel that with the trade surplus shrinking the currency is at the right sort of level. It has risen by a third since the peg with the U.S. dollar was first broken seven years ago. Wen said China “will steadily proceed with efforts to make the renminbi convertible under capital account to improve its management of the foreign-exchange reserves”–though that is pretty much boilerplate.