Illuminated signage at the headquarters of China Huarong Asset Management Co. on Financial Street in Beijing, China on Wednesday May 19, 2021.

Yan Cong | Bloomberg | Getty Images

BEIJING – Weak spots are emerging in China’s growing debt.

National debt levels have climbed to nearly four times GDP, while a growing number of corporate bonds have defaulted over the past 18 months.

Although the latest defaults represent a fraction of China’s $ 13 trillion onshore bond market, some high-profile cases have rocked investors as the common perception is that the Chinese government will not let companies backed by China. State fail.

The case of Chinese bad debt manager Huarong also spooked investors, causing a market rout this year when the company failed to file results on time and its US dollar-denominated bonds plunged.

Analysts said cases like these point to how the so-called implicit government guarantee evolves as the government attempts to improve the quality of the bond market – by eliminating weaker firms and allowing some differentiation in the market. within the industry.

As China’s growth slows, authorities seek to strike a better balance between maintaining control and bringing certain market-driven forces into the economy to support long-term growth.

In the first half of this year, the total number of corporate bonds in default in China stood at 62.59 billion yuan ($ 9.68 billion) – the highest figure for the first half since 2014 , according to data from Fitch Ratings. Of this amount, defaults by state-owned enterprises contributed more than half of that amount, or about 35.65 billion yuan.

For 2020 as a whole, bond defaults amounted to 146.77 billion yuan, a huge jump from just six years ago in 2014, according to Fitch. In that year, defaults totaled 1.34 billion yuan, and there were no defaults by state-owned enterprises, the rating agency said.

As investor fears intensify, here are three important developments to watch, according to economists.

1. Bond default in a gray area of ​​local government

An important step to counter the idea of ​​implicit guarantee in the Chinese market would be the default of a bond issued by a local authority financing vehicle (LGFV).

These companies are usually 100% owned by local and regional governments in China and were established to finance public infrastructure projects. Bonds issued by these companies rose amid expanding infrastructure as the Chinese economy improved.

“A lot of LGFVs are even worse than the so-called zombie companies, in the sense that they couldn’t pay the interest, not (to) mention the principal on their own,” said Larry Hu, chief China economist at Macquarie, in a June 25 article. Note. Zombie businesses are those that are heavily in debt and depend on government loans and grants to stay alive. “They were only able to survive with the support of governments.”

“The year 2021 is a window to break the implied guarantee, as it is the first time in a decade that policymakers have not (to) worry about the goal of GDP growth. As a result, they could tolerate more credit risk, ”he added. said, noting that it is only a matter of time before a default on an LGFV bond occurs.

In 2015, electrical equipment maker Baoding Tianwei became the first state-owned company to default on its debt, following the first default in China’s modern onshore bond market a year earlier.

Nomura said LGFVs are a “major focus” of China’s tightening campaign, and noted that bonds issued by the sector hit a record 1.9 trillion yuan ($ 292.87 billion) last year, compared to just 0.6 trillion yuan in 2018.

2. The “big overhang” of Huarong on the sector

For quality bonds in China, a major factor for future performance is how the case of Huarong Asset Management is resolved, analysts at Bank of America said in a note last month, calling the situation a “big overhang. “.

China’s largest bad debt manager Huarong is grappling with failed investments and a corruption case involving its former president, who was sentenced to death in January.

After missing its March deadline to release its 2020 results, the firm also said “auditors will need more information and time to complete” audit procedures. However, she added that failure to provide the results does not constitute a default.

Huarong’s biggest donor is the Ministry of Finance. China’s economy will need to grow fast enough to ensure that the central government’s budget is not further strained.

If there is a disorderly default on the Huarong dollar bond, we could see a large sell-off in Chinese credits, especially (investment grade) credits.

If Huarong’s case is resolved with government support, it should boost China’s asset management industry, as well as other entities linked to the Chinese government, according to Bank of America.

However, the bank added, “If there is a disorderly default on the Huarong dollar bond, we could see a large sell-off of Chinese credits, especially (investment grade) credits.”

Regulators are pushing Huarong to sell non-core assets as part of an overhaul, according to a Reuters report in early June.

If Huarong defaults, the cost of capital could rise “significantly” for other state-owned enterprises, as “markets reassess perceptions of implicit government guarantees,” Chang Wei-Liang, macro-strategist at the bank Singaporean DBS, told CNBC via email. As risks increase, companies must offer higher returns to attract investors.

Chang said China has enough money to resolve Huarong’s issues.

However, “the key question is whether the state will choose to intervene by providing support with additional capital, or by imposing losses on stock and debt holders first to strengthen market discipline. “, he added.

3. Weak points in some provinces and local banks

In order to determine where the potential hotspots for state-owned enterprise defaults might be, analysts at S&P Global Ratings found that smaller banks concentrated in north and south-central China are facing a deterioration in the quality of their assets.

“Urban and rural commercial banks with problematic loans above the industry average should write off 69 billion Chinese renminbi (RMB) on these loans to bring their ratio back to industry average levels, those in the northeast being the most affected.” , he added. According to the June 29 report.

A fiscally weaker province is likely related to a weaker economy, (and) a weaker economy means there could be more corporate bond defaults.

Francoise Huang

senior economist, Euler Hermes

This could affect the ability of small banks to support local state-owned enterprises, potentially forcing large banks to step in to keep the system stable, according to the report.

The most problematic provinces are those exposed to cyclical industries, S&P Global Ratings credit analyst Ming Tan told CNBC.

The authorities must strike a balance between allowing lower-quality loans to have a riskier rating and preventing problems from escalating, Tan said. “There is certainly a risk of mismanagement down the road, but so far what we are seeing is that it has been handled fairly well.”

China’s banking and insurance regulator revealed last week that in 2020, the banking sector had ceded a record 3.02 trillion yuan – or $ 465.76 billion – in non-performing assets. Other data released last week showed that China’s GDP grew 7.9% in the second quarter from a year ago, slightly below expectations.

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Some analysts have pointed to a weakness at the local level. Pinpoint Asset Management’s analysis found that consumption fell year over year in May for four provincial capitals – Wuhan, Guiyang, Shijiazhuang and Yinchuan.

“A fiscally weaker province is probably related to a less dynamic economic situation, (and) a weaker economic situation means there could be more corporate bond defaults,” said Françoise Huang, senior economist at Euler Hermes, a subsidiary of Allianz.

The longer-term problem is to restructure the economy of these weaker provinces to allow the more dynamic ones to grow, she said. “I don’t think the answer would be (to) keep investing in these underperforming sectors just to keep them alive.”

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