China's $74b debt-equity swap will not save weaker firms

Despite Beijing’s funding support for companies, corporate bond defaults in China are expected to continue at a brisk pace this year.
PBOC deputy governor Pan Gongsheng: Defaults are good.
PBOC deputy governor Pan Gongsheng: Defaults are good.

Despite the Chinese government’s Rmb500 billion ($73.9 billion) debt-for-equity swap lifeline launched in the latter half of last year, a significant number of Chinese corporate bonds are expected to default this year. 

Seven corporate bonds totalling Rmb4.8 billion have already defaulted, according to Chinese financial information provider Wind. Last year saw a record 124 corporate bond defaults totalling Rmb120.56 billion - a large increase from the 35 corporate bond defaults in 2017 totalling Rmb33.75 billion.

Bond issuance from private Chinese firms soared 70% year-on-year in November and December last year. Zhu Hexin, deputy governor of the People’s Bank of China (PBOC), takes this as a sign that measures to curb financial risks and stabilize debt are yielding results. 

Another PBOC deputy governor, Pan Gongsheng, indicated that the government will allow corporate defaults to continue. At the China Bond Market International Forum in Beijing in January, Pan said: “Corporate defaults are not necessarily bad. They foster the healthy growth of China’s bond market. Defaults will ensure market discipline and improve market pricing.”

If there are no defaults, it will be difficult to differentiate good bonds from bad ones, he added.

Ever since the Chinese government began to relax its policies in the second half of last year, the default of public bonds has continued. According to a recent Moody’s report, this indicates the regulator's tolerance of isolated default cases that do not trigger systemic risks. “The easing policies will not change banks' and investors’ risk aversion toward weak issuers, with credit unlikely to flow to such companies: for example zombie companies and highly leveraged companies relying heavily on shadow bank finance,” it noted. 

The cut to the bank reserve ratio in January confirms that the government will continue to try to alleviate refinancing pressure on companies, partly caused by the ongoing Sino-US trade war.

The Chinese government’s measures to support companies, however, does not mean that all companies will be bailed out. The Moody’s report continued, “Nevertheless, credit easing is not unbridled and is targeted on fundamentally sound companies that experience short-term liquidity pressure. Thus, weak issuers that rely on shadow bank financing will not benefit much from the easing policies.”

The onshore default rate is expected to climb this year due to high refinancing pressure, the government’s increased tolerance for defaults, and tight credit availability in an uncertain economic environment, concluded a report from Fitch last year. The government's clampdown on shadow banking led to a significant tightening in onshore credit and heightened corporate refinancing risk during the first half of last year, the ratings agency said.

The government crackdown on shadow banking presents a huge opportunity for private credit investors, said Donald Yang, chief executive officer of Abax Global Capital, a Hong Kong-headquartered alternative investment firm, at the HKVCA Asia Private Equity Forum 2019 in Hong Kong.

Coming to the rescue of Chinese companies is a Rmb500 billion debt-for-equity swap programme launched by the PBOC in the second half of last year. It is a scheme that serves both SOEs and private companies. “We treat SOEs and private companies the same,” said PBOC's Zhu.

This year, the Chinese government will step up efforts to enable high-quality companies, which face funding disadvantages compared to SOEs, to access debt-for-equity swaps. It will also up its efforts to use the swap to help distressed companies escape financial difficulties. “The debt-for-equity swap is a very important and effective measure to reduce leverage,” said Lian Weiliang, vice chairman of the National Development and Reform Commission (NDRC), a Chinese government body in charge of bonds, adding that some companies on the verge of bankruptcy have been restored to health by the programme. 

The Rmb500 billion funding support wants to address a funding shortage which resulted in a low rate of successful debt-for-equity swap projects. It has raised the rate of successful debt-for-equity swap projects from between 10% and 20% to more over 30% last year.

Although the Chinese government has encouraged financial institutions including commercial banks and insurance companies to participate in the debt-to-equity swap programme, the reality is that successful implementation is very difficult. Some Chinese banks lack expertise in the corporate restructuring required, and there is uncertainty about how banks can profitably exit a distressed company after becoming its shareholder.

Even with the scheme in place, the scale of distressed debt in China is large. The official figure for the non-performing loans (NPL) of commercial banks in China is over Rmb2 trillion. The actual number could be much higher if items such as off-balance sheet loans, shadow banking and company receivables are included.  

International investors account for less than 2% of the onshore market, according to the China Central Depository & Clearing.

“Still, we believe international investors will gradually increase their fund allocations to onshore corporate bonds as more global bond indexes include or increase their index composition of China’s onshore bonds,” Moody’s said.



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