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China’s SOEs face rising default risks

S&P looks at the outlook for China's SOEs in light of its recent decision to put the country's sovereign rating on negative outlook.

S&P Ratings recently placed its China sovereign rating on negative outlook. Will this affect the ratings on China’s state-owned enterprises (SOE)?

The sovereign outlook revision had a slight negative impact on our SOE ratings. We revised the outlook on 20 SOEs that we classified as government-related entities (GREs) or those with parent groups that are GREs. The ratings on these entities are closely linked with the sovereign rating because of the very high extraordinary government support, group support, or stand-alone credit profile (SACP). The outlooks on the ratings on 31 other SOEs were not affected because their government support and group support is moderate or lower, and the SACP of these entities is weaker.

Can SOEs be rated above the sovereign?

Not likely. SOEs' predominantly domestic operations, high linkages with the government, and likelihood of negative interventions mean that they would have the same or higher default risk in the event of a sovereign default.

Does a negative outlook on the sovereign indicate weaker support from the central government?

No. The extraordinary government support for the SOEs is not affected by the sovereign outlook revision. The central government continues to have strong financial capacity via state-owned banks to provide timely support to SOEs if they come under financial distress. The central government's debt level and the banking system's level of nonperforming loans remain modest.

Why is S&P expecting the default risk of China’s SOEs to increase?

Supply-side reform signals a shift in policy to support China’s SOEs. We believe the government has greater tolerance to allow struggling SOEs to close and be liquidated. Given the large number of struggling companies, the government's finances are probably insufficient to bail out every troubled company. Also, the government has budgeted funds for laid-off workers. Lenders are heeding this policy change and tightening credit to sectors that are targeted for capacity reduction. SOEs in targeted sectors for capacity consolidation and owned by provinces or local governments with weak financial capacity could be more vulnerable to default.

Can SOEs adequately service their debt?

SOEs’ debt servicing capacity has deteriorated steadily, with debt leverage above five times which is the highest category for financial risks in our assessment. A significant portion of cash flows are consumed by interest servicing, with lenders keeping companies afloat by rolling over their debt. SOEs dominate capital intensive and cyclical sectors like metals and mining, transportation, and capital goods. The outlook for leverage reduction remains poor for these sectors as weak top line is not fully offset by cost cutting and capex reduction.

Has there been meaningful progress with SOE reforms?

Progress has been very slow. The government announced the reform agenda in 2013 and the blueprint for SOE reform was released in September 2015. The blueprint is vague and leaves room for various interpretation and implementation. While the central government is pushing ahead with SOE reform, local governments are more timid as they balance conflicting objectives of preserving growth, tax revenues, and employment against SOE efficiency and financial risks.

The key to the reform is to improve company performance. On this score, the continued deterioration of the SOEs' financial risks has reached a critical level with liquidity stresses that have led some steel companies to default on their debt in recent months. The framework for reform is a long-term remedy for the structural and institutional problems including management and staff who are appointed by the ruling Communist party. A clearer separation of management and party would be necessary for SOEs to be innovative and make commercially oriented decisions.


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What about the recent mergers of SOEs and their impact on reform?

Mergers have created larger groups but their financial position has not improved. There are no concrete plans to reduce leverage or improve efficiency. Closures of unprofitable businesses, asset sales or privatization are not part of the plan. The anti-corruption campaign by the party's disciplinary committee has cast a long shadow on any SOE management looking to sell assets. Without concrete plans or drastic measures, we believe, the misallocation of capital in the SOE sector will be prolonged.

On a positive note, the mergers will create some synergies. Examples include centralized purchasing, reduction of duplicated investments, and improved bargaining position due to a larger operating scale.  Mergers within the same industries are more likely to benefit from these synergies than mergers of conglomerates.

In the past six months, the central government has announced that 12 SOEs will be merged into six separate groups in shipping, railway locomotive, construction, and mining. The number of central SOEs was reduced from over 110 at the end of 2014 to 106 at the end of 2015. A number of SOEs in food, tourism, building materials, and construction are being readied for merger by the end of 2016. The number of central SOEs will likely be below 100.

The government has proposed a debt-for-equity swap for corporate debts. Would this improve the credit profiles of SOEs?

Yes. The debt-for-equity swap essentially exchanges bank debt for an equity stake. It's a recapitalization that reduces a company’s debt load and enables highly leveraged corporates to recover their financial standing and provides room to make investments. This proposal is still being studied by a number of government agencies, and it is not intended to save struggling companies with limited prospects for recovery. In our view, the debt-for-equity swap is usually part of a debt restructuring for distressed companies. It would not happen in isolation without the agreement of other creditors and shareholders. The central government is pitching the proposal as a "win-win" solution for corporates and banks.

What are the implications of the debt-for-equity swap for creditors?

The impact is negative. When creditors are not paid in full, payment terms are altered or all creditors are affected, we could consider the swap to be a debt restructuring and possibly a distressed exchange. This will depend on whether lenders and investors have options other than to accept the debt restructuring or face non-payment. We view any delay or less-than-full payment by an issuer as potentially constituting a default. 

The author is Christopher Lee, Managing Director for Corporate Ratings at Standard & Poor's Ratings Services.


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