Default blues ahead for China?

Property developers and state-owned firms are the weak links in a likely chain of defaults. S&P Global Investors' Lee says China should act boldly to prevent financial contagion.

Several factors could increase the default rate beyond what the market expects and this could shut the bond market. 

First, government support towards state-owned enterprises (SOEs) is shifting, illustrated by the  default of China Railway Materials in April this year.

More than 100,000 SOEs at both central and local government levels receive preferential credit allocation by banks. Uninterrupted access to funding keeps many of the struggling ones afloat. If the government fails to rescue an important SOE – especially when the market expects such support – we could see deterioration in market access and the start of a vicious cycle that could negatively impact the broader financial system.  

Second, an unexpected default by a large property developer could spook the market. The opening of China’s exchange bond market in 2015 saw property developers tap this new source of funding, as they traded refinancing of maturities for higher leverage. Bond issuance in the exchange bond market increased eight-fold in 2015 compared with a year ago.

At the same time, property developers’ leverage has continued to deteriorate despite improving sales. Some large developers have seen their leverage ratios and debt servicing capacity weaken to a critical level that leaves little buffer for them to weather sales slippage or a turn in the property market. 

Thus, defaults by large property developers could shut the bond market for high-yield credit. This would trigger a repricing of bond spreads and increase funding costs for issuers. Another harmful side effect also includes potential disruption of construction and development plans – the pipeline for future property sales and liquidity. 

Finally, turmoil in the onshore market could spill into the offshore bond market which to-date has been insulated from rising defaults and widening spreads. In fact, offshore bond yields have tightened due to abundant liquidity and the market generally overlooking rising credit risks. If this changes there could be a significant impact on the refinancing for maturities for high yield issuers starting in 2017 through 2019. If both offshore and onshore markets are dislocated, default risks for issuers would rise if they cannot find alternative funding.

DEBT RISING

In the first four months of 2016, more than 10 Chinese issuers missed their payments and over 20 bonds defaulted. The number of defaults in 2016 has already exceeded that for the whole of the previous year. And in 2014, only one issuer defaulted. 

The impact of these defaults has been contained for now. Defaulted bonds also account for less than 0.5% of rated outstanding bonds.

However, this benign situation won’t last.

The debt burden for many companies is already very high and rising. There is huge pressure on corporate profitability from sluggish demand across a large number of industrial sectors. Lenders are also turning cautious as they confront deteriorating asset quality. At the same time, the government is looking to close struggling companies in sectors like steel and coal mining. 

Over the past 18 months, our analysts have seen the credit quality of the 240 companies we rate in Greater China deteriorate steadily. Nearly 15% of the S&P Global Ratings portfolio is on negative outlook. In the past 18 months, there were twice as many downgrades as upgrades. 

If one were to ask market participants two years ago whether any Chinese issuers would default, they would be met with incredulity – no way and no how. In reality, defaults were commonplace in the late 1990s leading to the closure of thousands of SOEs and lay-offs of tens of millions of workers. At the time, the bond market was in its infancy. 

In the early 2000s, recapitalization of Chinese banks and their eventual IPOs coincided with a period of rapid economic growth after China joined the World Trade Organisation. Corporates were restructured, and banks’ bad debts were sold and cleansed. This was an exceptional period and unlikely to be repeated. 

To solve China’s growing debt problem, the government will need to show that decisiveness and resolve that I saw as an analyst more than 15 years ago. In fact, the  last bad debt cycle in the early part of this century was much bigger than today’s. Banks had large amounts of troubled loans and government finances were much weaker. 

This current cycle has only just started and muddling along will not be an option. Rising defaults will disrupt China’s desire to maintain high growth to rebalance its economy. And similar to the past cycle, SOEs remain the weak link.

So taking lessons from the past, policymakers will need to take drastic action if we see rising defaults starting to choke liquidity for borrowers and investors. 

They will need to communicate clear goals and timelines to restructure or close struggling companies with weak prospects, mostly SOEs operating in competitive sectors. As a consequence, the government may need to increase deficit spending dramatically to ease the transition of companies and workers. 

Asset sales and a debt swap program similar to the local government program would also ease the debt burden. And more controversially, the government could implement the sale and privatization of SOEs in sectors that are not strategic, such as consumer, retail and property development. 

A clear path to debt reduction and shrinking the SOE sector would be aligned with the government’s goal to deleverage and allow the market a greater role to play in allocating resources. 

Policymakers managed a far bigger debt problem more than a decade ago.  What’s needed now is the political will to make the difficult decisions and see them through completion. 

Christopher Lee leads S&P Greater China Corporate Ratings team’s analytical and outreach activities and is also a member of the Asia-Pacific Corporate Ratings leadership team.  

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