Bar chart showing the Chinese domestic debt market by issuer

A number of default values ​​tests the safety net for Chinese bonds

When a state-owned coal company in central China defaulted on a $ 152 million bond this month, the slip was unlikely to rock the world’s second largest economy.

Before the failure of the Yongcheng Coal and Electricity Holding Group on November 10, according to Fitch Ratings, only five Chinese state-owned companies (SOEs) failed to repay the bondholders in the first 10 months of 2020 – in line with the level of recent years.

But within 14 days, Tsinghua Unigroup, a high-profile state-owned technology company, would also fall behind. This prompted China’s top finance official, Vice Prime Minister Liu He, to warn borrowers that Beijing would take a zero-tolerance approach to any financing deal, such as misleading statements or attempts by companies to evade debt.

Developments have rocked China’s nearly $ 4 billion corporate bond market, which is estimated to account for more than half of state-owned companies. In the week following the Yongcheng Coal default, at least 20 Chinese companies suspended Rmb 15.5 billion (US $ 2.4 billion) new issuance plans, all of which pointed to “recent market turmoil”.

Mr. Liu’s warning challenges the long-held belief by many investors that local governments will always bail out state borrowers. Analysts now fear that investors will judge the debt worse, which further increases the pressure on borrowers.

The risk is that these events have permanently broken investor confidence in the blanket support of local state-owned companies by local governments

“People don’t take risks because they think they can wait for governments to step in before selling assets,” said Logan Wright, an analyst at research firm Rhodium Group. “But now there will be greater government tolerance for pain.”

The most recent default settings differ from those in previous years “because local authorities themselves are now seen as a source of risk rather than a source of stability,” he added.

“The risk is that these events have permanently broken investor confidence in the blanket support of local state-owned companies by local governments,” wrote Xiaoxi Zhang and Wei He, analysts at Gavekal, in a research note. “It can be difficult to rebuild trust like that when it’s lost.”

Foreign investors have increased their exposure to Chinese bonds, but remain cautious on sovereign debt. According to Goldman Sachs, such investors own around 9 percent of the total onshore debt of the Chinese central government. However, they hold less than 1 percent of the country’s outstanding corporate debt – a market valued at $ 3.7 billion for non-financial corporations, according to the Bank for International Settlements.

Similarly, if domestic investors became cautious about local state-owned companies – which Gavekal estimates account for 60 percent of all corporate debt – it could put even more pressure on such companies and their often financially troubled state owners.

Some Yongcheng Coal employees say they haven’t been paid for months, but many investors have been content to ignore warning signs as the parent company is one of Henan’s largest energy companies and appears to have plenty of cash.

Huachen Automotive Group, another SOE that defaulted in late October, is also believed to have the support of its government owner in northeastern Liaoning Province. One of Huachen’s units is BMW’s partner in its successful joint venture for manufacturing in China.

Yongcheng and Huachen had one more thing in common: the debts of both companies were also rated triple A by major rating agencies.

According to the information provider Wind, 70 percent of all outstanding Chinese corporate and national debts are rated triple A despite the economic stresses caused by Covid-19. While China weathered the pandemic far better than any other major economy, growth of almost 2 percent is forecast for the full year – a tough test for companies that are used to 6 percent or more.

Overall credit growth in China has been stable this year, but many regions, including Henan and Liaoning, have struggled. “When the economy is under pressure, government funding is limited,” said Shen Meng of Chanson & Co, a Beijing-based investment bank.

“There is not enough credit flowing through the entire system. . .[local governments]respond to the fact that they have also constrained resources, ”added Rhodiums Mr. Wright.

The default values ​​highlighted investor disclosure concerns. Immediately thereafter, a manager at Yongcheng Coal informed creditors that most of his cash was tied up in “restricted” deposits. In September Huachen transferred his shares in BMW’s JV partner to a separate subsidiary, which later pledged them to a creditor.

In its statement on Sunday, Mr. Liu’s committee warned issuers that the authorities would severely punish cases of “false information disclosure” [and] malicious asset transfers ”.

Yongcheng Coal did not respond to a request for comment. On Monday, a Huachener subsidiary said in a statement that its parent company was being investigated by the Chinese Securities Commission for “alleged violations of information disclosure laws.”

Investors are waiting to see how willing regulators are to put a strain on the market as there is a risk of repercussions across the financial system.

Chinese officials “recognize that there is no lending discipline in the market,” said Michael Pettis, finance professor at Peking University. “Now is probably not the right time to test what would happen if real, serious failures and losses occurred. But at some point they have to do it. “

Additional coverage from Sherry Fei Ju in Beijing