As debt risk increases, here are three warning signs to watch out for

On Wednesday, May 19, 2021, the sign was illuminated at the headquarters of China Huaron Asset Management on Financial Street in Beijing, China.

Yancon | Bloomberg | Getty Images

Beijing — Weaknesses are emerging in China’s growing debt pile.

Government bond levels have risen almost four times GDP, but the number of corporate bonds that have defaulted over the last 18 months has increased.

The latest defaults are only a small part of China’s $ 13 trillion land bond market, but a notable case that upsets investors with the general perception that the Chinese government will not allow state-owned enterprises to go bankrupt. There are several.

The case of China Huarong Asset Management, a non-performing loan manager in China, also surprised investors, and this year the company failed to submit profits on time and the market plunged as US dollar-denominated bonds plummeted.

Analysts said such cases show how the state’s so-called implicit guarantees are changing as the government seeks to improve the quality of the bond market.

As China’s growth slows, authorities are trying to strike a better balance between maintaining control and incorporating market-led power into the economy in order to maintain long-term growth. ..

According to Fitch Ratings data, the total number of Chinese default corporate bonds in the first half of this year was 62.59 billion yuan ($ 9.68 billion), the highest in the first half since 2014. Of that, the default of state-owned enterprises contributed more than half, about 35.65 billion yuan.

In 2020, bond defaults reached 146.77 billion yuan, a huge leap from 2014, just six years ago, according to Fitch. That year, the total default was 1.34 billion yuan, and there were no defaults by state-owned enterprises, rating agencies said.

Economists say there are three important developments here that should be noted amid growing investor concerns.

1. Bond defaults in the gray area of ​​the municipality

A major milestone in countering the idea of ​​implied guarantees in the Chinese market will be the default on bonds issued by the municipal funding instrument (LGFV).

These companies are usually wholly owned by local governments in China and were established to fund public infrastructure projects. Bonds issued by these companies are skyrocketing in the promotion of infrastructure as the Chinese economy improves.

Macquarie Chief China Economist Larry Fu said on June 25, “Many LGFVs are more than so-called zombie companies in the sense that they couldn’t pay interest and pay their own principal. Even worse. ” Note. Zombie companies are companies that have a lot of debt and rely on loans and government subsidies to survive. “They could only survive thanks to government support.”

“2021 is a window that breaks implicit guarantees. It’s the first time in ten years that policy makers have to worry about GDP growth targets. As a result, they will be able to tolerate more credit risk.” Said Hu. However, keep in mind that it is only a matter of time before LGFV bond defaults occur.

In 2015, electrical equipment maker Baoding Tianwei became the first state-owned company to default after its first default in China’s modern land bond market a year ago.

LGFV is the “main focus” of China’s tightening, Nomura said, with bonds issued by the sector jumping from just 0.6 trillion yuan in 2018 to a record 1.9 trillion yuan ($ 292.87 billion) last year. He said he did.

2. “Big overhang” of Huarong Asset Management in the sector

Bank of America analysts said in a memo last month that in the case of China’s investment grade bonds, the main factor in future performance will be how the case of Huarong Asset Management will be resolved. I called it a big overhang.

Huayang, China’s largest non-performing loan manager, suffers from investment failures and corruption cases. Former chairman sentenced to death in January..

After missing the March deadline to announce 2020 results, the company also said,Auditors need more information and time to complete. “ Audit procedure. However, he added that failure to provide results would not be the default.

The biggest supporter of Huarong Asset Management is the Ministry of Finance. China’s economy needs to grow fast enough to prevent further pressure on the central government’s budget.

In the event of a chaotic default on Huarong’s dollar bonds, there could be widespread sales of Chinese credit, especially (investment-eligible) credit.

Bank of America said that if the Huarong Asset Management proceedings were resolved with government support, it would support China’s asset management sector and other Chinese government-affiliated entities.

However, the bank added, “If Hualong’s dollar bonds default in a chaotic manner, China’s credit, especially (investment grade) credit, could be significantly sold.”

Regulators urge Huarong Asset Management to sell non-core assets As part of a renewal, according to a Reuters report in early June.

In the event of a Huarong Asset Management default, the cost of capital of other state-owned enterprises could rise “significantly” as “the market reassesses the perception of implicit guarantees by the state”, said the Bank of Singapore. DBS macro strategist Chang Wei Liang said. I emailed CNBC. As risk increases, companies need to offer higher returns to attract investors.

Mr Chang said China has sufficient funds to address the issue of Huarong Asset Management.

But “the key question is whether the country chooses to intervene by providing support with additional capital, or by first imposing losses on shareholders and debtors to strengthen market discipline. That’s what it means, “he added.

3. Weaknesses of some state and regional banks

Financially weak states are probably associated with less dynamic economic conditions, which means (and) weaker economic conditions are likely to result in more corporate bond defaults.

Francoise Fan

Senior economist, Euler Hermes

This could affect the capacity of small banks to support local state-owned enterprises, and large banks may need to intervene to maintain system stability, the report said. Stated.

Mintan, a credit analyst at S & P Global Ratings, told CNBC that states with greater problems are exposed to the recycling industry.

Authorities need to strike a balance between giving low-quality loans a high-risk rating and keeping the problem from accelerating, Tan said. “There is definitely a risk of mismanagement in the future, but so far I think this is very well managed.”

Bank of China and insurance regulators last week revealed that the banking industry had disposed of a record 3.02 trillion yuan ($ 465.76 billion) of bad assets in 2020.Other data released last week showed that China’s GDP has grown 7.9% in the second quarter It’s been a little lower than expected since a year ago.

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Some analysts have pointed out weaknesses at the local level. According to a pinpoint asset management analysis, consumption in May decreased year-on-year in the four capitals of Wuhan, Guiyang, Shijiazhuang and Yinchuan.

Françoise Fan, a senior economist at Euler Hermes, a subsidiary of Allianz, said:

She said the long-term problem is to rebuild the economies of these weak states and grow more dynamic states. “I don’t think the solution is to continue investing just to keep these poorly performing sectors alive.”

As debt risk increases, here are three warning signs to watch out for

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