There were several reasons, back at the end of 2013, that our rating agency believed 2014 would see the first defaults in China’s bond market. China’s economy was due to enter a slower growth track and corporate debt payments would peak. The campaign to remove excess capacity and leverage would mean higher financing costs for Chinese companies than in other major economies. The downgrading of corporate credit ratings had increased. The government had become less ready to bail out companies in trouble. And so, in early March 2014, Shanghai Chaori, a solar panel producer, declared China’s first bond default. Since then, bond default cases have become frequent and have happened in more and more sectors.
The situation looks likely to worsen in 2017. Due to weak external demand, a slightly slower rise in consumption and more efforts to reduce overcapacity, China’s growth rate may moderate further, shrinking to about 6.5 percent in 2017. Nearly US$800 billion in corporate bonds is due to mature in 2017, putting the debtors under huge pressure. Worse still, China’s monetary policy may tighten in 2017 in order to prevent housing bubbles and reduce leverage. The depreciation pressure on the yuan will also make it barely possible for China to relax its monetary policy due to the risk of encouraging more capital outflow. A tightened monetary policy, if adopted, will push the cost of debt repayment financing higher and threaten the cash flow of enterprises.
The deteriorating credit risk has already been reflected in credit ratings. In the first 11 months of 2016, 155 debt-holding entities had their credit downgraded. The number has already exceeded the total for 2015. Such cases accounted for 37 percent of all credit downgrades for the first 11 months of 2016, 8 percent higher than the total in 2015. This proves that debtors’ overall creditworthiness has gotten worse.
In addition, several SOEs defaulted on their bonds and a few even faced liquidation. This is a signal that the government has become more reluctant than ever to provide credit support to struggling enterprises.
The debt and overcapacity policies already launched in 2014 will continue in 2017. These policies, including the debt-to-equity schemes, the launch of local government bonds and the reduction of overcapacity in the coal and steel sectors, will have different effects on the market’s credit risks. As a result, they add to the considerable existing uncertainties in the bond market and the risk will vary dramatically even among debtors in the same sectors.
Debt-to-equity Swaps
A policy allowing for the transformation of some bank loans into equities held in debtors by financial investors, mostly banks, was launched in October 2016. This can reduce the burden on the debtors, who can channel the saved money back into their own operations and thus have a greater chance of surviving financially. But this practice brings with it a serious risk of moral hazard. Some companies may exploit the plan to shun their liabilities and become even less ready to improve their business performance. It is worth asking whether further implementation of the policy will affect future credit risks.
The “debt-to-equity” policy is designed to help indebted companies that are leading players in sectors suffering overcapacity, have growth potential or are significant in terms of national security. Private companies have already successfully reduced their debts during the economic slowdown, or been forced to default or go bankrupt if they failed to manage deleveraging. Therefore, this “debt-to-equity” solution will be mainly applied to State-owned enterprises (SOEs) that are under the control of the central and local governments.
According to the Ministry of Finance, SOEs had US$12 trillion in outstanding debts on their books by the end of September 2016. 40 percent of it, or US$5 trillion, is probably accounted for by SOEs in the industrial sector [mining, manufacturing and public utilities supply]. Of the total capital financed through the financial market, 65.13 percent was bank loans. It shows that industrial SOEs owe about US$3 trillion to banks. Only US$187 billion of it, which was already categorized by the banks as bad-performing loans or loans with default potential, could be saved by the “debt-to-equity” scheme.
This means that the “debt-to-equity” program is only one of the ways of reducing the debt ratio, and can only work in a very limited way, given its small scale. As a result, the implementation of the program will not have much effect on reducing the overall corporate credit risk in 2017, although it may make sense for companies that could return to normal operations once rescued.
Reducing Overcapacity
The task of removing overcapacity in the coal and steel industries made progress in 2016. By the end of October, the target for the whole year had already been reached, with 45 million tons of steel production capacity removed from the market. The target of getting rid of 250 million tons of coal production capacity was also achieved ahead of schedule. The process of reducing overcapacity is likely to be accelerated in 2017 by further government efforts.
As a result, credit risks will vary even more among companies within the same industry. Those suffering from heavy losses and debts but weak competitiveness will face higher risk of a debt crisis. Such enterprises are used to relying on borrowing or government bailouts for survival.
But this just leads to further deterioration of their operations and increasing difficulty in recovering their loans. As the reduction of overcapacity continues, the government and banks will be less ready to save them. Then their credit risks may explode even faster than expected, and the enterprises may even be liquidated and driven out of the capital market.
However, reducing overcapacity also reduces supply. It normally pushes up prices when demand remains unchanged. This is exactly what has happened in the steel and coal industries. This short-term recovery hardly represents a real turning point for these industries, but it has provided breathing room for indebted enterprises that hold sound assets. Their credit status can be improved. Leading enterprises in these industries will especially benefit from the price rise in order to get out of the woods.
Local Government Bonds
At the end of 2015, China’s central government established a three-year plan to replace the existing bank loans borrowed by local governments’ financing platforms with local government bonds in order to reduce the risk and cost of local governments’ debts. This process will continue in 2017. The risks around local governments debts that built up before 2015 [with about US$2.2 trillion outstanding by the end of 2014] have basically been solved, whether they are a part of this scheme or not. Debts included in this scheme have little risk of explosion. Local governments will try their best to avoid a default on debts that are still outside of the scheme in order to keep their platforms safe, which are still important tools for them.
The purpose of the reform of local government debt is to stop the underwriting of corporate borrowing with government credit. Under this principle, any new debts built up by governments’ financing platforms or similar endeavors after the new Budget Law became effective on January 1, 2015 should be regarded as corporate debts that those companies are fully obliged to repay.
However, under the new Budget Law, the only legal method of financing for local governments is to issue a certain amount in bonds that are approved by the national legislature annually. The problem is their quota may not cover all the budgets of local governments, due to local governments’ limited tax revenues – especially compared with their responsibilities to provide public services. The public-private-partnership model in which private investment is invited into the operation of public services has not been proceeding as smoothly or quickly as expected. It is difficult to insulate the interests of local governments from their financing platforms, known as civic investment companies. The question whether more debts will have to be tackled in this way even after 2017 is yet to be answered.
From a longer-term perspective, those civic investment companies should be regarded as a part of the reforms that are redefining SOEs. The guidelines on this reform issued by several ministries at the end of 2015 define SOEs as either business-oriented or public interest-oriented. We suggest that the same standards be applied to civic investment companies. The public interest-oriented group will continue to be backed by government credit, while the credit risks of the business-oriented group will be reviewed on the basis of the market competition they face. Defaults are most probable among civic investment companies that lose government support but can’t compete in the market. They may be set up by low-level local governments in less-developed areas and do not work well in providing fiscal access for local governments. Companies that have a lot of payable loans on their books are particularly risky.
The author is managing director and head of research at China International Chengxin Credit Rating Co.,Ltd., a joint venture with Moody’s. He is also a researcher at the National Academy of Development and Strategy of the Renmin University of China.
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