China’s credit markets have held the credo for decades that if a central company is in trouble, it will always get a bailout.
Now, investors aren’t so sure.
The record-setting drop in the company’s dollar-denominated debt has been accompanied by rising concerns about China Huarong, the distressed asset manager controlled by the country’s finance ministry, raising fears of a contagion effect in the market.
While Huarong says it has access to liquidity and is making payments on time, bond prices suggest investors are bracing for the possibility of a restructuring – the most significant in China since the financial crisis of the late 1990s that gave birth to Huarong and several other distressed asset managers.
Whether or not there will be a restructuring, the fall in Huarong’s bonds highlights a historic shift in the world’s second-largest credit market. State-owned enterprises have replaced private companies as China’s biggest source of defaults as the Communist government reduces support for borrowers with weaker credit profiles to reduce moral hazard.
Fitch Ratings data show that SOEs defaulted on a record 79.5 billion yuan ($12.1 billion) of domestic bonds in 2020, rising to 57 percent of domestic bond defaults from 8.5 percent the previous year, and rising further to 72 percent in the first quarter of 2021.
The big question for investors is how much pain the Communist government is willing to endure in the process of resolving implicit guarantees. None of the SOEs that have defaulted so far are seen as having as high a level of systemic importance as Huarong.
The CCP authorities have tried to strike a balance between strengthening market discipline and avoiding a sudden loss of confidence that could trigger a potential crisis. But the turmoil surrounding Huarong underscores how quickly investor sentiment is deteriorating, even as the economic situation is strengthening. Some Huarong bonds have fallen to below 80 cents per dollar of face value.
China’s credit market is entering a new era as state-owned enterprises become a major source of stress, according to Fitch Ratings analyst Shuncheng Zhang. Regardless of the outcome of Huarong, policymakers are likely to allow more defaults by the state-owned sector, he added.
The stakes are high as China considers which companies to back. The outstanding balance of domestic bonds of state-owned enterprises equaled $3 trillion at the end of last year, or 91% of the overall balance, according to data compiled by Fitch. The share of such bonds held by international investors, while low, has been rising as the Communist Party has stepped up efforts to open up its financial markets.
While the speed at which Huarong bonds have plunged has shaken some investors, the company has been a source of potential risk for a long time. Under former Chairman Lai Xiaomin, who was executed earlier this year for taking bribes, Huarong expanded its business into securities trading and trusts, among other areas, in a major departure from the company’s original intent of helping banks dispose of bad debt.
The fall in Huarong bonds accelerated on Tuesday and spread to other Chinese debt issuers, including real estate companies, as a report in Caixin discussed the possibility of bankruptcy, including for Huarong. Fitch, Moody’s and S&P still view the company as investment grade, though all three said they will assess the possibility of a downgrade.
China Huarong bonds extended their decline Wednesday, falling 5 cents per dollar of face value at one point. A bond due in 2022 yields 35 percent, according to data compiled by Bloomberg.
S&P analyst Charles Chang said some degree of risk contagion is healthy for China’s bond market and shows investors are dealing with changing risk levels. Recent SOE defaults have triggered a stronger reaction among peer bonds than they did a few years ago, he said.
“The new thinking is that bailouts are not necessarily needed as long as they don’t create systemic risk,” said Ivan Chung, an analyst at Moody’s Investors Service. “More SOE defaults are expected in the future, but they are likely to be concentrated in regions with weaker finances and in sectors with high historical debt and labor burdens.”
It was not immediately clear if Communist Party leaders had discussed the fate of Huarong bondholders.
The Communist Party’s Ministry of Finance is reportedly considering transferring its stake to Central Huijin, a unit of sovereign wealth fund China Investment Corp, Bloomberg reported Tuesday. One of the considerations for the stake transfer plan is that Central Huijin is more experienced in dealing with debt risks, sources close to the matter said, adding that the Ministry of Finance plans to complete the said deal in the coming months, although the said plan is still pending approval by the State Council and there are variables.
“If the deal can be realized, it may improve the flexibility of providing financial support to Huarong,” said Dan Wang, an industry research analyst at Bloomberg. “But it also suggests that Huarong’s debt exposure may be much higher than the market previously expected.”
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