The last two years have seen a succession of thunderstorms of Chinese debt, one more ferocious than the other. There is no maximum, only greater. Remember that in the second half of last year, there was a wave of Chinese bond defaults, from Yong Coal to Founder, and finally even Evergrande and Suning were almost dragged down. But now, in the same two days, the news that China’s financial giant Huarong will default on its restructuring is fermenting in the market, driving a collective plunge in Chinese overseas bonds. And with Huarong’s $1.6 trillion debt volume and more than $300 billion of bonds coming due, the impact on China’s bond market and even financial market once it defaults is imaginable. Let’s look at the specifics.
Affected by the delayed disclosure of its annual report and the uncertainty of its restructuring prospects, China Huarong’s bonds in the offshore market plunged collectively last week, almost without a single survivor, and affected the Chinese offshore debt as a whole. Starting from April 12, a number of overseas bonds issued by Huarong were sold off, with many bonds dropping more than 10% in price on the same day, especially the long-dated bonds were the most affected.
In recent days, offshore investors began to consider their prospects from the worst, with Huarong’s dollar bonds experiencing a frenzied sell-off, with the buying price of several bonds having fallen below 80 cents per dollar of face value.
As of 7 p.m. on April 14, a Huarong perpetual bond with a 4.25% coupon was last traded at $55.61, down 13.67% from the previous day’s trading price; for the week, it was down 28.15%. The last traded price of the bond was $103.101. Another perpetual bond with a coupon of 4.5% was down 31.26% from the time before Huarong announced the postponement of its annual report release.
This round of selling of Huarong bonds has caused some of China Huarong’s bonds to fall in price to 60% of their face value, indicating that investors see a high probability of the company defaulting. The worries caused by Huarong have spread across Asian credit markets, with some of the real estate company’s bonds posting the biggest drop on record. Huarong’s stock in the overseas debt market is large, with about $22 billion in U.S. dollar debt issued, and a chain reaction could have unthinkable consequences.
The massive sell-off of Huarong’s overseas bonds has also affected other Chinese overseas bonds, which will have an impact on market sentiment.
If you are not familiar with the background of Huarong, here is a brief introduction. In the late 1990s, then Premier Zhu Rongji, in order to divest the bad debts of Chinese commercial banks and bring these banks up to market entry standards, set up four major asset management companies, with capital injections from the Ministry of Finance and the Chinese central bank, as well as Huarong’s own contributions, to buy these non-performing assets together. At that time, China Huarong and its peers purchased non-performing loans from several of China’s largest state-owned banks and disposed of them through auctions and sales to other investors such as foreign banks.
China’s Ministry of Finance holds a majority stake in China Huarong, so Huarong is a subsidiary directly under the Ministry of Finance.
After more than two decades of expansion before falling on hard times, China Huarong had grown from an asset management company founded to acquire and dispose of non-performing loans from large state-owned banks to a financial control platform with a variety of financial licenses, and it had expanded significantly, adding securities trading, lending and other financial services. In January, the company’s former chairman, Lai Xiaomin, was sentenced to death on bribery and corruption charges, which basically means that Huarong’s problems have become very serious. With the impact of the Lai Xiaomin case, coupled with regulatory pressure to return to its main business, the risks accumulated by the company’s extensive shadow banking business, including “blood transfusion” to real estate companies, are gradually being exposed.
Now, Huarong’s annual report is delayed and the prospect of restructuring is unclear, resulting in Huarong’s bonds being shorted overseas and the next step may be default. At this time, Huarong, as a direct subsidiary of the Ministry of Finance, once defaulted will probably drag down the Ministry of Finance, or at least affect the sovereign bond rating of the Ministry. Therefore, it is especially important to find out how to get out of the golden cage, following the default, without affecting the rating and credibility of the Ministry of Finance.
At this critical moment in the storm, the Ministry of Finance intends to transfer its stake in China Huarong to Central Huijin, a subsidiary of CIC, which is mainly a company that manages China’s foreign exchange investments. Central Huijin is one of three key subsidiaries of CIC, whose board members are appointed by the State Council and whose responsibility is to make equity investments in key state-owned financial enterprises under the authority of the State Council; Central Huijin has experience in helping troubled commercial banks, having subscribed for 60 billion shares in a non-public offering of Hengfeng Bank in 2019.
Before the equity transfer, China Huarong was directly held by the Ministry of Finance (MOF) in H shares and domestic shares, with 31.68% and 23.54% respectively, for a total holding of 55.22%, which was the data as of June last year; if the MOF transferred all the equity to Central Huijin, then Huarong would become a subsidiary of Central Huijin, which is a wholly-owned subsidiary of CIC, which is under the Ministry of Finance. If this transfer is made, in terms of hierarchy, China Huarong becomes a four-tier company from a direct subsidiary of the Ministry of Finance, that is, from the Ministry of Finance – CIC to Central Huijin to China Huarong, so the relationship with the Ministry of Finance is very far. The other three asset handling companies set up by Zhu Rongji were all directly owned by the Ministry of Finance.
Of course, such a temporary transfer, must avoid outside gossip, lest others say that your Ministry of Finance want to renege on the debt will be a problem. So, China’s Ministry of Finance explained that the consideration for the transfer is that “Central Huijin has better experience in dealing with debt risks”, and “such a transfer does not represent a change in government support”.
However, if we make a worse assumption that Huarong has a large deficit in its books and the Ministry of Finance intends to let it default on its debt, then a realistic consideration for the equity transfer is to change Huarong from a company directly owned by the government to a company owned by government-backed enterprises, so that the equity devolution can turn China Huarong’s default into a corporate debt default instead of a default linked to China’s national sovereignty. In other words, if the transferred shares are not linked to China’s sovereignty, the sovereign rating will not be affected. In other words, if this is the real purpose of the transfer, then the end of China Huarong is rather tragic, which means that his deficit is unimaginable and may even reach the point of insolvency. But if it defaults, the impact is nuclear. As of June 30, 2020, China Huarong’s liabilities totaled $1.56 trillion, with bonds payable reaching $338.8 billion.
Regardless of how China Huarong ends up, think about this behemoth, you invest in his bonds, there is really no other means but faith. It’s like buying a blind box, there’s no way to know what’s inside. You simply have no way to assess the value of his assets, the audit report is also impossible to disclose the details of each asset, the cost of buying and other information, children and grandchildren of many companies, business is also very complicated, lend him money is really purely believe that he can pay back, not how good the business, how good the value of assets, how sound debt, because these things outsiders simply can not figure out. The main body that may normally be too high to climb may also generate such a big risk.
Assuming that the end of China Huarong is more tragic, then still have to rank the risk of Huarong system. There are more companies in the Huarong system, and the main subjects are basically clear AAA, but if something happens to China Huarong, there will be another wave of downgrades: in recent days, Moody’s, S&P and Fitch have warned that they may downgrade the ratings of bonds issued by China Huarong and its subsidiaries. I see this outcome as unstoppable.
China’s finance ministry will have to weigh the risks against the benefits of sitting back and letting China Huarong default, with the risk that it could lead to a spreading crisis and the benefit of making investors understand that even state-owned enterprises don’t always have the government underwriting them.
Of course, the Chinese government is likely to restructure Huarong, allowing it to divest itself of bad debts, and large investors will face a discount on their debt, with Huarong’s debts to foreign creditors likely to be discounted by about 10%. That’s not a small loss for overseas investors either.
China Huarong’s woes are feared to lead to a revaluation of about $100 billion worth of Chinese bonds, including foreign debt issued by state-owned enterprises and local government financing platforms. And it could also have a ripple effect, acting like dominoes and dealing a huge blow to overseas bonds issued by China’s real estate and banks, among others. It will be even harder for Chinese SOEs to borrow more.
Some people may say that delaying the publication of annual reports is not a big deal, but they do not know that annual reports reflect the most realistic picture of a company’s balance sheet. Once the annual report are delayed, it means that the company’s debt may have a big problem.
The last main bankruptcy without disclosing the annual report was Baoshang Bank, while another difficult annual report household Hengfeng Bank was safely landed by the financial underwriting. With these two precedents in place, we can expect the market’s reaction to Huarong’s delay in publishing its annual report.
I did not think that a company doing badly hard to make themselves bad, I do not know what the final ending of China Huarong will be, is the road of the package business or Hengfeng. However, the result is basically certain, default or restructuring are to avoid debt. The only ones who are suffering are those who invested in Huarong and lent money to Huarong’s backstabbers!
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