A series of defaults on bonds issued by Chinese state-backed companies has sent shock waves through the world’s second largest debt market in recent days, raising questions about local government guarantees and the credibility of domestic ratings.
Since last week, China’s bond market has seen defaults by a mine operator, an integrated circuit maker and a car manufacturer.
The non-payments have rocked investor confidence as the bonds were issued by state-controlled firms, which are usually seen as less risky because they receive government backing and have investment grade credit ratings from domestic agencies.
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The unexpected delinquencies triggered an immediate sell-off in outstanding debt issues on concern that financially weak provinces might be unable to continue offering guarantees to companies they own. This, in turn, has caused borrowers to halt or delay sales of new bonds.
The idea is that government guarantees behind a bank or a state-owned enterprise may not protect investors from losses after years of assuming that these guarantees were solid
Logan Wright, director of China markets research at Rhodium Group, compared the loss of confidence in the bond market with the collapse of Baoshang Bank last year, which became the country’s first bank failure in nearly two decades.
“The idea is that government guarantees behind a bank or a state-owned enterprise may not protect investors from losses after years of assuming that these guarantees were solid,” Wright said.
Last Tuesday, Yongcheng Coal & Electricity Holding Group, a state-owned mine operator in Henan province, failed to make principal and interest payments on 1 billion yuan (US$151.8 million) in AAA rated commercial paper, triggering a wave of panic selling that sent its bond prices tumbling as much as 93 per cent.
According to Wind, a Chinese financial data provider, there have been no transactions in the past few days on Yongcheng Coal’s outstanding bonds after last week’s sell-off, reflecting investor fears the company might be unable to repay its debts.
“Due to the market’s insufficient expectations of a default at Yongcheng Coal, panic broke out in the bond market,” said a report by broker China International Capital Corp (CICC) at the weekend.
Bond issuance from the coal industry, weak state-owned enterprises and unrelated companies in Henan province have all suffered as a result of the default, CICC said.
“The primary market is frequently cancelling issuance, and the entire credit bond market is in an atmosphere of tight liquidity,” it said.
Integrated circuit maker Tsinghua Unigroup and car maker Huachen Automotive Group, also known as Brilliance Auto, are among the other state-backed firms struggling to repay debts.
There have been 110 corporate bond defaults in China this year, totalling 126.28 billion yuan, Wind said in a note last week. Last year China recorded 184 defaults worth 149.4 billion yuan. Overall defaults this year are expected to surpass 2019, the financial data firm added.
The chain of defaults has stirred questions about the reliability of local rating agencies in assessing risk, given there were no warnings or downgrades before Yongcheng Coal’s default.
Despite the recent increase in bond defaults, I am not aware of any improvement in the accuracy of China’s rating agencies
China has pledged to open its US$13 trillion bond rating market since 2017, but it only approved Standard & Poors for domestic operations in 2019. Fitch Ratings also gained approval in May this year, as part of the phase one trade deal with the United States.
Andrew Collier, managing director of Orient Capital Research, said China’s domestic rating agencies were often paid by clients and had no incentive to accurately assess risk.
“And they’re not scrutinised by the press or investors the way Western raters are,” he said. “Despite the recent increase in bond defaults, I am not aware of any improvement in the accuracy of China’s rating agencies.”
On Monday, Yongcheng Coal said in a Shanghai exchange filing it had met its interest payments, but did not mention repayment on the principal. The Henan government, the majority shareholder of Yongcheng Coal, has also sought to reassure investors it will continue to support its companies and will not “evade debt”, the 21st Century Business Herald reported, citing an anonymous source from the government.
State firms in China are increasingly using the corporate bond market to raise funds. Government-backed companies with weak credit profiles – rated AA+ or below by domestic rating agencies – had nearly 700 billion yuan worth of bonds set to mature this year, compared to nearly 500 billion yuan of bonds with similar ratings by private firms, Fitch Ratings said in a report on Monday.
Rhodium Group said in a report last week the defaults would increase the cost for local governments to maintain the credibility of their guarantees.
To control its large and growing debt pile, Beijing has reined in shadow banking, an informal lending channel that is used by many local governments to finance borrowing. But that initiative has increased the probability of local governments failing to meet their debt payments, the US-based research firm said.
What’s more, China has expanded local governments’ borrowing quota for infrastructure spending to offset the economic damage from the coronavirus pandemic.
However, these projects will not generate short-term revenues and will increase indebtedness, increasing the risk of default, Rhodium Group said.
The People’s Bank of China (PBOC) injected more than US$120 billion yuan into the country’s banking system on Monday to provide liquidity and sooth rattled nerves in the bond market. But analysts said authorities needed to be careful with intervention.
“They need to see the bond market try to price in this new credit risk, but they cannot be sure when risk aversion might spiral into broader market contagion and cause additional defaults or slow overall corporate credit growth,” Wright said.
“At the same time, authorities probably need to provide some short-term liquidity to prevent this credit market stress from impacting the banking system’s regular functions. But it is difficult to find the appropriate action to balance those two objectives.”
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