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Corporate China to face a rush of defaults in 2019

Increased pressure on state-owned 'zombies' risks disrupting global supply chains

Densely built-up residential areas of the Chinese city of Qingdao, in Shandong Province, rise behind a silhouette of a woman.   © Getty Images

TOKYO -- China is bracing for another wave of business failures this year, as companies fall victim to the slowing economy and unresolved trade tensions with the U.S.

Insolvencies will rise 20% in 2019, trade credit insurer Euler Hermes predicts -- far exceeding the global rate of 6%. This comes on top of last year's 60% jump in the country, where economic growth has reached the lowest in a decade.

The forecast comes as a slew of companies reveal the pain of slowing growth in their earnings statements. Calculations by Nikkei show that some 30% of China's roughly 3,600 listed companies suffered a fall in net earnings during 2018. About 400 are expected to book a net loss.

Those mainly affected were small to midsize private companies who also faced the government's credit crackdown; an effort carried out by President Xi Jinping to reduce the country's excessive corporate debt.

This credit crunch is expected to gain momentum in 2019, putting these companies under further pressure. Chinese corporate bonds already recorded an all-time high in defaults last year.

While credit agencies still largely expect a stable outlook for corporate bond ratings in the Asia-Pacific region this year -- partly due to the fact that the Chinese economy is still growing -- S & P Global Ratings recently downgraded two mainland Chinese property developers, Hong Kong-listed Yida China Holdings and Guorui Properties.

Fitch Ratings also assigned a stable sector outlook for its rated portfolio of 434 Asia-Pacific companies, with China's homebuilding sector having the only negative outlook. However, senior director Matt Jamieson noted the looming risks in a recent report. "The U.S.-China trade war could begin to take a toll on manufacturers," he said.

China's double digit increase in corporate defaults this year will "result on one hand from the ongoing softening and adjustments of the Chinese economy, notably in regards to credit growth, Belt and Road Initiative and international trade issues," the Euler report stressed.

Another significant cause for bankruptcies, was the "increasing inclination to use insolvency procedures, in particular by the authorities, in order to clean the 'zombie' state-owned enterprises (exceeding 20,000 cases according to some studies)."

Reducing the risks created by the high level of debt in China's corporate sector has been a priority for Xi in recent years. In the past, the Chinese government had tolerated high debt in order to keep the economy booming; since 2017, however, it has pressed banks to rein in lending to struggling state-owned enterprises known as zombies. These are companies that can only survive with government subsidies.

Chinese media has reported that Beijing wants all zombie state owned enterprises to close by 2020. This could also have consequences for growth.

Xiao Minjie, managing partner at a Japan-China M&A (merger and acquisitions) advisory company AIS Capital, says "in the short term, it will be a big hit to the Chinese economy," once the defaults surge. "Many of the zombie SOEs are old companies in sectors such as steel or trade commerce," he added, stressing that "including Japan, a wide range of countries will equally be affected by the disruption in the supply chain."

On the other hand, Mahamoud Islam, senior economist for Asia at Euler Hermes said "closure of non-viable corporations could lead to a better functioning economy in the long term."

Euler Hermes predicts the rate of insolvencies for other Asian nations will remain rather stable, with Singapore at 3%, Hong Kong at 2%, and Japan at 1% for the rate of growth in bankruptcies.

However, boosted by the surge in China, in 2019 Asia as a whole is expected to register an increase of 15% in corporate insolvencies; another double digit increase after last year's 37%. One out of four major insolvencies over the first quarter to the third quarter of 2018 were contributed by Asia.

Meanwhile, the credit agencies are watching the situation closely. According to S & P Global Ratings, for the three months through December, there were only seven corporate credit downgrades within Asia-Pacific, including South Korea's Hyundai Motor and India's Tata Motors, while there were six upgrades. Companies put on Credit Watch Negative totaled to only eight.

This could be the result of credit rating agencies mainly covering big corporations, whereas in China, zombie SOEs tends to be smaller corporations that are not included in their rating portfolios. Nonetheless, Cindy Huang, primary credit analyst at S & P, highlights the risk of a divergence in credit quality, stating that "We expect credit spreads for strong corporates to narrow, but weak companies continue to face higher risk of downgrades and defaults."

Matthew Chow, also from S & P Global Ratings, said there had been encouraging signs recently from some segments of China's beleaguered property sector after a number of companies successfully issued onshore and offshore bonds in recent months.

"The situation has improved from a few months ago. Right now we are seeing some improvement of liquidity of mainland Chinese property companies," he said. But, he added, "The weaker players have not benefited much from that."

Nikkei Asian Review deputy editor Dean Napolitano contributed to this report.

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