BEIJING -- Investors can no longer count on China's local governments to bail out state-owned companies that have trouble paying their debts, as a nationwide deleveraging campaign and tax reforms start to bear fruit.
Alarm bells rang late last month when Qinghai Provincial Investment Group, an aluminum company owned by the Qinghai government, missed a coupon payment on a $300 million bond.
While the payment was eventually made with the help of the company's controlling shareholder -- the Qinghai provincial government -- the slow rescue indicates that state support is no longer guaranteed in such cases, analysts say.
The risk of default in China's state sector -- long considered a safe haven by bond investors -- has increased at a time when the country is grappling with slowing growth and a protracted trade war with the U.S.
"Not all Chinese government-related entities can rely on state support for timely payment of their obligations," analysts at Fitch Ratings wrote in a recent research note. The abrupt turn of events, they said, could be prompted by Beijing's push to reduce implicit and explicit guarantees of state companies and improve market discipline.
The government reiterated its determination to address the pressing issue of debt at China's state-owned companies during the National People's Congess in Beijing this week.
"We will press ahead the system reform to limit debts of state-owned companies," Lian Weiliang, deputy director of China's National Development and Reform Commission said on on Wednesday.
Latest figures show debt levels of 115.65 trillion yuan as of last December, up 8.1% from a year ago. This represents 64.7% of the 178.75 trillion yuan in assets, up by 8.4%, recorded for the same month.
Only about 20% of onshore corporate defaults last year were made by state-owned enterprises, even though many of these companies have higher production costs, weaker competitive positions and are more leveraged than their private counterparts.
China's economy has long been plagued with "zombie" companies that can only survive with government support but which local officials consider vital for local employment and strategic development. Now, however, officials appear to be reconsidering whether they should keep such companies alive when they themselves are facing growing financial pressure.
"We have seen a shift in attitudes towards defaults, as the authorities are keen to expedite the reckoning of bad debt," said Carlos Casanova, Asia Pacific economist at credit insurer Coface. A major reason for this is Beijing's call for local governments to tackle zombie enterprises and clean up nonperforming balance sheets by 2020, he said.
"This means that there will be less support for local SOEs going forward," Casanova said. "Investors with exposure to bad debt owned by local SOEs or local government financing vehicles would be more exposed to default risks than they have imagined."
Funding an SOE rescue is also becoming costlier as the state sector faces a wave of debt coming due in 2019. S&P Global Ratings data shows that close to 1.6 trillion yuan ($238 billion) worth of debt on the books of so-called local government finance vehicles will mature by the end of this year.
The agency downgraded the Qinghai aluminum producer's credit rating to CCC- with a negative outlook, noting that the missed payment reflects a potentially weakened commitment on the part of the government to support the company.
"QPIG's credit quality deteriorated sharply, and it may not be an exception among ailing SOEs," said S&P analyst Claire Yuan.
At the same time, an abrupt end of government support is unlikely, said Gloria Lu, another S&P analyst, as a large number of SOE defaults would threaten China's financial stability.
Instead, state support will be more selective, according to Wang Dan, a Beijing-based analyst for the Economist Intelligence Unit. Wang expects a polarization in SEOs' credit profiles as governments become more likely to let smaller zombies die while keeping the bigger ones afloat.
One reason for this, she said, is that local governments are pocketing less cash after the introduction of nationwide tax reforms last year requiring them to turn over a bigger cut of tax revenues to the central government. This weakens their ability to bail out SOEs, especially those that do not generate enough revenue, Wang said.
The Qinghai case could "shake the confidence of bond investors" in China's state sector, she added, making it more difficult for ailing SOEs to raise funds when their profits are already being squeezed in a slowing economy.
She suggests that investors seek to convert their bonds into equity in cases where the company's troubles are purely caused by liquidity. But if poor operations are the root cause, which is the case for most troubled SOEs, "there isn't much investors can do," Wang said.