HONG KONG -- Not so long ago a Chinese bond default was barely heard of. Yet in the past two months, talk in the country's financial circles has been of little else.
A swath of failures to repay principal or interest on outstanding bonds has sent this year's default total to a record $25 billion and raised concerns of a looming debt crisis that could derail China's post-pandemic recovery. It follows a period in which Chinese companies have gorged on cheap borrowing, giving the world's second-largest economy one of the world's most debt-dependent corporate sectors.
With the defaulting issuers including several state-controlled entities, the rise in nonpayments has shattered assumptions that the Chinese state would always bail out such companies -- a notion that previously provided bond investors with the comfort of an implicit government guarantee. That, perhaps more than the volume of defaults, has sent shock waves across China's $15 trillion bond market.
To some economists and market analysts, the situation is a sign of Beijing's intention to impose more discipline on corporate borrowers and to try to rein in excesses at a time when the country's strong economic recovery from the coronavirus pandemic makes such action easier.
But the potential that Beijing overplays its hand with an excessive withdrawal of liquidity is seen as a risk that will overhang the Chinese economy in 2021.
"Worries about potential credit events getting out of hand top the list of concerns about China," said Chi Lo, greater China senior economist at BNP Paribas Asset Management. "A potential policy mistake by tightening up prematurely or pushing deleveraging measures, along with retreating from the implicit guarantee too quickly, could pull the rug from under the economic recovery and increase the tail risk of a domestic financial crisis."
Lo and a number of other economists believe it unlikely that the defaults will lead to a wider systemic crisis, since authorities have enough levers to support the economy.
But they agree that Beijing's resolve to restart deleveraging and structural reforms, an effort which began in 2016 but has been interrupted by the trade war with the U.S. and the impact of the coronavirus pandemic, will curb economic growth. Lo estimates 2021 gross domestic product expansion will be 6.6%, far below the current market consensus of 11.3%, due to the renewed focus on dealing with the debt overhang.
"The defaults by state-owned entities may just mark the beginning of a repricing of the risk premium, resulting in more differentiation between quality and uncompetitive companies," said Michelle Lam, greater China economist at Societe Generale. "This will inevitably add to tightening pressures on credit conditions and inevitably lead to a slowdown in economic growth in the second half of 2021."
Chinese companies have relied on debt-fueled expansion for years, leaning on the surplus liquidity pumped in by the authorities to power the economy since the 2008 global financial crisis.
Nonfinancial corporate debt climbed to 159.1% of GDP in the first quarter from 152.2% a year earlier, according to the Institute of International Finance, which counts 400 banks and financial institutions across the globe as members. The ratio is the world's second highest, behind only Hong Kong. In comparison, the proportion in the U.S. stood at 78.1%, in the euro area at 109.8%, 106.4% in Japan and 96.1% on average across emerging markets.
Defaults in China's onshore bond market, where companies borrow in yuan, scaled new records in 2018 and 2019 as the effects of the deleveraging campaign over the previous two years rippled through the economy. But authorities completely eased off earlier this year as part of measures to nurse the economy through the pandemic. The central bank enhanced liquidity by giving banks more incentives to buy corporate bonds. Companies were also allowed to delay repayments by extending maturities.
Now, China's economic resurgence is giving policymakers the space to tighten up in a series of areas where they are worried about financial risk. This is occurring not just in the country's $4 trillion corporate bond market; it extends to the growing power of online finance platforms such as that of Ant Group, whose $39.6 billion stock market listing plan was derailed in November when Beijing toughened the rule book governing its lending.
In the bond market, one of the first intimations of trouble came when Yongcheng Coal & Electricity Holding Group, a state-run coal miner, failed to repay a 1 billion yuan bond in November, blaming tight liquidity. Subsequently, chipmaker Tsinghua Unigroup, an affiliate of Beijing's Tsinghua University, failed to repay a $450 million dollar bond after it defaulted on a 1.3 billion yuan local issue. Huachen Automotive Group Holdings, a state-run carmaker and parent of the local partner of BMW, also defaulted, and later entered into bankruptcy protection.
Acquisitive fashion group Shandong Ruyi Technology Group, once hailed as the "LVMH of China," missed the deadline on two domestic bonds -- a maturity and an interest payment -- in 24 hours.
Now the focus is on what 2021 might bring. In the offshore market, where Chinese companies borrow in foreign currencies, about $104 billion worth of bonds will mature in 2021, 40% more than this year. Some 7.1 trillion yuan of bonds are due to mature in the domestic market, with Fitch Ratings warning that 1.15 trillion yuan of that relates to companies with excessive borrowings or weak balance sheets.
The specter of rising defaults is also drawing attention to the quality of the ratings given to borrowers by Chinese agencies that score credit risk. Two-thirds of all bonds rated by domestic agencies -- including those from Tsinghua Unigroup and Yongcheng Coal at the time they defaulted -- have either a AAA or AA+ rating, while almost all have an investment grade rating.
A gap between the ratings issued by Chinese credit agencies and those of their western peers is often apparent. In the case of Shandong Ruyi, while both Moody's Investors Service and S&P Global Ratings classified the Chinese fashion group in the "junk" rating category all along, China's Dagong Credit Rating gave it "AA+" until a downgrade to "AA-" in March.
Beijing is now rushing to clean up the rating agencies. "There are still problems such as ratings being fictitiously high, lack of enough differentiation [between issuers] and pre-warning mechanisms being weak. These shortcomings are restricting the high-quality development of our bond market," said Pan Gongsheng, deputy governor of the People's Bank of China, at a symposium to discuss issues surrounding credit agencies on Dec. 11.
The country's most powerful graft buster has also been called in. This month, the Central Commission for Discipline Inspection released a video of two former executives of Golden Credit Rating in which they appear to confess to taking bribes from the companies in exchange for higher evaluations. "I became numb and insensitive and slowly turned into a slave of money," Jin Yongshou, former president of the agency, was filmed as saying.
Concerns extend beyond the rating agencies. Lou Jiwel, a former finance minister who now serves on the country's top policy advisory body, on Sunday criticized current financial regulators for their inconsistent approach to the bond market troubles in a conference speech, warning of risks to the national economy from the debt problem.
"The investigation and cleanup of high-risk institutions and the disorder of financial infrastructure must be contained," said Lou, according to transcripts published by news portal Sina.com.
Some analysts, bankers and economists are sanguine about Beijing's ability to damp down excess borrowing and tame any default risk before it spreads systemically.
"The market has by and large held up," said the head of one global bank's debt capital markets team. "We are talking about a market that has a very low default rate, an improving macro environment and low interest rates. Investors aren't concerned about systemic defaults. They will instead have to run credit-by-credit analysis."
In percentage terms, the rise in defaults may not seem so alarming. Only 0.5% of the outstanding onshore nonfinancial corporate bonds have defaulted so far this year, compared with 0.6% in 2019 and 0.5% the year before, according to data from Societe Generale. The situation is worse for maturing offshore nonfinancial corporate bonds, where this year a record 1.8% are in default compared to 0.4% last year. However those numbers compare with defaults rates of more than 5% for high yield bonds in the U.S. and Europe.
Investors have also come back after a sell-off last month on hopes that a cyclical recovery will ease companies' financial burdens. The Bank of America China Corporate Bond Index is within touching distance of a record high hit in February. Ten-year sovereign bond yields have slid back to 3.31% after hitting their highest level in nearly 20 months in November.
"There is an effort underway to rationalize between the good and bad companies," said Soo Cheon Lee, chief investment officer at Hong Kong-based debt investment group SC Lowy.
The asset manager, which oversees $2 billion, has added two more analysts this year, taking its China-focused research team to three, to run the numbers on companies whose stressed balance sheets might offer outside investors a financial opportunity.
"While we don't foresee a systemic crisis, the exercise is going to be painful in the short-term for companies and pave the way for external capital to play a role," Soo said. "The China opportunity will only get bigger."
Additional reporting by Nikkei Asia chief business news correspondent Kenji Kawase.