MNI EXCLUSIVE: More SOEs May Default As China Targets Zombies

China is set to allow more struggling state-owned companies to default or even go bankrupt, forcing investors to re-evaluate assumptions of local government backing for their debt, but authorities will limit failures to out-of-favour sectors such as heavily-polluting industry and be careful to control their pace in order to avoid generating systemic risk, policy advisors told MNI.

The orderly cleanup of zombie companies, for the most part state-owned, will be a major focus for the Chinese government over the next five years, as the country upgrades industry and frees up credit resources for key sectors, national and local government advisors told MNI, asking to remain anonymous. But such moves will proceed cautiously, at a time when the economy is recovering from the effects of the Covid-19 pandemic and the gradual opening up of financial markets increases the potential for volatile capital flows, they said.

Meanwhile, regulators may yet be forced to step in to limit damage from a corporate bond sell-off which began when Yongcheng Coal & Electricity Holding Group Co Ltd failed to make principal and interest payments on CNY1 billion in maturing commercial paper on Nov. 10, one advisor said. The Henan-province based company had been rated AAA by a domestic credit agency. Two other big government-backed enterprises defaulted last month, with Huachen Automotive failing to make payments on a CNY1 billion bond and Tsinghua Unigroup missing payments on a CNY1.3 billion debt. All three companies face large maturities at the end of the year.

IMPLICIT GUARANTEE

Investors have dumped corporate bonds, including debt issued by state-owned firms and local government funding vehicles, particularly in old-style heavy industry such as coal and car manufacturing. Some 53 corporate bond sales for total CNY28.5 billion have been cancelled since Nov. 10, three times more than that in the week of Nov 2. Even government bonds have been hit, with the yield on 10-year debt rising 3 basis points Wednesday to 3.31%, the highest since May, 2019.

Until now, investors had assumed local governments would ensure even loss-making state-owned enterprises made their payments, artificially depressing risk premia. But, while this was the case when the economy and real estate market were booming, local administrations have faced years of financial constraint and slow revenue growth, another advisor said.

In addition, national policy makers now want a clean-up of zombie companies, the advisor said. These only stay in business thanks to their ability to obtain new loans. State-owned enterprises account for 60% of all corporate debt, which in turn accounts for 60% of China's total debt, the advisor noted.

China's earlier deleveraging campaign, at it most intense from 2017-2018, focused on the private sector, but now it is the turn of state-owned enterprises, particularly large, highly-leveraged firms in heavily-polluting areas suffering from excess capacity, the advisor said.

POORER REGIONS

But the details of what occurs will depend on bargaining between central government and local administrations which have long looked to big companies as sources of revenue and employment, he noted. Some firms may be supported despite outmoded technology or poor environmental performance if they are key to local economies, a third advisor said, pointing to Shanxi province, where authorities reassured investors that bonds issued by their coal producers were not at risk in the aftermath of Yongcheng's default.

Authorities will also tread carefully with firms held in high investor regard, in order to limit market fallout from defaults, advisors said,

Another key factor is the differing capacity of local governments to provide bailouts. Administrations in western and northeastern areas may struggle more than their richer eastern counterparts to provide help. Governments in poorer areas may have to sell assets, or borrow from local banks, which may in turn increase financial risk, an advisor said. In the long run, the central government may have to transfer more tax collection to the regions to help them cope, he said.