Test of resolve

China’s reforms promise to improve risk pricing and end a long history of government bailouts, but slowing growth and rising defaults are testing the resolve of the country’s regulators.

China’s muddled thinking over the rising level of debt trapped within its financial system was thrown into stark relief due to two interlinked events in the last two weeks of April.

First came a long-expected announcement that still held an element of surprise: a state-owned enterprise was finally being allowed to default on its debt. Power equipment manufacturer Baoding Tianwei Group, a unit of a leading military contractor, missed an interest payment of Rmb85.5m ($13.8m) due on bonds of Rmb1.5bn, after racking up huge losses.

Earlier that week, Kaisa Group Holdings became the first Chinese developer to default on its US currency debt. Now, Baoding Tianwei, a small-but-vital cog in the state machine, was being forced to admit in public to its financial failings. The default appeared to mark a genuine shift in the thinking of a government determined to open a cooling economy to market forces.

China was also effectively breaking a longstanding taboo over moral hazard, the ingrained belief that the country’s state-owned enterprises could do what they wanted, on the assumption that government would always bail them out. The government was sending a clear signal to investors: risks existed in the financial system, and should be factored in when buying debt securities. CICC, China’s largest investment bank, described the default as a “landmark” event in the history of the country’s bond markets.

As it turned out, this was not true at all. Far from being China’s pivotal moment, it was just another example of Beijing’s signalling its intention to do something big and brave, before scuttling back into its shell. In this instance, the volte-face came just six days later, when state lender China Construction Bank handed Baoding Tianwei an undisclosed loan, ensuring that it would meet its bond repayments.

“When it comes to the domestic bond markets, the first order of priority is clearly the issuance of local government debt. Until that is completed, the timing of a default on an SOE may have to be deferred.”

Analysts were quick to describe this as a missed opportunity for a country burdened with rising liabilities at all levels. Mainland corporations are now among the world’s most indebted. As at the end of 2014, the ratio of debt to economic output, including all corporate and central and local government liabilities, stood at more than 250% of GDP, an increase of 90% since 2008, according to data from the People’s Bank of China.

Worse, Beijing stood accused of misleading the investment community, having signalled right before turning left.

“They sent mixed signals over Baoding,” said one renminbi market specialist in Hong Kong. “It appeared that China had accepted a key inherent weakness in its economic and financial system – and that it accepted the need for all firms, even its prized SOEs, to fail.” Then, it backpedalled, leaving “the whole industry feeling very confused”.

In dodging a painful, but necessary, event in the development of its capital markets, China also missed a chance to prove to the world that its reforms were on track. Growth is slowing even as debts soar. Steel and coal production both slipped sharply in April, with exports falling 6.2% year on year in April, as opposed to expectations of an increase. Beijing could have used Baoding’s failings to show domestic and foreign investors how an SOE would go about restructuring its debt and to demonstrate how creditors could recover capital in a default situation.

Almost immediately, analysts started looking beyond the troubled firm for answers. Baoding may well have been, to use the words of Anne Stevenson-Yang, co-founder of independent Beijing-based consultancy J Capital Research, an “almost incredible debt scofflaw”.

Balancing act

However, Beijing and its leading state banks, including CCB, do everything for a reason. So, what was the logic behind its thinking this time? The answer almost certainly lies in two of China’s most pressing challenges: first, the need to tackle the surfeit of local government debt and, second, the perilous state of the country’s army of bloated and often badly run SOEs.

Local debt has long been a thorn in the government’s side. At the height of the 2008 financial crisis, with a looming recession at home, Beijing ordered provincial authorities to pump-prime the economy. They did and borrowed heavily through local government financing vehicles (LGFVs) to fund huge infrastructure projects. By mid-2013, direct and indirect local debt had mushroomed to Rmb18trn, or around 30% of total GDP, though some analysts believed the official number was as much as double that level.

The latest move to resolve this issue came on May 19, when the wealthy coastal province of Jiangsu completed a landmark bond sale, printing Rmb52.2bn worth of municipal paper with a coupon only slightly higher than equivalent Treasury rates. Jiangsu failed in its first attempt to sell Rmb64.8bn of bonds in April, after banks balked at the low coupon on offer. This time Beijing spared no effort in getting the standalone municipal market off to a good start, extending a range of guarantees and inducements, including a pinch of extra yield, to induce the co-operation of vacillating state lenders.

It is to this tangled web of local debt that analysts turn when seeking explanations for the Baoding bailout. The threat of unsettling a market preparing to repackage trillions of renminbi of LGFV debt into fresh municipal bonds was too much for China’s conservative leaders.

“When it comes to the domestic bond markets, the first order of priority is clearly the issuance of local government debt,” said CG Lai, head of global markets and corporate sales for Greater China at BNP Paribas in Hong Kong. “Until that is completed, the timing of a default on an SOE may have to be deferred.”

That may turn out to be a long time hence: mainland banks are being leaned on heavily to buy all new debt from municipal authorities and their LGFV offshoots.

SOE reform

Moreover, Beijing faces another wearying challenge: the need to reform the nation’s wheezing state enterprises. On April 27, leading Party newspaper the People’s Daily outlined plans to whittle down the number of systemically important SOEs to 40 from 112, a process that might also involve the forced merger of truly giant industrial firms, such as PetroChina and Sinopec.

The argument in favour of fewer state-run firms benefiting from better oversight and a slimmer, more transparent management structure has long been clear. Returns on assets at SOEs fell by a third between 2007 and 2013, according to SASAC, the state agency that regulates them. Still, an attempt to transform them in the 1990s created national giants at the expense of horrendous job losses.

Now, Beijing faces a far harder challenge: to reform SOEs and restructure their debts without stalling the economy and scaring away investors. It will be a painful process, requiring delicate timing and more than a little luck.

“It’s clear that they will have to write off some of the debts at SOEs, by letting them default on local and foreign-currency debt and allowing them to start over,” said Wei Yao, chief China economist at Société Générale. “Over the coming years, you will see a lot of debt restructuring coming out of China and a lot of SOEs going under. It will be painful, but necessary.”

Analysts are of the opinion that this process will not involve the sort of defaults that intermittently pepper Anglo-Saxon-style markets, wherein companies cease trading and begin insolvency proceedings. More likely, said Wei, it would involve a “structure planned long in advance by central government, and which will try to mitigate the impact on the jobs market. You’re likely to see restructuring take place over an elongated period of three to five years. It’s difficult, but doable”.

J Capital’s Stevenson-Yang believes that the market is likely to be forced to absorb “a good hundred billion dollars or so in external bond defaults” over the next few years. That may explain why Baoding’s default was endorsed then nixed. It simply happened too soon, analysts say, and was not part of the grand plan.

Two more questions remain: is credit risk waxing or waning in China; and is there any way for Beijing to stave off or entirely avoid restructuring the country’s crushing debt burden?

The answer to the first question is that credit risk is almost certainly on the rise. Beijing could have removed a small slice of moral hazard from the market in allowing Baoding to default on its debt. Bad timing and an attack of nerves scuppered that chance. Its move to allow local authorities to issue municipal debt merely marks the start of a massive bailout programme designed to reduce the interest burdens of local authorities – a process quickly tagged as “quantitative easing with Chinese characteristics”.

The bailout plan could well “lower liquidity risk for local governments, and present China with the chance to develop a proper bond market”, noted SocGen’s Wei. However, the likelihood is that it will do little to alleviate domestic financial risk, and may well exacerbate the problem.

“I don’t necessarily see credit risk rising,” said Andrew Polk, a senior economist at The Conference Board in Beijing. “Rather, the credit risks that were previously introduced (in 2009 and once again in 2012) are now bubbling to the surface.”

China’s top leaders would surely love to return to a well-thumbed chapter in their economic playbook, in which they simply grow their way out of trouble. This, however, looks increasingly unlikely. Credit growth expanded at more than twice the rate of nominal GDP in the first three months of 2015 (12% against 5.8%), and the TCB’s Polk believes there is “no way for China to grow its way out of debt” under those circumstances.

Ultimately, he says, there will have to be “a large-scale government bailout of the banking system at least and, perhaps, the shadow banking system, as well” – a process now well under way, thanks to the formation of a new municipal bond market. That means heaping yet more risk atop an economy already creaking under flagging growth and soaring debts. In seeking to alleviate credit risk, China may merely have augmented it. That, surely, was not the original long-term plan.