After three record years of bond defaults, Chinese policy makers rushed when the pandemic hit to prevent another wave of missed payments. Now they are taking advantage of a strengthening economy and stable financial markets to take a tougher stance with indebted giants such as China Huarong Asset Management Co. and China Evergrande Group -- firms that had been considered “too big to fail.” The result has been a repricing of risk in China’s credit markets that should discourage the kind of debt-fueled expansion that not only threatens the financial system but could also weaken President Xi Jinping’s grip on power.

1. How big is the problem?

Chinese defaults were at a record pace by mid-year with more than $25 billion in onshore and offshore payment failures. That compares to $29.9 billion for all of 2020. Defaults in the private sector in China actually dropped early last year, largely due to pandemic-related pressure valves such as delaying repayments, swapping bonds or canceling early repayment. However, the year ended with 140.1 billion yuan ($21.6 billion) in onshore defaults, almost matching the record of more than 143.6 billion yuan in 2019. (The 2018 total of 122 billion yuan was itself more than quadruple the level in 2017.)

2. Where are defaults hitting?

Real estate firms made up around 30% of the defaults in the first half of this year, with $7.6 billion of missed payments in onshore and offshore bonds, according to data compiled by Bloomberg. The roster included China Fortune Land Development Co. and Sichuan Languang Development Co. Transportation, tourism and retailing were especially hurt by the pandemic in 2020. Historically, defaults have mainly been in the private sector. But late in the year state-linked companies like Yongcheng Coal & Electricity Holding Group Co. and Tsinghua Unigroup Co., which is associated with one of the country’s top tertiary institutions, also ran into trouble.

3. What’s the significance of that?

It’s shaken investor confidence, as companies with ties to the state were long considered to have an implicit government backing. Now even those that are deeply entwined are drawing fresh scrutiny. Evergrande, the largest issuer of dollar junk bonds in Asia, saw its ratings fall further in June even after it secured a $4.6 billion infusion from state-linked companies and ramped up asset sales as it seeks to reduce its $100 billion burden. Evergrande hasn’t sold dollar bonds since January 2020. Another focus has been bad-debt managers that are charged with cleaning up China’s soured loans. One key player is Huarong, which failed to release its 2020 results on schedule. Beijing’s silence over its plans for the company have left some of its longer-dated bonds trading at stressed levels. Huarong and its subsidiaries have nearly $40 billion of debt outstanding.

4. What’s the government’s dilemma?

Allowing the defaults by a few state-backed firms showed that it wants a market-based approach, but in an orderly manner. Ending moral hazard -- a tolerance for risky moves in the belief that the state will always bail you out in case of trouble -- for the likes of Huarong and Evergrande would make the financial system more resilient over the long run. But a major default would cause significant short-term pain for investors from New York to London who enjoy the juicy yields on Chinese bonds. The danger for Xi is that it could trigger precisely the kind of crisis he’s trying to avoid, where investors fearing contagion panic and begin selling off good debt with the bad. Xi has doubled down on perceived threats to the Communist Party and economic stability ahead of a 2022 leadership shuffle that could see him hold on to the presidency for an unprecedented third term.

5. How did we get here?

Chinese companies have been piling on debt for at least a decade, ever since the leadership team under Xi’s predecessor responded to the 2008 global financial crisis by going on a borrowing binge. That kept China’s economy chugging, but at a cost. The corporate debt to GDP ratio surged to a record 160% at the end of 2017, from 101% 10 years earlier. Xi and his lieutenants vowed to rein it in, issuing directives on how money was to be loaned and managed. A particular goal has been to curb China’s $10 trillion ecosystem of shadow banking. So-called local government financing vehicles, which were established to fund infrastructure projects, have already defaulted on many trust loans that were part of that shadow system. None have defaulted on a public bond, but an LGFV defaulted this year on 915 million yuan worth of commercial bills. So-called hidden debt at local levels was raised to a national security issue at the annual legislative gathering in Beijing in March.

6. What’s different now?

Eager to avoid another debt bubble, policy makers have said post-pandemic economic stimulus won’t be aimed at the property sector. Authorities are instead looking to curb borrowing in that debt-bloated sector by introducing “three red lines” -- metrics regarding debt that property developers have to meet if they want to borrow more. What’s more, the credit market has been showing signs of resilience in the face of rising stress. While Beijing is likely to step in if default levels trigger any type of systemic threat to markets, indications that contagion risks have been relatively well-contained this year could mean an even great tolerance for defaults.

7. What’s the impact been?

Potential investors are reassessing risks. They’ve also grown more skeptical about the quality of Chinese issuers’ financial reporting. Meanwhile, China has seen a booming market for junk bond investors. An expanding pool of souring debt and a new generation of risk hunters helps create a more diverse market where creditworthiness is better reflected in pricing. China is seeking help on credit analysis from some of the international rating firms favored by overseas money managers, and offering U.S. investors greater access to the potentially lucrative pool. Ultimately, rising defaults should help create a more disciplined, efficient market.

8. How does bankruptcy work in China?

Troubled companies get as long as nine months from when the court accepts a filing to submit a restructuring plan to creditors, who then have as many as 30 days to vote on it. If it isn’t accepted the company can be declared bankrupt, triggering liquidation. In practice, the process can drag on beyond nine months and foreign investors have had limited enforcement rights on some state-owned assets, according to Pacific Investment Management Co. Concerns exist about the government’s heavy involvement in major restructuring cases and the reluctance of banks to pursue court-supervised plans because they don’t want to bear losses. On the other hand, foreign investors are getting improved access to assets of bankrupt firms in mainland China under a new agreement between Beijing and Hong Kong. The pilot program allows courts in Shanghai, Shenzhen and Xiamen to recognize insolvency proceedings in Hong Kong.

More stories like this are available on bloomberg.com

©2021 Bloomberg L.P.