Chinese one-hundred yuan banknotes are arranged for a photograph in Hong Kong, China, on Monday, April 15, 2019. China’s holdings of Treasury securities rose for a third month as the Asian nation took on more U.S. government debt amid the trade war between the world’s two biggest economies. (Bloomberg)

Chinese companies are facing a reality check after years of ramping up debt. A deleveraging campaign that President Xi Jinping began in 2016 to curb risks in the nation’s financial markets has led to a crackdown on unregulated lending -- so-called shadow banking -- and tighter rules on asset management. That made it harder for some firms to raise funds to repay existing debt, leading to a record number of bond defaults in 2018. There was a respite in the first half of 2019 as the government moved to try to alleviate the liquidity crunch, but China’s default risks are still seen as rising, due in part to slowing economic growth.

1. How big is the problem?

It’s big, with the potential to worsen. More than 55 billion yuan ($8 billion) of local note defaults took place in the first half of 2019, including 20 first-time defaulters. The tally last year was a record about 122 billion yuan, more than quadruple the 2017 amount. Private sector firms accounted for more than 90 percent of total defaults last year, and that’s still the trend.

2. Why is that?

It’s the liquidity crunch, mainly. Investors and banks, which historically have favored state-backed borrowers, are still reluctant to extend credit to smaller, private companies. On top of that, the government’s surprise seizure of Baoshang Bank Co. in late May -- the first such takeover in two decades -- cut many investors’ tolerance for risk. Although yields for AA- rated firms, considered junk level in China, have fallen to the lowest level since April 2018, the one-year spread for top- and lower-rated corporate notes widened after the bank takeover, illustrating the risk aversion. At the same time, growth in the broader economy has been losing steam, and weaker companies are expected to experience funding squeezes and higher repayment pressure.

3. Where are defaults hitting hardest?

The last time they peaked, in 2016, most of the failures were in industries with excess capacity such as coal and steel. This time, delinquencies are coming from a wider range. Oil firm CEFC Shanghai International Group Ltd. and coal miner Wintime Energy Co. were the biggest defaulters in 2018, according to data compiled by Bloomberg. This year, China Minsheng Investment Group Corp., a conglomerate with a wide range of assets including property, aviation and health care, came under pressure from its $34 billion debt pile. It said in April that cross defaults were triggered on its dollar bonds after missed payments and a potential demand by its affiliate’s lenders for immediate repayment of a loan.

4. 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 went on a borrowing binge in response to the global financial crisis. That kept China’s economy chugging but at a cost. The corporate debt to GDP ratio surged to a record 160 percent at the end of 2017, from 101 percent 10 years earlier. Xi and his lieutenants vowed in 2016 to rein in excessive corporate borrowing and financial market leverage in an effort to reduce the risk to the economy. The government issued directives on how money is to be loaned and managed, with a particular goal of curbing China’s $10 trillion ecosystem of shadow banking.

5. What’s the impact of rising defaults?

Given signs that authorities are more comfortable letting borrowers renege on payments both in the domestic market and offshore, potential investors are reassessing risks. They’ve also grown more skeptical about the quality of Chinese issuers’ financial reporting. Kangde Xin Composite Material Group Co., a laminating film maker based in the eastern province of Jiangsu, was found to have fabricated 11.9 billion yuan of profits during 2015-2018 in an investigation by the China Securities Regulatory Commission.

6. Has the government stepped in?

Yes, while stopping short of any outright bailouts. Since July 2018, officials have injected liquidity into the financial markets through measures such as cutting banks’ required reserve ratios. Regulators have offered banks cash and asked them to lend more to help small firms. In attempts to address the liquidity shocks after the bank seizure, China’s top financial regulators urged big banks and brokerages to provide liquidity support to smaller peers, which are the main buyers of corporate debt. The challenge will be encouraging market-driven efforts to resolve corporate debt issues without reinforcing the old image of a state-dominated financial system.

7. How does bankruptcy work in China?

In the current process, troubled companies get up to nine months from when the court accepts a bankruptcy reorganization filing to agree on a restructuring plan with all parties. If they fail they can be declared bankrupt, triggering liquidation. 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. In practice, the process can be much longer and foreign investors have had limited enforcement rights on some state-owned assets, according to Pacific Investment Management Co.

--With assistance from Molly Dai, Shuqin Ding, Laurence Arnold and Grant Clark.

To contact Bloomberg News staff for this story: Tongjian Dong in Shanghai at tdong28@bloomberg.net

To contact the editors responsible for this story: Neha D’silva at ndsilva1@bloomberg.net, Lianting Tu, Paul Geitner

©2019 Bloomberg L.P.