Chinese companies are facing a reality check after years of ramping up debt. A de-leveraging campaign that President Xi Jinping began in 2016 to curb risks in 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 to raise funds to repay existing debt, leading to a record number of bond defaults in 2018 and 2019 as economic growth slowed. The coronavirus pandemic has only worsened the outlook this year in the world’s second-biggest bond market.

1. How big is the problem?

Chinese defaults actually dropped by 26% as of late May from a year earlier, to 35.2 billion yuan ($5 billion), according to Bloomberg-compiled data. That’s because as the pandemic shut down most economic activity, at least a dozen companies managed to relieve pressure by delaying bond repayments, swapping bonds or canceling early repayment. However, such short-term measures often end up just buying time, while the credit risk remains. The trend has been obvious: In 2019, onshore defaults totaled more than 140 billion yuan ($18.7 billion), compared with 2018’s high of 122 billion yuan, which itself was more than quadruple the level in 2017. Private-sector firms accounted for more than 80% of defaults in 2019, data compiled by Bloomberg show.

2. Why is that?

Investors and banks historically have favored state-backed borrowers and are reluctant to extend credit to smaller, private companies. On top of that, the government’s surprise seizure of Baoshang Bank Co. in May 2019 -- the first such takeover in two decades -- cut many investors’ tolerance for risk. Meanwhile, growth in the broader economy had been losing steam long before Covid-19 emerged, and weaker companies can be subject to funding squeezes and higher repayment pressure. The pandemic hit transportation, tourism and retailing especially hard.

3. Where are defaults hitting hardest?

In 2016, most were in industries with excess capacity such as coal and steel. This time, delinquencies have been coming from a wider range. In February, Peking University Founder Group Corp.’s failure to make good on a local bond came after a court in Beijing agreed to a key creditor’s request to put the conglomerate under debt restructuring. In December, Tewoo Group, a major commodities trader based in Tianjin, restructured $1.25 billion of debt in an unprecedented deal in which most investors accepted heavy losses. It was the biggest dollar-bond default among state-owned companies in 20 years. Earlier in 2019, China Minsheng Investment Group Corp., a conglomerate with assets including property, aviation and health care, came under pressure from its $34 billion debt pile. Known as CMIG, it embarked on a mission to free up cash by slashing executive pay and offloading assets.

4. Has the government stepped in?

Yes. To counter the economic squeeze from the virus, China’s central bank is providing hundreds of billions of yuan in loans and regulators have created a “green passage” for companies to sell “anti-epidemic bonds” if they meet certain criteria. The central bank has also provided a lending facility to commercial banks with a lower interest rate. More broadly, officials have been easing some of the stress for the past two years, for instance by injecting 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, and urged big banks and brokerages to provide liquidity support to smaller peers, which are the main buyers of corporate debt. In draft rules released in December, China’s central bank, economic planning agency and securities regulator jointly vowed to improve the mechanism for dealing with bond defaults and resolving credit risk more effectively.

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 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 in 2017 on how money was to be loaned and managed. A particular goal has been to curb China’s $10 trillion ecosystem of shadow banking. In fact, Chinese local government financing vehicles, which were established to fund infrastructure projects, have already defaulted on many trust loans (which were part of that system), but had yet to suffer a bond default as 2020 began.

6. 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. In one case, the China Securities Regulatory Commission found Kangde Xin Composite Material Group Co., a laminating film and equipment maker in Jiangsu province, had fabricated 11.9 billion yuan of profits during 2015-2018. Meanwhile, China has seen a booming market for junk bond investors. A fast-expanding pool of souring debt and a new generation of risk hunters also helps create a more diverse market where creditworthiness is better reflected in pricing.

7. How does bankruptcy work in China?

In the current process, troubled companies get as long as nine months from when the court accepts a bankruptcy reorganization filing to agree on a restructuring plan with all parties. If they fail the company 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 drag on beyond nine months and foreign investors have had limited enforcement rights on some state-owned assets, according to Pacific Investment Management Co.

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