What happens when a company set up by the Chinese government to help clean up toxic debt in the country’s banking system gets into trouble itself? It seems we’re about to find out. Investors were spooked when China Huarong Asset Management Co., one of the country’s biggest distressed asset managers, failed to release financial statements in the wake of the execution of its former top executive for bribery. But what has triggered broader worries is the prospect that China may let a state-backed institution fail. The ending of a presumed safety net that’s long been priced into Chinese bond values would mean a seismic shift for investors across emerging markets.

1. What’s China Huarong?

It’s one of the four state-owned firms set up by China’s government in 1999 to help clean up a banking system riddled with bad debt. The firm was left reeling in 2018 after then-chairman Lai Xiaomin was accused of bribery and ultimately found guilty of receiving 1.79 billion yuan ($273 million) in illicit payments. Under his watch, China Huarong expanded into areas including securities trading, trusts and other investments, deviating from its original mandate of disposing of bad debt. Lai was sentenced to death and executed in January, in an unusually harsh sentence for such a crime.

2. How did it get in trouble?

China Huarong first spooked investors when it failed to release its 2020 financial reports by a March 31 deadline, which prompted a trading halt in its shares and structured products in Hong Kong. Concerns about the firm’s financial health were sent into overdrive after reports emerged of a potential restructuring. Bondholders, panicked about the prospect of taking a haircut on their investments, spurred a selloff in the firm’s dollar-denominated notes, which tumbled to record lows before recovering some losses as of mid-April.

3. How bad did things get?

The firm said it has access to liquidity and is making payments on time. And there were reports that the bad-debt manager had submitted an overhaul plan to regulators and received positive initial feedback. But that did little to assuage investors worried about the long run, with some of the firm’s bonds falling to as low as 45 cents on the dollar just days later. While it seems China Huarong’s units were able to find cash to repay imminently maturing bonds and the nation’s financial regulator has said the firm has ample liquidity, the dollar bonds are still trading in the region of 60 to 85 cents -- a level that’s nearly unheard of for a quasi-sovereign, A-rated state firm like China Huarong.

4. Why is that unheard of?

Any signs that Beijing is rethinking its support for a central, state-owned firm like China Huarong would have deep repercussions for the broader market. While authorities have long sought to wean investors off the assumption that the government will step in to prevent defaults, a potential restructuring or default for China Huarong would be the nation’s most consequential since the late 1990s. The company is majority owned by China’s Ministry of Finance and is deeply intertwined with the nation’s $54 trillion financial industry.

5. Is it the only state-linked firm in trouble?

No. Chinese President Xi Jinping has dialed back support for weaker borrowers to reduce moral hazard, and state-owned enterprises have replaced their private counterparts as the country’s biggest source of defaults. SOEs reneged on a record 79.5 billion yuan ($12.2 billion) of local bonds in 2020, lifting their share of onshore payment failures to 57% from 8.5% a year earlier, according to Fitch Ratings. The figure jumped to 72% in the first quarter of 2021.

5. What does that mean beyond Huarong?

If Beijing steps away from what markets have seen as a policy of backstopping lenders with important public policy roles, that could put other firms at risk: China’s local bond market is dominated by other state-linked borrowers. And despite the government’s pronouncements about letting market forces have their way, nearly all bond valuations involve some assumption of state support. Any change in that would involve a fundamental reassessment of the way investors and rating companies look at the credit risk of Chinese companies.

6. How deep is Huarong’s hole?

China Huarong and its subsidiaries have about $42 billion outstanding in local and offshore bonds alone. Of that, global investors have some $22 billion at stake in dollar notes. Because the company was considered a quasi-sovereign, investment-grade borrower, that debt was popular among institutional investors including BlackRock Inc., Goldman Sachs Group Inc. and Allianz SE.

7. How big is the broader risk?

The stress at China Huarong has spilled over into the nation’s broader $885 billion market for dollar bonds. These borrowers could find themselves in trouble if there’s a dramatic reassessment of the risks tied up in buying this debt. The stakes are high as Beijing considers which companies to support. SOEs had the equivalent of $3 trillion in onshore bonds outstanding at the end of last year, or 91% of the total, data compiled by Fitch show. A small but growing portion of those bonds is now owned by international money managers, after a steady relaxation of China’s restrictions on foreign investment in recent years.

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