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Analysis: China's bond defaults show Beijing's war on debt is back

SHANGHAI/SINGAPORE (Reuters) - A spurt of missed debt repayments by three Chinese state-owned firms - a coal miner, a chipmaker and an automobile company - has shaken local markets and heightened speculation that a campaign to wean the economy off heavy credit is back.

The defaults have angered investors, who say their faith in the firms’ top-notch ratings, seemingly sound finances and implicit state backing has been violated.

While the notable lack of state support for struggling state-owned enterprises (SOEs) suggests Beijing now has more confidence in the economy’s ability to absorb such failures, it has caught many bondholders off guard.

A default late last month by Huachen Automotive Group Holdings Co, the parent of German automaker BMW’s Chinese joint venture partner, exemplified opaque risks, underdeveloped pricing mechanisms and investor naivety in China’s corporate bond market.

“If the company had told investors it was in great trouble, I wouldn’t have bought and held the bonds,” said Shanghai-based hedge fund manager Vincent Jin, who bought Huachen bonds early this year.

Huachen boasted a AAA issuer rating when it launched its 1 billion yuan ($151.93 million) three-year, privately placed bond in October 2017. It comes from one of China’s poorer provinces, Liaoning, but as recently as April told bondholders it had adequate cash, lots of land and state backing.

Creditors were therefore stunned when Huachen not only defaulted but was also dragged to court by a creditor for bankruptcy restructuring.

Moreover, one month before its bond delinquency, Huachen transferred its prize 30% stake in Hong Kong-listed Brilliance China Automotive Holdings Ltd to a subsidiary, leaving bondholders with no access to those assets.

Jin missed the warning signs in Huachen’s books. At the end of 2019, the company had 144.8 billion yuan in liabilities - mostly short-term - three times shareholders’ interest. With the exception of BMW, all of Huachen’s auto brands were bleeding cash.

As rumours swirled of Huachen’s problems, Jin didn’t cut his losses, assuming the government wouldn’t let a heavyweight SOE fail.

BACK TO NORMAL

For some, such defaults suggest credit markets are merely picking up where they left off last year, before COVID-19 paralysed the economy and as the Communist Party waged a war on indebtedness and unproductive investment.

“It’s really more of the messaging than anything else, and unless there’s some threat to the financial or economic stability of China then the central government is happy to let the state firms go under,” said Andrew Collier, managing director, Orient Capital Research. “Clearly the central government does not want to step in and is now basically telling local governments that they’re on their own.”

For investors, that leaves big questions about SOEs’ changing risk profile and their relationship with the state.

In the central province of Henan, Yongcheng Coal & Electricity Holding Group Co, a AAA-rated state-owned mine operator, defaulted on Nov. 10, only three weeks after issuing fresh debt and a week after moving its stake in Zhongyuan Bank to two government subsidiaries.

SOE defaults are not new, but blocking bondholders from liquid assets is, said Rocky Fan, economist at Sealand Securities.

“It’s like telling investors: I don’t want to pay back your money,” Fan said.

“If that’s the case, there’s no way you can assess a company’s risk, or price a bond, based on its fundamentals.”

Yongcheng’s 270-day commercial paper bore a 4.39% coupon, well above the 1.84% risk-free rate on government debt at the time of issue, but “still low considering the risks”, said a director at a local securities firm.

In a separate instance, Tsinghua Unigroup, a chipmaker backed by Beijing’s prestigious Tsinghua University, defaulted on a three-year, 1.3 billion yuan bond on Nov. 15, shortly after a rating agency warned of debt risks at the company.

The defaults sent other bonds issued by Yongcheng, Huachen and Tsinghua Unigroup to about a tenth of their face value.

“For too long (risk) has been mispriced. This is what misallocation of capital looks like,” said Fraser Howie, an independent analyst and co-author of the book “Red Capitalism”.

“You’ve been pouring money into companies that simply don’t deserve it.”

QUICKSAND

More than 90% of Chinese rated issuers have stamps of AA or higher. That absence of differentiation has complicated efforts to price risk.

“Most sophisticated investors understand that there is a major difference between lending to a state-owned enterprise, and lending to the state,” said Michel Lowy, founder and chief executive officer of SC Lowy, a global banking and asset management group focused on distressed and high-yield debt.

“(This) is a quick reminder of the difference, and of the fact that China does not have the intention to bail out every state-owned enterprise that has made wrong choices.”

Huachen’s bondholders say the automaker’s sudden default could have been complicated by local politics.

Two months before Huachen’s default, Liu Ning, former governor of Qinghai province, was appointed Liaoning’s governor, while Zhang Guoqing, former mayor of Tianjin, became provincial Party Secretary. Both leaders implemented significant restructuring in their previous jurisdictions, which were both deeply indebted.

It’s treacherous terrain and one that most foreign investors, even those that thrive on risk, avoid.

“For us, as fundamental investors, it’s not a market to play,” said Tiansi Wang, a senior credit analyst at Robeco in Hong Kong. She said the defaults are nevertheless a good sign.

“It’s not healthy if nobody ever takes the pain - then you don’t have a proper risk pricing environment.”

($1 = 6.5818 Chinese yuan)

Reporting by Andrew Galbraith and Samuel Shen in Shanghai and Tom Westbrook in Singapore; additional reporting by Rong Ma in Beijing; Editing by Vidya Ranganathan and Sam Holmes

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