- An unprecedented wave of bond defaults by state-owned enterprises is challenging the longstanding assumption that such debt carries an implicit government guarantee.
- The recent default wave largely reflects local governments’ decreasing willingness and ability to provide bailouts, rather than a significant deterioration in credit fundamentals.
- Defaults will likely continue, but the government has the resources and determination to prevent a systemic crisis.
Several Chinese state-owned enterprises (SOEs) have defaulted on bonds in recent weeks, sending shockwaves through the broader bond market. The defaults raise two questions. First, do recent defaults reflect a broader increase in credit risks across China’s corporate landscape? Second, have Chinese authorities changed their stance about permitting defaults on SOE bonds, which were once viewed as carrying an implicit government guarantee?
Politics not economics
The answer to the first question is a qualified no (see below for qualifications). On a cyclical basis, credit fundamentals in China are improving. The macro-economy is performing well, and monetary policy is still relatively loose. The central bank has signaled its intention to tighten its broader monetary stance, but this process will be gradual and data-dependent.
The answer to the second question is yes. China’s corporate debt burden has increased dramatically due to successive waves of stimulus that began with the 2008 financial crisis, and SOE debt comprises a disproportionate share of total corporate debt. Absent frequent bailouts, SOE defaults would already be far more common. Since the first-ever SOE bond default in 2015, such incidents have occurred sporadically. Still, the share of SOEs among total onshore bond defaults (by bond value) remained below 10% every year through 2019, even though SOEs dominate overall bond issuance. This year the SOE share of total defaults has risen to 22%.
Tackling moral hazard
No law requires the Chinese government – either central or local – to backstop SOE debt, but for years investors assumed that SOE debt carried an implicit guarantee. This assumption was based on the view that authorities would not tolerate the political embarrassment and potential financial contagion resulting from an SOE default. The implicit guarantee assumption distorted capital allocation by channeling credit to borrowers with weak fundamentals but strong political connections.
Chinese officials have long declared the need to eliminate so-called rigid repayment expectations in the bond market. People’s Bank of China Governor Yi Gang wrote on 18 November that China must “gradually break” such expectations. The failure of Baoshang Bank last year was a landmark for demonstrating the government’s willingness to impose haircuts on at least some bondholders. In other cases, however, the desire to eliminate moral hazard has conflicted with more immediate concerns to ensure that a single default did not spark contagion that leads to systemic risk.
The result has been a balancing act between bailouts and market discipline. Officials handle each situation differently, based on specific circumstances. Bailouts are still common, but debt markets no longer assume that SOE debt is risk-free. Investors pay greater attention to credit fundamentals and also seek to analyze the strength of each particular SOE’s political status to judge the likelihood of a bailout. Local government officials are also more relaxed about permitting SOE defaults. Recognizing that lenders no longer treat all SOEs from the same region equivalently, officials no longer assume that a single SOE default will doom the entire regional economy.
In fact, some Chinese bond investors now worry that the pendulum has swung too far and that some SOEs are actively seeking defaults to avoid repaying debts. Before their recent defaults, bonds issued by Brilliance Auto Group and Yongcheng Coal and Electricity were both rated AAA, with financial statements showing profitability and ample cash on hand. Shortly before defaulting, both companies also engaged in asset transfers with other local SOEs that, in retrospect, appear designed to shield valuable assets from seizure by creditors. In a meeting on 21 November, the Financial Stability and Development Committee, a cabinet-level office that oversees China’s financial regulatory agencies, acknowledged these concerns, promising “zero tolerance” for bond market fraud.
The last domino
Despite the rise in SOE defaults, one important taboo remains unbroken. The first default by a so-called local government financing vehicle (LGFV) has yet to occur. LGFVs are investment platforms that local governments use to finance infrastructure spending outside their normal fiscal budgets. Though they are legally equivalent to other SOEs, the IMF classifies their borrowing as part of China’s “augmented” fiscal deficit. Investors broadly view their debt as carrying a stronger implicit guarantee than other SOE debt, since LGFVs are effectively agents of fiscal policy. Nevertheless, LGFV debt has risen sharply over the last decade, with estimates of the total ranging from RMB 30-50tn (USD 4.6-76tn), and this taboo, too, will eventually be broken.
Risks are rising
The first question raised above was answered with a “qualified no.” The first qualification is that the government’s increased willingness to permit SOE defaults means that default risks are rising, even if credit fundamentals are improving on a cyclical basis.
The second qualification is that on a secular basis, China’s credit fundamentals are probably deteriorating. China’s overall debt-to-GDP ratio will rise sharply this year due to pandemic-related stimulus policies. China’s potential growth rate is also slowing due to slower productivity growth and a shrinking workforce, implying lower returns on investment and therefore less debt-servicing capacity. Yet President Xi Jinping’s ambitous soft targetfor GDP growth through 2035 implies some degree of continued reliance on low-quality, debt-financed investment. Many of these projects will not produce sufficient cash flow to service debt. A related secular trend is the weakening fiscal capacity of many local governments, which renders them less able to afford bailouts. Weak fiscal capacity is a particular challenge in China’s rustbelt northeast, where most of this year’s SOE defaults occurred.
Though individual defaults will continue to rise, at the central government level, Chinese fiscal and monetary authorities still have the resources necessary to prevent a systemic crisis. If such a crisis appears to threaten, authorities will not let concerns about moral hazard or market discipline dissuade them from forceful interventions to prevent it.