The default option

The Chinese bond market can trace its roots back to the 19th century, when provincial governments within the Qing empire issued bonds to foreign investors, raising funds to build roads and railways, or fight bandits. Some of these bonds even made the news recently. As the Sino-US trade war escalated last year, Donald Trump met with a group called the American Bondholders Foundation, who asked him to push China to repay debt accrued during the late Qing Dynasty to build a railroad. The bonds, which went into default following the dynasty’s collapse in 1911, were said to be worth $1 trillion after factoring in inflation and interest.

In more modern times, the first onshore default in China’s bond market came as late as 2014 when Chaori Solar failed to repay a coupon (see WiC229). It marked the end of an era involving the so-called “Beijing put” – a belief that the government would always rescue defaulters in the local bond market for fear of an investor panic that threatened the wider financial system.

Almost paradoxically, foreign investors have been increasing their exposure to the Chinese bond market, even as defaults become more commonplace. Yet even as the state media cheers evidence of the nation’s creditworthiness (the inclusion of Chinese bonds in major global indices such as the FTSE Russell World Government Bond Index in September, for instance) local confidence has been hit by a slew of corporate defaults.

More startlingly, the failures have often happened at companies scored favourably by local credit rating agencies, as well as those backed by provincial governments.

The most rattling default?

In recent years November and December have become high-alert months for investors in Chinese bonds, as companies run into year-end cash crunches (see WiC477). This year brings the additional stresses created by Covid-19 and an annual growth rate that is expected to plummet below 2%. Yet investors were still wrong-footed when Yongcheng Coal and Electricity announced on November 10 that it was unable to pay interest on a Rmb1 billion ($150 million), 270-day issuance of commercial paper sold the previous month. Its financial footing was thrown further into doubt a week later as it declared itself unable to fulfill obligations on two earlier issued long-term bonds worth Rmb2 billion at maturity.

This came as a shocking revelation for its investors, who are questioning how Yongcheng was able to sell short-term debt less than a month before reneging on it.

Worse, the Rmb1 billion notes were given a top-notch AAA score by local rating agency China Chengxin (CCXI).

Yongcheng is China’s leading producer of high-grade anthracite coal, a business that contributes more than 90% of its profits, offsetting losses from its chemicals and logistic units. Its major shareholder is Henan Energy and Chemical, one of the biggest SOEs in Henan (and under the control of the provincial branch of state asset administrator Sasac). Prior to Yongcheng’s latest fundraising a policy document on the coal industry had been making the rounds among bond investors, reports 21CN Business Herald. The expectation was that the Henan government was about to restructure the local coalmining industry, raising the prospects that Yongcheng would generate up to Rmb15 billion in funding by divesting non-core operations to its parent. Instead investors were informed that there were no funds available, not even for the bonds sold a few weeks earlier.

The Yongcheng default crystallised concerns at central government levels. A meeting of the Financial Stability and Development Committee chaired by Vice Premier Liu He this week concluded with a statement that acts of intentional “debt evasion” will be severely punished. There would be “zero tolerance” of improper disclosure and “malicious transfer of assets” (more on this later), the statement added.

Allegations of “debt evasion” have since become a subject of wider debate in the market, with the National Association of Financial Market Institutional Investors (NAFMII), a quasi-official regulatory body of bond issuers, announcing investigations of several financial intermediaries suspected of misconduct in Yongcheng’s recent bond sale. Haitong Securities is also being accused of “illegal issuance of bonds” and “market manipulation”, NAFMII said in a statement of its own. Other parties in the recent Yongcheng deal, including CCXI, the rating agency, are said to be under investigation too.

No more ‘rigid repayments’?

Similar to the way that the ‘Beijing put’ once reassured investors that defaults wouldn’t happen, local governments have still been expected to support SOEs that run into trouble. The local media description of this commitment translates as ‘rigid repayment for creditors’ should delinquencies arise.

However, this premise had already been punctured by the 2019 debt restructuring debacle at Qinghai Salt Lake, the country’s biggest potash producer.

Last September Qinghai Salt Lake was said to be sitting on Rmb70 billion worth of assets, including Rmb700 million in cash. However, it then initiated a rare debt restructuring after a creditor filed a lawsuit over a Rmb4.4 million overdue coupon payment.

The decision to force a restructuring, despite the cash holdings at the company, fuelled allegations that the biggest shareholder – the Qinghai government – was taking the opportunity to restructure the company in the interests of equity investors, and relegating the rights of bondholders.

Such restructurings involving SOEs typically do creditors no good as they often involve the non-cash transfer of more valuable assets between stakeholders. As part of the process bondholders are sometimes forced to sell their debt holdings at steep discounts.

Earlier this year an investment firm in Qinghai province also defaulted on $850 million worth of offshore bonds and Tianjin Real Estate Group, a property company backed by the Tianjin government, also defaulted on a Rmb215 million bond in August.

Cases like these mean that investors are putting much more of an effort into differentiating between state-backed issuers and avoiding the SOEs backed by local governments in less developed regions or with tainted credit records.

Yet the recent defaults have also reminded investors that they should pay attention to the management styles of the provincial bosses as well – especially those coming from Qinghai, it seems.

Wang Guosheng was Party secretary of Qinghai before being appointed as provincial head of Henan – Yongcheng Coal’s home province – in March 2018. Liu Ning, formerly governor of Qinghai, became the governor of Liaoning in August this year. Both Wang and Liu had a strong influence at Qinghai Salt Lake, the province’s biggest SOE. And according to Hong Kong’s Ming Pao newspaper, the way the duo might chose to restructure delinquent SOEs in their current positions could be shaped by their experience in Qinghai.

Should BMW bosses be losing sleep?

In the case of Liu Ning, his handling of an ailing carmaker in Liaoning will be carefully watched by Germany’s BMW. The German carmaker has been drawn into the bond crunch crisis thanks to its joint venture partner, which has joined the list of defaulters.

Huachen Automotive is a property-to-automobile conglomerate under the Liaoning government. Many of its businesses are lossmaking but its crown jewel is a 30.4% stake in Hong Kong-listed Brilliance China, which owns a 50% stake in BMW’s China joint venture BMW Brilliance Automotive (BBA), as well as 51% of another venture with Renault.

Similar to the case involving Qinghai Salt Lake a year ago, a court in Shenyang in Liaoning province accepted an application this week from an auto mould supplier to restructure Huachen in respect of Rmb10 million in unpaid contract money.

The decision to go into a debt restructuring came after Huachen said it could not repay the principal and interest on a Rmb1 billion bond.

Back in 2018, BMW said it was planning to raise its stake in BBA to 75% from 50%, paying about $4.2 billion by 2022 for the equity. But following a series of asset reshuffles among local SOEs in recent months, Huachen’s 30.4% stake in Brilliance China has been pledged as collateral to a trust firm under the Jilin government, making the latter a senior creditor in the Hong Kong-listed firm.

The maneouvre has angered a number of Huachen creditors who have filed for arbitration on the asset transfer – which happened a month prior to the company entering into bankruptcy restructuring.

Foreign carmakers were barred from owning more than 50% in their China joint ventures until April 2018, when Chinese President Xi Jinping announced at the Boao Forum that the cap would be progressively lifted. Against the backdrop of escalating tariffs, the announcement was viewed as an important pledge to open up China’s market. That should mean that the financial crisis at Huachen will be resolved in a way that doesn’t impinge on BMW’s position, reckoned Ming Pao, a Hong Kong newspaper. “As the Chinese government’s first ‘textbook case’ on the removal of foreign ownership restrictions, Huachen’s bankruptcy should not be allowed to affect Brilliance China and the agreement with BMW,” it suggested.

But the implication is that the same protections may not apply to Huachen’s bondholders – given that the most prized asset, the Brilliance China stake, is likely to be taken out of the equation.

Any other big-name defaults?

In 2018 Xi Jinping visited one of Tsinghua Unigroup’s largest factories in Wuhan as part of a bid to spark the development of the semiconductor sector. However, one of the poster boys for Chinese chipmaking has just shocked investors by missing a payment on a Rmb1.3 billion debt issuance last month.

Unigroup’s critics won’t be as surprised by its sudden default. When former boss Zhao Weiguo visited Taiwan in 2015, telling reporters about his plans to join hands with MediaTek, and even to invest in TSMC, the world’s biggest foundry, the remarks provoked widespread ridicule. Foxconn’s Terry Gou, for one, was derisive: “Zhao Weiguo is just a ‘stock market investor’. You simply can’t go to Morris Chang [TSMC’s founder] and ask a godfather of the semiconductor industry how much would he sell his company for.”

With strong backing from the Chinese government, Unigroup still expanded aggressively, however. Partly fuelled by acquisitions, the company’s total assets soared from Rmb6.6 billion in 2012 to Rmb299 billion as of June – bringing with it Rmb203 billion in total debt.

Last month’s default is stoking questions about what some analysts term the ‘reckless growth’ in China’s semiconductor industry in general (see WiC513). But for bond investors, it is more a question of trying to guess which of the most indebted SOEs the Chinese government will still support in the event of a potential bond default.

After all, Unigroup was supposed to be a pioneer in the national push into chipmaking. It is also a commercial affiliate of Tsinghua University, Xi Jinping’s alma mater. Its default follows the bankruptcy last year of Founder, a major SOE backed by Peking University. That means that two of the most prestigious colleges in China have now been tainted by a credit event.

More defaults to follow?

At least the country’s most indebted property developer – China Evergrande – has bought itself more time to balance its books. After the collapse of its fundraising plan to spin off its Hengda property unit on the A-share market, two state enterprises from Guangdong have agreed to buy Rmb30 billion worth of equity from current investors in Hengda. That lessens the immediate need for Evergrande to raise funds (it had contractual obligations to buy back the equity of many of the existing Hengda shareholders in the event that it wasn’t able to launch an A-share listing by the start of next year).

However, there have been other corporate bond defaults this week, including a unit of Hong Kong-listed property firm Fullsun.

According to Wind, a financial data aggregator, there have been 109 bond defaults in China so far this year, on Rmb126 billion of borrowing. That compares with 184 defaults last year on Rmb149 billion of issuance, a record.

That said, 2020 may still end up setting an unwanted milestone as the more recent defaults from a slew of seemingly solid SOEs have sent jitters through the local bond market, making it harder to raise new capital.

Issuance worth Rmb25 billion was cancelled or postponed between November 9 and 16, Securities Times reported, while data from East Money, another financial data provider, suggests that coupon rates for newly issued bonds from state firms have increased more than 20% since October.

Winter is coming, perhaps in more ways than one, to the nearly $4 trillion corporate debt market in China, of which state-owned enterprises are thought to account for more than half.

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