China's debt reckoning hammers 'too big to fail' borrowers

BEIJING (BLOOMBERG) - China's campaign to cut leverage and instil corporate discipline is reshaping the nation's US$12 trillion (S$16 trillion) credit market.

One of China's most prolific debt issuers has not sold a single dollar bond in one year and five months, the longest dry spell since 2013. An investment grade-rated conglomerate mostly owned by the government, it is facing a cash crunch in a test of state support.

Analysts at UBS Group and Goldman Sachs Group now say the notion of "too big to fail" no longer applies in China, as defaults this year exceed US$23 billion, a record amount.

Beijing is taking advantage of a strengthening economy and stable financial markets to toughen up its corporate sector. The result is a repricing of risk that should discourage the kind of reckless debt-fuelled expansion that inflated some companies to a dangerous size.

The spawning of such bloated empires created a threat to the financial system as well as a challenge to Chinese President Xi Jinping's grip on power.

Ending the practice of allowing risk-taking by indebted giants such as China Huarong Asset Management and China Evergrande Group while they are being shielded from potential consequences would make the financial system more resilient over the long run, but a major default would cause significant short-term pain.

"The government has grown more comfortable with defaults... but Huarong and Evergrande present much bigger and more systemic challenges," said Professor Jeffrey Chwieroth, who specialises in international political economy at the London School of Economics and is a co-investigator at the Systemic Risk Centre.

"Deleveraging and eliminating the prevalence of government guarantees may induce undesirable consequences and market panic."

For the Communist Party, which celebrates its centenary next week, inaction is no longer an option.

Officials are repeatedly warning of bubble risks after last year's monetary and fiscal stimulus pushed economic leverage to a record. The shift was visible in last month's credit data, which showed corporate bond issuance contracting by the most in four years.

Issues stemming from over-leveraged conglomerates are mounting. HNA Group, a little-known airline operator that grew into a sprawling giant before collapsing, faces some 1.2 trillion yuan (S$250 billion) in claims from creditors, Bloomberg News reported this month. The group spent more than US$40 billion on acquisitions across six continents from 2016.

One of China's biggest defaulters last year was Tsinghua Unigroup, which had aspirations to be the nation's first giant in the global semiconductor industry and once planned a US$23 billion bid for United States memory chip giant Micron Technology.

These firms were in many ways emblematic of the way China grew in the years after the global financial crisis. The authorities unleashed a stimulus blitz that fuelled a heady economic expansion through bingeing on credit.

Concern over the scale of the country's resulting debt mountain and the possibility of a "Minsky moment" prompted Mr Xi to launch a deleveraging campaign in 2017, before shelving it during the trade war with the US. Minsky moment refers to the onset of a market collapse brought on by the reckless speculative activity that defines an unsustainable bullish period.

With Mr Xi renewing his drive to cut debt, the real estate sector has become a major target. The government previously said it had drafted new financing rules for the industry, which accounts for about 29 per cent of economic output.

Evergrande has pledged to meet at least one of those borrowing limits, known as the "three red lines", by the end of this month. The firm is ramping up asset sales as it seeks to reduce its US$100 billion burden.

Evergrande has not sold dollar bonds since January last year and its rating was cut further into junk this week by Fitch Ratings.

Another focus has been the bad-debt management industry, tasked with cleaning up China's soured loans. A key player is Huarong, which became embroiled in financial scandal under its former chairman before his arrest in 2018. After Lai Xiaomin was executed this year on bribery charges, concern over the company's future intensified when it failed to release its 2020 earnings in March.

Beijing's silence over its plans for Huarong have left some of the firm's longer-dated bonds trading at stressed levels. Huarong and its affiliates have US$39.8 billion of debt outstanding.

Companies are under more scrutiny than ever as Mr Xi enters a crucial period in his rule. The Chinese leader has in the past year doubled down on perceived threats to the Communist Party ahead of a leadership shuffle next year that could see him hold on to the presidency for a third term.

Beijing has increased regulation of corporate giants such as Alibaba Group and Tencent Holdings, and forced high-profile entrepreneurs like Mr Jack Ma and Meituan founder Wang Xing to lay low.

State-owned enterprises are not immune. These enterprises and other non-private corporates accounted for 54 per cent of the value of onshore defaults in the first four months of the year, according to JPMorgan Chase & Co.

Evidence of broader market contagion has been relatively limited. Investment-grade dollar bond spreads over respective government bonds have tightened since blowing up to a nine-month high in the wake of Huarong's missed earnings report.

But the stakes are high: A surprise default or painful restructuring risks triggering widespread panic.

While Beijing will likely intervene to avoid a credit crisis should that happen, there is considerable uncertainty over the timeliness and extent of such support, wrote Goldman Sachs analysts in a note earlier this month. UBS analysts agreed, warning investors to prepare for fading government support for state-owned enterprises.

"The problem with 'too big to fail' is that it can quickly turn into 'too big to save'," said Peking University finance Professor Michael Pettis. "China has since the financial crisis maintained stability by repressing risks. It can't do that forever."