Debt in China’s corporate sector could soon test the Communist Party’s expressed intention to play by market rules.
In August, the sector had a debt-to-GDP ratio of up to 105%, by some counts. The real interest rate by then had soared to about 8%, leading some to call such debt China’s greatest financial risk, as opposed to that associated with shadow banking or local governments.
Still, corporations will sail through 2013 without a default, a threshold the Chinese government hasn’t allowed its large and medium companies to cross.
But the stakes will be raised next year. Chinese companies in 2014 must pay US$427 billion in interest and principle on securities, a surge of 19% on this year, according to data compiled by China International Capital Corporation.
Debt in China’s corporate sector is concentrated in a handful of industries, many of which have operated at overcapacity for several years. Metal and mining has taken on “aggressive” debt, Standard & Poor’s Rating Services noted in an August report. Coal and transportation services were also exposed to significant levels of borrowing.
The burden in sectors such as telecommunications and consumer retail were relatively low.
Debt in the steel industry has drawn particular worry this year. In August, Chinese media reported that 86 large and medium steel firms had accrued US$494 billion in total debt in the first half of the year. The industry-wide debt ratio was nearly 70% at the time. The soaring debt levels came as companies reported huge losses, hindering their ability to pay interest. Baoshan Iron & Steel, one of the country’s biggest steel producers, reported a 67% drop in profits in August.
Shipbuilding is another worrying sector. China Rongsheng Heavy Industries Group, China’s biggest private shipbuilder, had a debt-to-equity ratio of 134% in the first six months.
Under normal market conditions, it seems many companies wouldn’t stand a chance. Yet, for more than a decade, China hasn’t allowed corporations to default. Shandong Helon, a rayon maker, nearly did on US$60 million in commercial paper in April 2012. But the government came to the rescue before that could happen, pushing state banks to bail the company out. A long list of large and medium companies approaching default on payments, including Suntech Power and LDK Solar, have received state support.
Signals such as these have looked like an implicit government guarantee on the bonds; removing the prospect of default has kept ratings on the financial instruments high. Under such conditions, China’s corporate bond market has grown rapidly during the past few years as the stock exchange has languished.
This is changing, though. The bleak outlook for corporate debt in 2014 comes just a month after the national leaders pledged to let market forces play a decisive role in resource allocation, which could eventually translate into allowing some companies to fail.
Growth is also slowing in China. Some analysts have put 2014 GDP growth at 7.3%, down from an expected 7.5% this year. That means that some companies will take in less money in the coming years, making it harder to pay back loans.
Under this kind of pressure, will the government allow failure? Some analysts say yes.
The Chinese government will allow some companies to default, Zhu Haibin, chief China economist at JPMorgan, said in an email on Monday. If it does, that ends the implicit government guarantee on the bonds and will help investors assess the real risks associated with corporate bonds.
“I think lack of default is a fundamental flaw in China’s corporate bond market, especially given its fast expansion in recent years,” Zhu said. “So allowing for default and establishing a default mechanism is good news for the corporate bond market.”
Despite the new leadership’s pledge to allow for stronger market forces, the timeframe for this is still unclear. Christopher Lee, managing director at Standard & Poor’s Corporate and Government Ratings, said the process of letting companies default will be incremental.
“The prospects of bonds defaulting next year in China – I think there is still a low level of probability for that,” Lee said. “If the government can execute what they plan to do, it will happen in the future but not so soon.”
The risks are high for letting market forces rule here. The “too-big-to-fail” mentality may persist in some of China’s most indebted sectors, such as steel, because of the number of people they employ.
“Default would cause big problems,” Helen Lau, a senior commodities analyst at UOB Kay Hian in Hong Kong, said on Monday. “Closing down a steel company would lead to large unemployment, and this could lead to unrest.” For this reason, it’s almost unimaginable that a firm such as Baoshan Iron & Steel would be allowed to fail.
While leaders test the waters of market reforms, it is dilemmas such as these that will hinder the process. Strengthening the role of the market in the Chinese economy clashes head on with some of the top goals of the Communist Party. Maintaining employment and stability is one of those. Upholding the reputation of its star firms is another.
In the coming years, the Shandong Helons of China – smaller firms owned by local governments – can’t count on Beijing to pick up the tab. But the Baoshans and the Rongshengs, the country’s mega employers, still have little to worry about in the foreseeable future.