From implicit guarantee to cherry-picking, what’s behind the wave of onshore bond defaults in China?
Beyond the higher capital inflows, China’s bond universe is facing another structural change. With the rebounding but still challenging economic growth, repayment pressure for corporates has worsened and bond defaults have increased sharply although still from a very low level. This trend derails from the past experience in two ways. First, state-owned enterprises (SOEs) have become a major source of bond defaults. Second, a few highly rated SOEs are experiencing difficulties in repayment since 2019. In this note, we analyze bond defaults through the measurement of corporate and provincial fiscal health.
Although the size and ratio of onshore bonds with repayment pressure have climbed, the number of first-time defaulters has declined from 42 in 2019 to 27 in 2020. Furthermore, the top 5 defaulters make up 54% of onshore bond defaults in 2020. This shows the repayment pressure is driven by larger but fewer firms, of which many are SOEs. The question is whether there is a rationale behind this trend and the answer is yes. In fact, the financial health for SOEs has worsened rapidly. The US-China trade war in 2019 and the shock from coronavirus in H1 2020 have clearly contributed to the deterioration. Although the SOEs still have better financial health than POEs, the decline is steeper.
Still, the most important factor that differentiates SOEs from private firms is on government support. In 2019 and 2020, SOEs in Hainan, Liaoning and Qinghai face the highest difficulty in repayment, but it is hard to find a single underlying reason. On liquidity, Qinghai and Liaoning have the largest decline in total social financing and shadow banking, showing the interlaced pressure between lower risk appetite from banks and harder access to credit. But Hainan is indeed the province with the biggest share of issuers not being able to repay but with much less liquidity concern and manage to gain extension, indicating government support is any form is vital to rollover the debt.
However, the fiscal situation of local governments has worsened in the past few years driven by local government special vehicles (LGFV). The challenges have further exacerbated after the Covid-19 shock from both on-balance sheet and LGFV bonds. We find provinces with more pressure for bond repayment also having higher debt ratios and worse fiscal deficits on average. In other words, debt and fiscal deficits of local governments seem to come hand in hand with more bond defaults.
Moving forward, bonds defaults could remain an issue in 2021 but they are likely to remain concentrated in specific names or sectors. The good news for local governments is the cyclical rebound in economic growth will partially ease the need to support corporates. But the heavier local government debt burden will remain a concern as the Chinese economy is expected to decelerate structurally after the technical rebound in 2021. As such, the support from local governments to SOEs is likely to be less certain over time, especially for the regions with higher debt ratio and fiscal deficit. The good old days of implicit guarantee may be over and cherry-picking of the best SOEs will be the new norm.
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