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Treasury & Capital Markets
The painful reckoning for China’s SOEs
The huge debt pile these enterprises have amassed raises fresh concerns
Christoph Kober 1 Jun 2016
Dwindling state support and a more difficult refinancing environment for troubled Chinese state-owned enterprises (SOEs) signify growing momentum in the painful effort to tackle high leverage and low profitability within the sector.  But as the government allows more SOEs to fail, the huge debt pile they have amassed raises fresh concerns.
 
China’s onshore debt market has seen a small revolution this year. Previously unthinkable particularly for debt issued by state-owned companies, defaults have reached a record high. Since January, 10 issuers have defaulted, affecting more than 20 corporate bonds and similar instruments. That is more than the full-year total for 2015.
 
Notably, central and provincial level governments more frequently opt to let distressed SOEs under their aegis enter restructuring or foreclosure procedures, rather than simply bailing them out with cash contributions and guarantees. Notable cases of large state-owned or government-related enterprises having been allowed to fail this year include Guangxi Non-Ferrous Metals Group, Tianjin’s Bohai Steel and the Greenland Group affiliate Yunfeng. 
 
The new reality in China’s onshore debt market: whether private or not, “there is no escape from default,” sums up Christopher Lee, managing director for corporate ratings, Greater China, at S&P Global Ratings (formerly Standard & Poor’s Ratings Services).
 
“This is very new to investors and markets in China,” Lee continues. Investors have adjusted quickly to the new reality, though, pricing in increased default risk in debt markets.  “Spreads between AA+ and AAA rated issuers [in China] have widened to 130 bps,” he notes. That compares to less than 50 bps as late as January this year.
 
According to Chinese news reports, firms in China have delayed or cancelled more than 100 bonds due to rising funding costs. But not only capital markets have witnessed more wary investors.  Banks, too, appear to expect less of the state support they had been used to in the past. 
 
According to Lee and his colleague Leo Hu at S&P Global Ratings, “there are early indications of reduced ongoing liquidity support to SOEs [including] a reduction in the amount of total bank credit facility, an increase in the collateral required by banks, higher funding costs, tapping of alternative funding channels, and increasing leverage [with short-term debt].”
 
In depth
 
Just how much do SOEs contribute to the onshore debt market and how much of it is at risk? In their report published Monday, Societe Generale analysts Wei Yao and Frank Benzimra estimate that 12% of the debt of 980 listed non-financial SOEs is at risk. Including ostensibly less efficient non-listed SOEs, they further estimate the total debt-at-risk at 18% of the total debt in the sector.
 
Their calculation continues: “If this debt has 30% recovery rate, banks’ loans and bond exposure to SOEs in China would amount to 5.2 trillion yuan, equivalent to 40% of commercial banks’ capital base.” That startling number is also equivalent to 7.6% of GDP.
 
SOEs make up 80% of the corporate bond market in China, they note. Companies in the steel sector are most susceptible to default. More than half of the debt in the sector (53%) is at risk, the bank warns and bases this analysis primarily on low interest coverage ratios (EBITDA/interest expense).
 
According to data from S&P Global Market Intelligence, 46 listed Chinese companies in the materials and utilities sectors currently report ICRs below 1x. This means their annual earnings cannot cover the cost of their debt, even before taxes as well as non-cash charges including depreciation are considered.
 
At the moment, 50% of Chinese SOEs rated by S&P Global Ratings rely on ongoing liquidity support from central, provincial and/or municipal governments for their sources of liquidity. The proportion is highest among chemical engineering and construction, metals and mining, transportation infrastructure and utilities sectors. Less than a third of SOEs in the oil and gas, real estate and automobile sectors, meanwhile, require government support.
 
Government support for these businesses, many of which have been consistently loss-making, is constrained by the new “supply side” reforms that are promoted by the central government as well as increasing leverage at local governments. Instead, as part of the reform, alternative strategies to deal with unprofitable SOEs are being tested, among which debt-for-equity swaps, loan securitization and the creation of “bad banks” are touted as most effective methods to alleviate stress on bank balance sheets.
 
Societe Generale highlights the defaults at the capital goods manufacturer Erzhong and Nanjing Tanker, the state-owned carrier, as examples of how China’s new bankruptcy paradigm is finding application.  Rather than direct government support, debt-for-equity swaps conducted with creditor banks acted as white knights to save the two companies from foreclosure.
 
Analysts at the French bank cast doubt on the effectiveness of the measures, however.  “None of the ideas the government has floated so far – debt-for-equity swaps, loan securitization and bad banks – can lessen the burden on banks by any meaningful degree,” they write.  Indeed, while debt-for-equity swaps ideally exchange risky exposure to loans with the possibility of realizing the upside potential of being an equity investor, the swaps might simply “postpone asset quality problems, while stripping banks of their status as senior creditors.”
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