What to Make of Recent Chinese Defaults?

For years, a conundrum has confronted investors and Chinese officials alike: How do you move to a more market-oriented system if it means state-owned enterprises (SOEs) lose their implicit government guarantee and are allowed to default, fanning fears of a debt crisis?

That problem took center stage again lately following over a dozen defaults by SOEs this year alone. One striking example occurred a little over a month ago, when local SOE Yongcheng Coal & Electricity defaulted on a $150 million AAA-rated issue—a credit rating that clearly stemmed from the perception of government backing. Interestingly, Yongcheng appeared to have enough cash to cover the note, but it transferred major assets to other SOEs without compensation a week prior, ostensibly to hide them from creditors. Thus, the events suggested SOEs could dictate default on their terms, making it more difficult for markets to assess credit risk, which runs counter to the purpose of allowing default. That compounds questions about local governments’ blanket support of local SOEs. With local SOE bonds accounting for 60% of China’s onshore market, the circumstances understandably spooked investors and aggravated long-standing fears of a debt crisis. However, while there are important takeaways from the development, the response from Beijing, its policy priorities and the relatively small scale suggests systemic risks remain minimal. 

There are two primary risks related to broader credit events. The first, and most immediate, surrounds liquidity: Do banks have access to funds on a short-term basis to roll over their obligations? In the days after the default, one-year interbank rates jumped to nearly twice that of earlier this year.^[i] In response, the People’s Bank of China quickly intervened to calm nerves, injecting $30 billion in one-year loans with the promise it would conduct another medium-term lending operation on December 15 to roll over maturing loans for the month. In the weeks since, liquidity measures have stabilized.

The second risk concerns solvency, or the quality of balance sheets. What is the scale of bad debt held across the financial system? This is the oft-cited fear surrounding Chinese debt levels given the opacity of its government-run financial system and suspiciously low non-performing loan ratios. But while headlines scream crisis, defaults as a percentage of total corporate bonds outstanding remain small. For example, according to Goldman Sachs research, private enterprise defaults have accounted for 3.5%, while SOE defaults only 0.5%.

That may not seem to address future concerns, as there now appears to be more tolerance for defaults from Beijing and local governments. In a mature developed market like the US, a wave of defaults wouldn’t be good news, but in China, it signals some broader, positive shifts. From a policy perspective, allowing SOEs to default is wise—letting bad firms go bust is a crucial component to appropriately pricing risk. Yet the government’s primary goal remains retaining control, which requires maintaining economic and social stability. That suggests officials will closely manage systemic risks. Yongcheng’s debt was quickly rescheduled and extended. In a bigger context, Evergrande—a large property developer recently facing a liquidity squeeze—secured $4.6 billion from state-linked companies to shore up its finances. The local SOE market will have to regain some trust after these events, but they likely do not have material market-wide significance.

More broadly, these developments fit into an ongoing theme of financial discipline promoted by Beijing. In the past several years, the government addressed debt concerns by forcing deleveraging while cracking down on shadow bank lending. As a result, credit growth decelerated notably. Its return this year is probably temporary, part of the broader effort to cushion the economy from the pandemic. Expecting the government to guide it down for 2021 is reasonable, in my view. Moreover, the recent high-profile cancellation of Ant Financial’s IPO and subsequent strengthening of fintech regulatory requirements shows the government has potentially learned from its prior experiences. Higher capital requirements and oversight of a growing—and potentially massive—financial base should promote future stability, assuming the government is not overly heavy-handed. It is all consistent with a measured policy response that balances stability with growth and very long-term market-oriented change.