Zombies Spreading Shows Chaori Default Just Start: China Credit

The number of Chinese companies with debt double equity has surged since the global financial crisis, suggesting the first onshore bond default won’t be the last.

Publicly traded non-financial companies with debt-to-equity ratios exceeding 200 percent have jumped 57 percent to 256 from 163 in 2007, according to data compiled by Bloomberg on 4,111 corporates. The yield on five-year AA- notes leapt 13 basis points in two days to 7.82 percent on March 6, the most in almost four months, after Shanghai Chaori Solar Energy Science & Technology Co. said it won’t be able to fully pay an 89.8 million yuan ($14.7 million) coupon due today on its March 2017 bonds. Chaori Vice President Liu Tielong said in an interview today the company still can’t make the payment.

Some “zombie” companies in China that have cash shortages will fail as authorities end an overly loose monetary policy, Xia Bin, an adviser to the State Council and former central bank board member, said on Feb. 10. Chaori may become China’s “Bear Stearns moment,” prompting investors to reassess credit risks as they did after the U.S. securities firm was rescued in 2008, according to Bank of America Corp.

“After the first one, there may be more defaults,” said Zhang Yingjie, Beijing-based deputy general manager in the research department of China Chengxin International Credit Rating Co., Moody’s Investors Service’s joint venture in China. “The domestic economy is slowing, liquidity is tightening globally and more bonds are maturing this year with greater refinancing pressure, so there may be more defaults.”

Cooling Growth

Total debt of publicly traded non-financial companies in China and Hong Kong has surged to $1.98 trillion from $607 billion at the end of 2007. Some 63 companies have a debt-to-equity ratio exceeding 400 percent, compared to the average of 73 percent. In latest filings, 351 have negative ratios of earnings before interest, taxes, depreciation and amortization to interest expenses, while 409 have coverage of less than 1. Renewable energy, materials, household appliances and software companies dominate the rankings.

Premier Li Keqiang is trying to balance efforts to avoid sharper slowdowns in economic growth with steps to rein in debt. Expansion in gross domestic product is set to cool to a more than two-decade low of 7.5 percent this year from 7.7 percent in 2013, according to the median estimate in a Bloomberg survey.

‘More Selective’

Li told the National People’s Congress this week that China will develop a regulated regional borrowing mechanism, after local-government liabilities surged to 17.9 trillion yuan as of June 2013 from 10.7 trillion yuan at the end of 2010.

Authorities have also started a cleanup of the $6 trillion shadow-banking industry and identified sectors of the economy in need of consolidation, including property. Default risks for trust products are under control, the official Xinhua News Agency reported today, citing central bank adviser Chen Yulu.

The government is signaling greater willingness to let borrowers be subjected to market discipline, according to Christopher Lee, head of corporate ratings for Greater China at Standard & Poor’s.

“We expect more discrimination in terms of credit risk and more selective lending,” Hong Kong-based Lee said by phone yesterday. The Chinese government will allow any further defaults “in a selective and controlled basis as opposed to the Big Bang approach, which is not their style,” he added.

Chaori’s Liu said in the interview today that the Shanghai government’s attitude has been to let the market decide. The company is trying to sell some overseas solar plants to raise money to repay debt, Liu added.

Chain Reaction

While any Chaori default likely won’t prompt an immediate liquidity crunch in China, it may lead to a chain reaction, Hong Kong-based strategists David Cui, Tracy Tian and Katherine Tai at Bank of America wrote in a March 5 note. It took a year for the U.S. financial crisis to escalate, they said.

Contagion has been avoided so far. China Credit Trust Co. last month repaid principal while giving only partial interest payments to holders of the Credit Equals Gold No. 1 product after a coal miner it lent money to collapsed, while other trusts have had to defer payouts.

Worsening Signs

Credit-default swaps insuring China’s debt against non-payment have jumped 23 basis points in the past year to 85 basis points. The extra yield investors demand to hold five-year AA-corporate notes in China over similar-maturity government bonds widened seven basis points to 356 basis points on March 5, the biggest increase since November. It reached 361 basis points yesterday, down from 418 on Feb. 7, the highest in almost two years.

The yield on the country’s benchmark 10-year government bond has declined 4 basis points this year to 4.52 percent as investors seek haven assets. The yuan slumped 1.4 percent in February, its worst month on record, and was at 6.1140 per dollar as of 12:45 p.m. in Shanghai today.

“We’ve had trust defaults, we’ve had corporate defaults and we’ve had the currency weakening so there’s a whole bunch of indicators that say it’s getting worse in China,” said Tim Jagger, a Singapore-based fixed-income manager at Aviva Investors Asia Pte., U.K. insurer Aviva Plc’s Asian asset management unit. “Until you get some bigger picture direction to the contrary, it’s very difficult to construct a buy case at these levels.”

Yields Surge

More corporate bonds onshore may default this year, said Li Ning, an analyst in Shanghai at Haitong Securities Co. Companies with bonds that lack guarantees and have higher credit risks similar to the Chaori debt include Zhuhai Zhongfu Enterprise Co., Star Lake Bioscience Co. and Nanning Sugar Industry Co., Li said.

An official at Zhuhai Zhongfu who asked not to be identified said the company won’t have any problem paying interest on its bonds this year because manufacturing is normal and its relationships with banks are good. An official in Star Lake’s investor relations department who asked not to be identified wouldn’t comment when called. There was no immediate reply to faxed questions today. An official in the securities department of Nanning Sugar said the company couldn’t answer questions before March 14 when the annual report is due.

The yield on the 2015 securities of Zhuhai Zhongfu, a beverage packaging manufacturer, has surged 234 basis points this week to a record 24 percent, according to exchange data. The rate on Nanning Sugar’s 2019 notes has jumped 27 basis points to 10.6 percent. It had a debt-equity ratio of 316 percent at the end of 2012.

‘More Cautious’

China’s Finance Minister Lou Jiwei said yesterday growth as low as 7.2 percent would meet this year’s target of “about” 7.5 percent as he tried to moderate expectations for the economy. Premier Li, who reiterated that China will pursue a “prudent” monetary policy, announced a target of 13 percent growth in M2, the government’s broadest measure of money supply.

The one-year swap rate, the cost of fixing the floating seven-day repurchase rate for 12 months, reached a record high of 5.38 percent on Jan. 2 and has since eased to 4.42 percent amid speculation the central bank wants easier conditions for companies to pay debt. China’s renewable energy industry alone faces a record $7.7 billion in bonds maturing this year.

Four companies pulled domestic bond sales on the Chaori news. Suining Chuanzhong Economic Technology Development Co. will delay a 1 billion yuan offering due to “serious fluctuations in the bond market,” it said on ChinaBond’s website March 5. Taizhou Kouan Shipbuilding Co., Xining Special Steel Group and Qunsheng Group Co. scrapped offerings for similar reasons.

“In the long term, investors will be more cautious and see that returns also reflect risks, which will benefit the development of the rates and bond market,” said China Chengxin International’s Zhang. “The past distorted relationship between returns and risks can then be corrected.”

— With assistance by David Yong, Judy Chen, and Justina Lee

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