China Faces Default Chain Reaction as Credit Guarantees Backfire

  • Slowing economy raises risks as loan failures surge 86%
  • Guarantee firms expand coverage to LGFV bonds, online lending

China’s credit guarantees, lauded by Premier Li Keqiang for helping fund smaller firms, are backfiring as a slowing economy risks causing a chain of defaults.

Failures of guaranteed loans surged 86 percent last year to about 400 billion yuan ($63 billion), according to UBS Group AG. At the nation’s Big Five lenders, such borrowings made up 18 percent of the total and 29 percent of non-performing financing, the Swiss bank said in a note. Standard & Poor’s said specialist guarantee firms are suffering, while the industry’s second-largest company halted operations amid accusations that it took on too much financial risk.

QuickTake China's Pain Points

Credit guarantees, which began as a way to help smaller firms obtain funding by merging the risks of various borrowers, have now expanded to cover debt such as bonds issued by cash-strapped local-government financing vehicles and online peer-to-peer loans. The business works on the assumption that borrowers are unlikely to default at the same time, a premise that collapsed in the U.S. during the global financial crisis when slumping home prices sparked a chain reaction of defaults.

“The borrowers are all exposed to the same risk, and that’s the economic slowdown," said Liao Qiang, Beijing-based senior director for financial institution ratings at S&P. "That’s why all of a sudden this cross-guarantee practice is backfiring. A relatively well-performing company could be jeopardized just because it has to honor obligations.”

China’s guarantee firms backed 2.6 trillion yuan of loans as of end-2014, an 18 percent increase from the previous year, Moody’s Investors Service data show. They also provided surety for 56.3 billion of new bonds, 79 percent more than in 2013, China Chengxin International Credit Rating Co. said.

Chinese banks are already grappling with bad loans that swelled to a 5 1/2-year high of 1.5 percent on June 30. Even if the borrower doesn’t default, the failure of a guarantor would weaken loan quality and pressure lenders to put up more capital, according to Matthew Smith, an analyst at Macquarie Group Ltd. in Shanghai. The banking regulator didn’t respond to a fax seeking comment.

There are three kinds of credit guarantees in China. One is a straightforward pledge made by the parent company, while another involves unaffiliated firms providing surety for each other. The third is offered by specialist firms in return for a fee paid by the borrower. There are 8,000 guarantee firms in the nation, China Chengxin said in August. Fewer than 50 are rated and only one has an international investment grade, according to Moody’s.

In the third quarter, default swaps insuring Bank of China’s bonds against non-payment rose 51 basis points, the most since the period through June 2013, to 162.4. The contracts were at 143.8 on Thursday. Deutsche Bank AG signaled this week that it may sell a $3.5 billion stake in Huaxia Bank Co., suggesting fading appetite among global lenders for tie-ups with their Chinese counterparts.

China’s State Council, or cabinet, said in August that the government would help develop guarantee companies and is considering the establishment of a national guarantee fund. This came after Premier Li said in December that the practice was essential to helping smaller enterprises and farmers obtain financing.

Less Assuring

James Yip, a fund manager at Shenwan Hongyuan Asset Management (Asia) Ltd. in Hong Kong, said that while he would accept a lower yield on debt supported by a strong guarantor, the enhancement has become less reassuring amid the economic slowdown.

"A guarantee may knock up the bond’s credit rating by one or two notches, but we also look at the guarantor’s background and leverage," he said. "Many guarantee companies over-guarantee, so if the credit event becomes a more widespread problem, the firm’s ability to support all its guaranteed debt will be limited."

Industry Troubles

The risks came into focus this year when Hebei Financing Investment Holding Group, China’s second-largest guarantee company, was put under control of a state firm. It struggled to make repayments amid “concentrated defaults and overdue payments” by firms it backed, according to a statement last month. Shanghai Stock Exchange imposed buying restrictions on the company’s bonds on Sept. 21. In March, Sino-Capital Guaranty Trust Co. was barred from insuring debt after it failed to pay up on defaulted notes.

State-owned China National Investment and Guaranty Corp., the nation’s largest guarantee company, had outstanding guarantees of 110 billion yuan in June last year, according to Guotai Junan Securities Co.. That’s 18.7 times its net assets. China National didn’t respond to a call seeking comment.

“When the economy was strong, people didn’t take guarantees seriously -- it was more a ‘it’s just a promise,’” said Joe Zhang, former deputy head of China investment banking at UBS and author of "Inside China’s Shadow Banking: The Next Subprime Crisis." "Now that the economy has declined, these promises are biting, and biting hard.”

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