(Bloomberg) –
China’s fragile economic recovery is entering a dangerous new phase for the nation’s $ 4.1 trillion corporate murder market.
With the economy now strong enough for policymakers to repay financial support, yet too weak to rescue the most troubled lenders, some fund managers have pledged to default on domestic Chinese debt to reach record highs this year. Crime has already begun to rise after a remarkably quiet second quarter, and pressure on lenders is set to grow as 3.65 trillion yuan ($ 529 billion) of adults by the end of the year.
While there may be a few crises to be seen, debt specialists at SC Lowy and Adamas Asset Management in China are becoming more selective, arguing that the calm by government in local credit markets is unlikely to last. Analysts say that non-state-owned companies, developers with lower ratings and some financial vehicles for local government are particularly vulnerable as borrowing costs climb and refinancing becomes more difficult.
“The government has neither the fire brigade nor the will to support it all,” said Brock Silvers, chief investor at Adamas Asset Management in Hong Kong, adding that he expects the definition of onshore in China to reach a new annual record. That would mean another 72.2 billion yuan of misdemeanors at the end of December, according to data compiled by Bloomberg.
Local defaults so far this year have been remarkably rare, given that the Covid-19 pandemic lasted China’s economy to the worst conclusion in decades in the first quarter. Offenses at sea fell 17% to 49 billion yuan in the first half, in part because the government encouraged lenders to refinance debt, accept payment delays or find other solutions, such as exchanging bonds for fresh notes with longer maturities.
Read more: China makes bad loans disappear as virus pummels banks
Authorities’ outsized focus on preventing defaults now seems to be diminishing as the economy declines and the threat of market contamination diminishes, a policy stance that is in line with the government’s long-term goal of financial system to improve the risks. Chinese companies regained 10.4 billion yuan of notes in July and about the same amount so far in August, with luxury home developer Tahoe Group Co. among the last to miss payments.
“We have seen some illusory improvement in ‘defaults’ this year, but the deeper drilling of the picture is less comfortable,” said Owen Gallimore, Head of Credit Strategy at Australia & New Zealand Banking Group Ltd. in Singapore.
Gallimore predicts that China’s bond market will catch up with the offshore trend, with defaults on dollar debt detected by Bloomberg surpassing last year’s total of 55%. He said financing stress is likely to be concentrated in non-state lenders and could affect more real estate companies, which make up most of China’s high-yield debt.
The nation’s developers must refinance or repay $ 199.3 billion in debt to onshore and $ 12.3 billion offshore notes by the end of the year, data compiled by Bloomberg show. And they will have to come up with the cash, while also following issuance guidelines introduced this month, which limit the size of bond offers by real estate companies in China’s interbank bank to 85% of deferred debt that is coming.
Even if authorities become more tolerant of defaults, they are not likely to turn off the credit cranes completely. On August 17, the People’s Bank of China added 700 billion yuan of one-year financing through its medium-term lending facility, more than compensating emerging maturities in a move that Citic Securities Co. described as more accommodating than expected.
The result for bond investors is that security selection is now doing much more than earlier this year, according to Soo Cheon Lee, chief investor at SC Lowy, a global banking and asset management group in Hong Kong. Smaller companies and lenders that are commodity-driven than to sector-related stress – such as airlines and hotels – are likely to remain under pressure, Lee said.
In just the past week, companies including Haikou Meilan International Airport Co., cruise ship operator Genting Hong Kong Ltd. and rental company Bohai Leasing Co. issued new warnings that they may struggle to repay creditors.
At least ten Chinese companies that won investor approval to delay paying off their debts following the outbreak of the virus will have payment deaths over the next eight months, and at least 83 companies with $ 46.3 billion in outstanding bonds will see uncertainty about meeting their obligations, according to company statements and rating agencies, the highest number of lenders since Bloomberg began tracking the figures in January 2019.
China’s ratio of interest-bearing corporate debt to gross domestic product rose 13 percentage points this year to 164.4% at the end of June, according to the National Institution for Finance & Development, a think tank.
Local government financing cars have also piled up debt, selling the equivalent of $ 361.1 billion in domestic and offshore bonds so far this year. Questions about whether they can repay more intensively this month after an LGFV from the northeastern Jilin province later raised funds to bondholders than usual – a sign of possible difficulties in securing the money.
Jilin is just one of several Chinese provinces that have higher risks of LGFV repayment, according to Li Yuze, an analyst at China Merchants Securities. Others include Heilongjiang, Liaoning, Yunnan, Guizhou and Sichuan, Li said.
Whether investors have the risk of increasing defaults at sufficient prices is debatable. Corporate returns to land have risen from their lowest levels in more than a decade in May, but they are still well below long-term averages, according to ChinaBond indices. Spread between credit with lower and higher rating is also close to the tight end of its historical range. “We think liquidity in the credit market will continue, but we have to keep in mind that the underlying cash flow and foundations of companies are still very weak,” said SC Lowy’s Lee. “We see a lot of land mines.”
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