Default of ‘AAA’-rated SOE spooks markets; the dangers of US presidential election information silos

SinoInsight  1

On Nov. 10, Yongcheng Coal & Electricity Holding Group Co, a state-owned enterprise in Henan Province, defaulted on a 1 billion yuan ($151 million) bond. Yongcheng said it failed to make principal and interest payments worth 1.032 billion yuan on the ultra-short bond. 

On Nov. 11, two other Yongcheng bonds saw their price plummet by over 90 percent, and were trading at 6.56 yuan and 9.51 yuan respectively. Other bonds issued by Henan Energy and Chemical Industry Group, the parent company of Yongcheng who owns 96.01 percent of the latter’s shares, also saw the price of their bonds plunge by more than 86 percent. 

On Nov. 13, Henan Energy and Chemical Industry Group canceled a meeting with major creditor banks in the province after fearing that it could turn “chaotic” when too many creditors arrived. Henan Energy and Chemical Industry Group is the largest provincial-level coal producing company in Henan Province. The Henan State-owned Assets Supervision and Administration Commission is its actual controller. 

Investors fear that Yongcheng’s default will trigger a cross-default with Henan Energy and Chemical Industry Group, as well as a credit crisis. China Chengxin Credit Rating Group lowered the credit rating of both companies from “AAA” to “BB” in light of the recent default. 

Recent defaults by AAA-rated SOEs in China have triggered panic in the mainland corporate bond market. Prices of credit bonds have dropped by as much as 30 percent. 

OUR TAKE
1. We have consistently warned that the Chinese economy has not recovered from the coronavirus pandemic, despite CCP propaganda. In fact, China’s economy is further deteriorating this year. The defaults by top-rated SOEs signal that the CCP regime is struggling to sustain its Ponzi-style, debt-driven economic growth. 

2. The Yongcheng default is looking like the prelude to a local government bond market crash. According to mainland media reports, Yongcheng has 47 billion yuan of cash on hand and 6.7 billion yuan with its parent company Henan Energy and Chemical Industry Group. Even so, Yongcheng still defaulted on its 1 billion yuan ultra-short bond, and the Henan provincial government did not step in to rescue the company. The lack of government intervention hints at the enormity of the local SOE credit and debt problem, as well as the unwillingness of financial institutions to bail out risky SOEs and delay the inevitable. 

SOE defaults like that of Yongcheng do not occur out of the blue. Beijing has been harping on systemic financial risks in recent years, suggesting that the CCP leadership is well aware that debt risks could erupt at a moment’s notice. Until recently, local officials were reluctant to allow SOE defaults to avoid tarnishing their political achievements and being singled out as the “first case” of local debt crash. However, with the first domino down, we may see a wave of local debt defaults in the near future. 

3. In 2015, the Xi leadership issued a policy on local government debt to delay and resolve a local government implicit debt crisis. Under the policy, local governments were allowed to restructure 14.34 trillion yuan worth of short-term, high-interest bonds to long-term low-interest bonds over the course of three years. Many local governments took advantage of the debt swap policy to “resolve” the maturing bonds issued by local financing institutions such as banks and local government financing vehicles. 

One outcome of the 2015 debt swap policy was the gradual transformation of lower-rated, urban investment credit bonds into higher-rated local government bonds. Such high-yield bonds then became the target of leveraged investment by financial asset management institutions. Bank wealth management funds also entrusted non-banking financial institutions to invest tens of billions of yuan in still-risky restructured debt. Ironically, a move by the central government to lower the PRC’s debt crisis, twisted by inherent shortcomings of the CCP authoritarian system (local officials overly focused on acquiring political achievements to boost career advancement), backfired, resulting in greater financial risks. 

4. China saw a total of 136 bond defaults worth 155.4 billion yuan from January to November this year, according to data from financial information provider Wind. In comparison, there were 184 bond defaults worth 149.404 billion yuan in 2019. 

Of the 136 bond defaults this year, 56 involved public sector enterprises. Mainland financial analysts note that the difference in value of bond defaults between 2019 and 2020 stems from defaults in the CCP-favored public sector, which tend to be greater in scale than defaults in the private sector. 

Public sector defaults deal a blow to market confidence because government bonds are considered less risky than private bonds. Going forward, we believe that SOEs will find it much harder to sustain the model of refinancing old debt with new debt, as investors account for higher risk. This will lead to a vicious cycle of SOE bond defaults.