SinoInsight 1
Chinese companies, including state-owned enterprises, have recently begun defaulting on their debts one after the other, a worrisome phenomenon for investors.
Nov. 13
1. Lou Jiwei, a member of the Standing Committee of the Chinese People’s Political Consultative Conference and former finance minister, said at the 11th Caixin Summit in Beijing that the time has come for China to “study an orderly exit of loose monetary policies.” Carefully managing the exit pace will be the key challenge given China’s high debt levels, because debt crises could trigger if stimulus is withdrawn too quickly. Lou added that stimulus should be maintained at the current pace and be made less expansionary in 2021.
2. In an announcement on the National Interbank Funding Center website, Baoshang Bank said it would write down the principal of a 6.5 billion yuan ($984.27 million) tier-two capital bond and not make remaining coupon payments worth a total of 585.6 million yuan. Baoshang added that the write down complied with commercial bank rules and clauses in the bond’s prospectus after the People’s Bank of China and the China Banking and Insurance Regulatory Commission notified the bank it had experienced a “non-viability trigger event.” Chinese regulators also said that Baoshang was “seriously insolvent” and unviable.
Nov. 16
1. Fujian Haixia Bank “temporarily canceled” the sale of a second tranche of tier two bonds worth 500 million yuan on Nov. 17 due to “market fluctuations.”
2. Tsinghua Unigroup defaulted on a 5.6 percent, 1.3-billion-yuan privately issued onshore bond, citing tight liquidity. The semiconductor conglomerate is backed by the PRC government.
3. Chinese automaker Brilliance Auto Group Holdings Co. announced that it has defaulted on 6.5 billion yuan of debt and has 144 million yuan of interest overdue. In recent years, Brilliance Auto, which is linked to BMW AG, issued a total of 34 bonds and 14 subordinated bonds (total value of 16.2 billion yuan). The total value of Brilliance Auto’s bonds with a maturity range of one to three years exceeds 10 billion yuan.
OUR TAKE
1. We are consistently warning readers about China’s debt crisis, and how “cracking sounds” can be heard from the local debt “iceberg,” with this current round of defaults being only the tip.
Debt crises remained hidden in recent years owing to government policy. The CCP’s Ponzi-style debt restructuring and stimulus measures allowed corporate and government entities to secure refinancing, while transferring debt risks to the public (small- and medium-sized enterprises, the private sector, etc.). Meanwhile, unresolved systemic financial problems and risks continued to exist. Thus, while CCP propaganda claims that debt risks have been “controlled,” its reality is built upon a shaky foundation of postponed and worsening China’s debt problems.
2. In the last issue of the newsletter, we analyzed Yongcheng Coal & Electricity Holding Group Co’s bond default case. Recent information in mainland media reports suggest that the Henan provincial government engineered the Yongcheng default to evade debt issues.
On Nov. 3, Yongcheng announced it was transferring 1.15 billion shares held by Zhongyuan Bank to two Henan SOEs, Henan Machinery Group (500 million shares) and Henan Investment Group (650 million shares), at no charge. Concurrently, Yongcheng transferred a number of its “insolvent” (but not valueless) coal subsidiaries to its parent company Henan Energy and Chemical Industry Group for free, while taking in four underperforming companies previously held by its parent company and a government-owned entity.
According to Yongcheng’s Nov. 3 announcement, the equity transfer deals would reallocate negative 550 million yuan worth of net assets, or negative 1.46 percent of its balance sheet, elsewhere. Those assets generated net profits of negative 700 million yuan in 2019. At a glance, Yongcheng was getting rid of bad businesses. However, investors noted that the Henan State-owned Assets Supervision and Administration Commission, the actual controller of Yongcheng’s parent company, had in fact completed the relevant equity change registration work stated in Yongcheng’s Nov. 3 announcement as early as September and October this year after documents were filed on July 28. But Yongcheng only chose to announce the equity transfers shortly before it defaulted on its 1 billion yuan bond on Nov. 10, a suspicious move. Investors concluded that Yongcheng must have transferred out valuable assets that could be liquidated quickly while taking in hard to liquidate assets from its parent company and the other government-owned entity.
Yongcheng’s “loss-making” equity transfers make sense in examining the bigger picture. The Henan government almost certainly knew that Yongcheng would default on its debt. Not wanting to expend resources to save the company, the Henan government instead shifted away Yongcheng assets that could be easily liquidated to other government-owned entities, while allowing the company to default on debts and eventually file for bankruptcy. This way, the Henan government keeps the upsides and “curbs” its debt risks, leaving investors to foot its losses.
The Henan government’s strategy for dealing with a debt crisis indicates the CCP can no longer cover up rampant debt problems within the regime through stimulus measures alone. Instead, local governments are “allowing” some SOEs and even small- and medium-sized banks to default and file for bankruptcy so as not to pay creditors and investors. This strategy, however, is bound for backlash because it undermines the overall creditworthiness of the CCP regime. Once investors catch on that government or government-linked bonds are no longer “safe” assets, and judge Beijing to lack creditworthiness, then the CCP’s Ponzi-style financial policies will naturally run its course and the regime’s debt crisis will trigger across the board.
3. The CCP has consistently shifted government debt risks to the public in recent years. For example, local governments pushed urban resettlement policies in 2015 to raise property prices and the value of land, which was later sold at policy-inflated prices to boost government fiscal revenue. That year, local authorities also vigorously promoted P2P platforms under the guise of pushing “financial innovation,” while selling “high-yield” financial products composed of risky urban bonds, bank debt, and non-performing SOE assets to the public. The central government, however, soon moved to curb the financially risky P2P industry and their products. By 2017, the once booming 1.18 trillion yuan, 6,000-plus company industry was reduced to just 29 P2P platforms. Local government shenanigans left the Chinese people with high debt ratios and seriously weakened China’s consumption power.
China’s SOEs, many of which have long been poorly run and are rife with corruption, are also part of the system where government risks are loaded onto the public. To stay financially viable, SOEs either rely on administrative monopolies to gain an advantage or become “zombie” enterprises surviving on “unlimited” bank loans. While Xi Jinping initially sought to deleverage SOEs, financial and political problems in 2015 turned him towards the policy of “state advances, private sector retreats” (國進民退), which exacerbated the public sector’s squeeze on private enterprises.
The CCP’s debt “house of cards,” however, is on the verge of collapse as the private sector can no longer shoulder the onus of the public sector’s financial baggage. The Sino-U.S. trade war in 2018 led to the collapse of many small- and medium-sized enterprises. In 2019, several large private companies shuttered due to debt problems, and some were merged with SOEs or came under the control of the State Council’s State-owned Assets Supervision and Administration Commission. The wave of business failures resulted in rising unemployment, diminishing consumption power, and a devastated economy—bad news for SOEs getting used to pushing their debt problems to the private sector.
he pandemic and a global economic slowdown leaves the CCP with no choice, but to rely on “quantitative easing” measures again to stimulate the economy. Additional stimulus, however, means a rapid rise in government debt. To curb debt risks, the CCP must “allow” SOEs to abandon their underperforming assets, default on debt, and erode government creditworthiness in general.
4. Lou Jiwei’s remarks above indicate that the CCP is deliberately allowing SOEs to default and file for bankruptcy to lower the regime’s debt and defuse debt risks. This suggests that China’s economic and financial situation is nowhere near as rosy as depicted in CCP propaganda and reported by Western news outlets.
We will not be surprised to see a wave of defaults and bankruptcies across China in the near future. The defaults will steadily undermine confidence in government bonds and make it harder for local governments and SOEs to secure refinancing. As government and government-linked entities further up the chain encounter financing difficulties, China’s debt crisis will surface.
SinoInsight 2
The U.S. State Department’s Office of Policy Planning is releasing a “Long Telegram”-style document that outlines America’s approach to the CCP threat, according to Axios. Titled, “The Elements of the China Challenge,” the 74-page document offers an overview of the CCP’s malign activities, lays out the ideological sources of CCP conduct, lists the PRC’s vulnerabilities, and presents ten tasks for the U.S. to accomplish to meet the China challenge.
The ten tasks include:
1) Securing “freedom at home” by “preserving constitutional government, promoting prosperity, and fostering a robust civil society.”
2) Maintaining the world’s strongest military.
3) Fortifying the post-WWII “free, open, and rules-based international order.”
4) Reevaluating the U.S. alliance system and international organizations
5) Strengthening the U.S. alliance system, reforming international organizations “where possible,” and creating new international organizations “rooted in freedom, democracy, national sovereignty, human rights, and the rule of law.”
6) Promoting U.S. interests by cooperating with Beijing on terms of “fairness and reciprocity,” “constraining and deterring” the PRC when required, and “supporting those in China who seek freedom.”
7) Educating Americans about the China challenge.
8) Training a new generation of public servants to “attain fluency in Chinese and acquire extensive knowledge of China’s culture and history.”
9) Reforming the U.S. education system to equip students “to shoulder the enduring responsibilities of citizenship in a free and democratic society by understanding America’s legacy of liberty,” as well as prepare them to meet the “special demands of a complex, information-age” and globalized economy.
10) Championing the principles of freedom in words and deeds.
Noteworthy points in the document on ideology and the CCP’s global domination agenda include:
- “The CCP aims not merely at preeminence within the established world order … but to fundamentally revise world order, placing the People’s Republic of China (PRC) at the center and serving Beijing’s authoritarian goals and hegemonic ambitions.”
- “China is a challenge because of its conduct.”
- “Home to an extraordinary culture and to moral and political traditions stretching back thousands of years, China today is a great power governed by an authoritarian regime modeled on 20th-century Marxist-Leninist dictatorship.”
- “The failure to understand China’s interests and objectives derives in no small measure from neglect of the CCP’s governing ideas … the PRC’s determination to achieve ‘national rejuvenation’ and transform the international order so that it places China at the center and serves Beijing’s ruling ambitions stem from the CCP’s Marxist-Leninist ideology and hyper-nationalist convictions.”
- “Neither the communist authoritarianism the CCP has imposed on the people in China nor its hyper-nationalism are inevitable. Indeed, prominent alternatives to CCP authoritarianism have prospered in the region. No less steeped in Confucian traditions than the population of the People’s Republic of China, the people of Hong Kong, Taiwan, and South Korea embraced freedom and democracy.”
The document identifies the following vulnerabilities of the CCP:
- China’s economy “faces significant difficulties,” including hundreds of millions of Chinese earning a low income, rising unemployment compounded by the COVID pandemic, an export dependence, reliance on the U.S. dollar for international transactions, reliance on the U.S. and other countries for high-value technology, immense debt problems, diminishing consumption, widening rich-poor divide, etc.
- Worsening demographic conditions.
- Severe environmental degradation.
- Regime-wide corruption.
- The immense resource and financial burden of repression (“stability maintenance”). Per the document, “PRC spending on national domestic security grew from 348.6 billion RMB ($57.2 billion) in 2007 to 1.24 trillion RMB in 2017 ($197 billion in nominal dollars).”
- The People’s Liberation Army “lacks popular legitimacy.”
- Leadership succession woes.
- The PRC’s “conduct of foreign affairs generates distrust abroad,” including spreading disinformation internationally and “wolf warrior” diplomacy.
OUR TAKE
1. The State Department Office of Policy Planning’s assessment of the CCP’s ideology and how it drives the PRC’s conduct, as well as the Party’s world domination agenda, echo our own (see here and here). The document’s excerpt on culture and education also hues close to the points in our “culture strategy” piece. The task of reevaluating and reforming existing international organizations, as well as the creation of new ones, affirm our 2018 analysis of a U.S. reshaping the CCP-hijacked world order. The document’s analysis of a Chinese economy encountering “significant difficulties” also affirms previous editions of our newsletters.
“The Elements of the China Challenge” is perhaps the clearest and most tangible manifestation of the ideological turn in U.S. policy on China, a phenomenon we forecasted in 2018. This document will likely shape American outlook towards the CCP regime for several administrations to come, especially given the bipartisan consensus on the threat of Communist China.
2. At a glance, neither the document nor the ten tasks for America to accomplish advocate containment or regime change. If anything, the ten tasks are mostly defensive in nature. However, the document’s focus on the CCP’s ideology and the recommended tasks inevitably sets Washington on the path of zero-sum, “you die, I live” competition with Beijing. Further, faithful implementation of the ten tasks will create conditions necessary for triggering CCP regime collapse. The potential of the State Department Office of Policy Planning’s paper to change both the U.S. and China is substantial.
3. CCP elite politics and factional struggle are at the heart of the regime vulnerabilities listed in “The Elements of the China Challenge.” If Xi Jinping gains an overwhelming advantage over his factional rivals, the CCP will weather virtually all of the vulnerabilities identified by the United States. Conversely, each of the vulnerabilities could trigger regime collapse if the factional struggle stays finely balanced, as it is now. Fierce factional fighting will inhibit the CCP’s “discipline and ruthlessness,” rendering Beijing unable to properly resolve any of its vulnerabilities.
With an accurate grasp of CCP elite politics and factional dynamics, the U.S. can create and exploit asymmetric openings in the current great power competition, sidestep risks, and seize opportunities.
