"As China\u2019s debt risks grow, here are 3 warning signs to watch"

" \n Weak spots are emerging in China\u2019s growing debt pile. \n \n\n \n National debt levels have climbed to nearly four times of GDP, while an increasing number of corporate bonds have defaulted in the last 18 months. \n \n\n \n Although the latest defaults represent a fraction of China\u2019s $13 trillion onshore bond market, some high-profile cases have rattled investors since the common perception has been that the Chinese government will not let state-supported firms fail. \n \n\n \n The case of Chinese bad debt manager Huarong has also spooked investors, causing a market rout this year when the firm failed to file its earnings in time and its U.S. dollar-denominated bonds plunged. \n \n\n \n Analysts said cases like these signal how the state\u2019s so-called implicit guarantee is changing as the government tries to improve the bond market\u2019s quality \u2014 weeding out the weaker firms, and allowing for some differentiation within the industry. \n \n\n \n As China\u2019s growth slows, authorities are looking to strike a better balance between maintaining control and allowing some market-driven forces into the economy in order to sustain growth in the long term. \n \n\n \n In the first half of this year, the total number of defaulted corporate bonds in China amounted to 62.59 billion yuan ($9.68 billion) \u2014 the most for the first half of a year since 2014, according to data from Fitch Ratings. Of that, defaults by state-owned companies contributed to more than half that amount \u2014 about 35.65 billion yuan. \n \n\n \n For the whole of 2020, bond defaults amounted to 146.77 billion yuan, a huge leap from just six years ago in 2014, according to Fitch. That year, defaults totaled 1.34 billion yuan, and there were no defaults by state-owned firms, the ratings agency said. \n \n\n \n As investor fears ramp up, here are three important developments to watch, economists say. \n \n\n \n Read: Bogoso-Prestea Mine: Confusion rocks GSR sale to FGR over purchase agreement \n \n\n \n 1. Bond default in a grey area of local government \n \n\n \n A major milestone to counter the idea of implicit guarantee in China\u2019s market would be a default of a bond issued by a local government financing vehicles (LGFV). \n \n\n \n These companies are usually wholly owned by local and regional governments in China, and were set up to fund public infrastructure projects. Bonds issued by such firms have been surging amid an infrastructure push as the Chinese economy improved. \n \n\n \n \u201cMany LGFV are even worse than so-called Zombie companies, in the sense that they could not pay the interest, not (to) mention the principal on their own,\u201d Larry Hu, chief China economist at Macquarie, said in a June 25 note. Zombie companies are those that are heavily indebted and rely on loans and government subsidies to stay alive. \u201cThey could survive only because of the supports from the governments.\u201d \n \n\n \n \u201cThe year of 2021 is a window to break implicit guarantee, as it\u2019s the first time in a decade that policymakers don\u2019t have (to) worry about the GDP growth target. As a result, they could tolerate more credit risk,\u201d Hu said, noting it\u2019s only a matter of time before an LGFV bond default occurs. \n \n\n \n In 2015, electrical equipment manufacturer Baoding Tianwei became the first state-owned enterprise to default on its debt, following the first default in China\u2019s modern onshore bond market a year earlier. \n \n\n \n Nomura said LGFVs are a \u201cmajor focus\u201d of China\u2019s tightening drive, and noted that bonds issued by the sector surged to a record 1.9 trillion yuan ($292.87 billion) last year, from just 0.6 trillion yuan in 2018. \n \n\n \n 2. Huarong\u2019s \u2018big overhang\u2019 on the sector \n \n\n \n For investment-grade bonds in China, a major factor for future performance is how the case of Huarong Asset Management is resolved, Bank of America analysts said in a note last month, calling the situation a \u201cbig overhang.\u201d \n \n\n \n China\u2019s biggest manager of bad debt, Huarong, has been struggling with failed investment and a corruption case involving its former chairman, who was sentenced to death in January . \n \n\n \n After missing its March deadline to publish its 2020 results, the firm also said \u201c auditors will need more information and time to complete\u201d the audit procedures. It added, however, that failure to provide the results does not constitute a default. \n \n\n \n Huarong\u2019s biggest backer is the Ministry of Finance. China\u2019s economy will need to grow quickly enough to ensure the central government budget isn\u2019t strained further. \n \n\n \n If Huarong\u2019s case is resolved with government support, it should boost China\u2019s asset management sector, as well as other Chinese government-linked entities, says Bank of America. \n \n\n \n However, the bank added: \u201cIf there is a disorderly default of Huarong\u2019s dollar bond, we could see a broad sell-off of China credits, especially (investment grade) credits.\u201d \n \n\n \n Also: Government exceeds T-bills target by Ghs 434 million \n \n\n \n Regulators are pushing Huarong to sell non-core assets as part of a revamp, according to a Reuters report in early June. \n \n\n \n In the event of a Huarong default, the cost of capital could rise \u201csignificantly\u201d for other state-owned companies as \u201cmarkets re-evaluate perceptions of implicit guarantees by the state,\u201d Chang Wei-Liang, macro strategist at Singapore bank DBS, told CNBC via email. As risks go up, firms have to offer higher returns to draw investors. \n \n\n \n Chang said China has enough money on hand to address Huarong\u2019s problems. \n \n\n \n However, \u201cthe key question is whether the state will choose to intervene by providing support with additional capital, or by imposing losses on equity holders and debt holders first to reinforce market discipline,\u201d he added. \n \n\n \n 3. Weak points in some provinces and local banks \n \n\n \n In an effort to find out where potential hot spots for SOE defaults might be, S&P Global Ratings analysts found that small banks concentrated in north and south-central China face deteriorating asset quality. \n \n\n \n \u201cCity and rural commercial banks with above-sector-average problematic loans would have to write-off Chinese renminbi (RMB) 69 billion in these loans to bring their ratio to sector-average levels, with those in the Northeast worst hit ,\u201d the June 29 report said. \n \n\n \n That could affect the ability of small banks to support local state-owned companies, potentially requiring larger banks to step in to maintain system stability, the report said. \n \n\n \n The provinces with greater issues are those exposed to cyclical industries, S&P Global Ratings credit analyst Ming Tan told CNBC. \n \n\n \n Authorities need to strike a balance between allowing poorer quality loans to have a riskier rating, and keeping problems from accelerating, Tan said. \u201cThere\u2019s definitely risk of mismanagement happening down the road, but so far, what we\u2019re seeing, is this has been managed quite well.\u201d \n \n\n \n China\u2019s banking and insurance regulator disclosed last week that in 2020, the banking industry disposed of a record high 3.02 trillion yuan \u2014 or $465.76 billion \u2014 in non-performing assets. Other data released last week showed China\u2019s GDP grew 7.9% in the second quarter from a year ago, a touch below expectations. \n \n\n \n Some analysts have pointed to weakness at a local level. Pinpoint Asset Management analysis found that consumption declined year-on-year in May for four provincial capitals \u2014 Wuhan, Guiyang, Shijiazhuang and Yinchuan. \n \n\n \n \u201cA fiscally weaker province is probably related to a less dynamic economic situation, (and) a weaker economic situation means there could be more corporate bond defaults,\u201d said Francoise Huang, senior economist at Euler Hermes, a subsidiary of Allianz. \n \n\n \n The longer-term issue is restructuring the economy of these weaker provinces to allow more dynamic ones to grow, she said. \u201cI don\u2019t think the solution would be (to) continue investing into these less-performing sectors just for the sake of keeping them alive.\u201d \n "

"As China\u2019s debt risks grow, here are 3 warning signs to watch"

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