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China Recovery Could Bring More Defaults

HONG KONG (S&P Global Ratings) Nov. 17, 2020--The market in China is refocused on corporate default risk and market workouts as several state-owned enterprises (SOEs) come under credit stress. Last week's missed payment by a company that seemed to be getting state support shows government willingness to accept default could be on the rise as the economy recovers from the COVID-19 shock, S&P Global Ratings said today.

"More defaults are coming as Chinese authorities refocus on deleveraging of SOEs now that the worst of the pandemic has passed," said Chang Li, China country specialist at S&P Global Ratings. "Default rates are still low overall, however, and will unlikely lead to systemic risk."

A missed bond payment by Yongcheng Coal and Electricity Holding Group Co. Ltd. (YMD) led to sell-off in China bonds of SOEs in the same province, Henan. YMD's failure to pay when due on Nov. 10, 2020 could lead to a cross default by its parent, Henan Energy and Chemical Industry Group Co. Ltd. Including both companies, that puts Chinese renminbi (RMB) 50 billion (US$7.6 billion) at risk of default. We do not rate either of these companies.

In our view the sell-offs, which were sharper for domestic than overseas bonds, reflect the potential willingness to allow even large SOE to default. Henan Energy is one of the largest SOEs in Henan province. It is in the coal and chemical industry, with total revenue of more than RMB180 billion in 2019 and total debt of RMB130 billion yuan. Besides the bond sell-off, more than RMB20 billion in planned domestic bond issuance was cancelled in the week following YMD's missed payment.

We believe risk aversion may have been heightened by a seemingly abrupt removal of government support. Before missing its RMB1 billion bond payment, YMD was believed to be swapping loss-making chemical businesses for profitable coal businesses. Moreover, YMD had issued an RMB1 billion medium-term note in October. These actions together were taken as signs of government support.

"In our view, YMD's missed payment surprised the market because it indicated the local government's attitude to provide support had reversed within just one month," said Mr. Li. "The market may see this as a signal that the SOE deleveraging and reform will accelerate as the economy recovers from the pandemic."

Like most stressed SOEs, YMD and its parent have weak credit profiles. For example, Henan Energy's ratio of debt to EBITDA exceeded 9x at the end of 2019. In this sense, their credit stress and default are not completely outside of investor expectations. We believe market participants are more attuned to default risk, which has been on the rise since 2018. Moreover, credit conditions have tightened in the second half of the year.

China's multi-year program to reduce deleveraging has not been very effective, and the pandemic added a new layer of stress as revenues declined and, in some cases, debt rose to plug cash flow holes (see "Rising Funding Costs May Tip China's Weaker SOEs Into Default," published on RatingsDirect on Sept. 15, 2020). SOE deleveraging campaigns may still be one of the top priorities for China authorities. Besides anything else, it is an important way to meet a three-year SOE reform target for a significant improvement in operating efficiency.

We also expect that the strain put on public resources will lead to more market-based debt restructuring in China. The pandemic and increasingly stringent regulations from central authorities could restrain local governments' power to coordinate financial resources, and even the willingness to provide support. Debt restructuring is often the preferred option for many stakeholders because it preserves the company as a going concern without hurting local employment, helps the corporate restore refinancing capacity by improving business performance, and provides a higher recovery rate for creditors than liquidation does (see "China Paves Way For Better Default Resolution Systems," July 27, 2020)

We don't anticipate this run of SOE distress will cause systemic risk, given the default rate in China is still well below 1% of outstanding bonds. However, the government will likely take steps to address investor concerns on information disclosure or poor governance--such as failure to pay even with cash at hand, or moving assets around to limit recovery. The interbank market regulator NAFMII has said it would look into the whether YMD and intermediary companies had properly disclosed risks. A more transparent market can facilitate government's deleveraging efforts and market-based corporate debt restructuring.

We believe that investors will focus more on the stand-alone credit profile (SACP) of companies amid these signs that government support is waning. Indeed, weaker SACPs will likely, in our view, correlate with lower odds of timely support for more commercially minded SOEs. As such, SOE funding conditions will continue to diverge, and default risk will also increase in both onshore and offshore market.

We believe the government willingness to support will remain stronger for more public policy-focused SOEs. Nonetheless, the trend of credit polarization is likely among these SOEs as well, as reforms push governments to commercialize some of their operations and rely on them less for policy investments.

Table 1

SOE Credit Events Since Late October
Issuer Event date Outstanding onshore bonds (bil. RMB ) Province/Gov't Event
Huachen Automotive Group Holding Co Ltd 23-Oct-20 17.2 Liaoning Failed to repay its private bond of RMB1 billion.
Shenyang Shengjing Energy Development Group Co. Ltd. 23-Oct-20 0 Liaoning An application to restructure this heating service provider was accepted by the local court, with two outstanding onshore bond totaling RMB500 million immediately due. The guarantor of the bonds then reportedly repaid the bonds days later.
Tsinghua Unigroup Co. Ltd. 29-Oct-20 17.7 Central gov't owned The company decided not to exercise the call option on its RMB1 billion private perpetual bond. On Nov. 16, it defaulted on a different RMB1.3 billion bond after failing to secure an extension for repayment.
Qinghai State-Owned Assets Investment Management Co. Ltd. 30-Oct-20 13.3 Qinghai The company announced it would not recall the RMB1.5 billion perpetual bond, leading to a coupon step-up of 309 bps; merely a month earlier it has said it would rall the bond.
Yongcheng Coal & Electricity Holding Group Co. Ltd. 10-Nov-20 24.4 Henan Unexpectedly defaulted on a RMB1 billion bond, sparking the risk of major cross-default after a 10-day grace period. It repaid the coupon of the defaulted bond three days later.
Henan Energy & Chemical Industry Group Co. Ltd. 10-Nov-20 25.5 Henan As the parent company of Yongcheng Coal and Electricity, about 45% of the company's outstanding bonds face cross-default risk due to pre-existing clauses.
Data as of Nov. 17, 2020. SOE--State-owned enterprise. RMB--Chinese renminbi. Source: Wind, Bloomberg, S&P Global Ratings.

Related Research

This report does not constitute a rating action.

S&P Global Ratings, part of S&P Global Inc. (NYSE: SPGI), is the world's leading provider of independent credit risk research. We publish more than a million credit ratings on debt issued by sovereign, municipal, corporate and financial sector entities. With over 1,400 credit analysts in 26 countries, and more than 150 years' experience of assessing credit risk, we offer a unique combination of global coverage and local insight. Our research and opinions about relative credit risk provide market participants with information that helps to support the growth of transparent, liquid debt markets worldwide.

China Country Specialist:Chang Li, Beijing + 86 10 6569 2705;
chang.li@spglobal.com
Secondary Contacts:Christopher Lee, Hong Kong + 852 2533 3562;
christopher.k.lee@spglobal.com
Charles Chang, Hong Kong + 852-2912-3028;
charles.chang@spglobal.com
Gloria Lu, CFA, FRM, Hong Kong + 852 2533 3596;
gloria.lu@spglobal.com
Research Assistants:Boyang Gao, Beijing
Alex Yang, Hong Kong

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