A trio of high-profile defaults in China is pushing up the funding costs of local government-owned enterprises. The strain comes as the entities encounter a steep maturity wall in 2021. S&P Global Ratings believes the failures will raise refinancing risks on US$25 billion of bonds due this year.

We also see a geographic dimension to the sell-off. Investors have become cautious about state-owned firms based in provinces they perceive as weaker or as being associated with recent defaults. Such provinces include Henan, Chongqing, and Yunnan.

Investor caution about the sector has been building since last year, after a series of defaults shook the long-held belief in China that the government would always bail out the firms it saw as important.

The surprise default, in September, 2020 of Yongcheng Coal & Electricity Holding Group Co. Ltd. rattled that expectation. The entity is one of the largest state-owned enterprises (SOEs) in Henan province.

In January, the Hebei government tried but failed to avert the default of China Fortune Land Development Co. Ltd. (CFLD), a large private enterprise. That was followed by the missed payment last week of the state-owned Chongqing Energy Investment Group Co. Ltd. (CQEG). The firm is a major energy supplier to the municipality of Chongqing.

As investors lost faith in the state's implicit guarantee on SOE debt, bond prices fell. In recent months, certain local state-backed issuers have seen their dollar financing costs rise by as much as 300 basis points.

Events have revealed investor sensitivity to perceived provincial fiscal weaknesses. Some regions have less fiscal capacity to bail out troubled entities based there, making the implicit guarantee more tenuous and failure more likely.

This has prompted investors to more carefully evaluate the credit risk of each entity, and price their debt accordingly. The strains will likely polarize yields and funding access among SOEs, with entities belonging to some provinces hit harder.

Chart 1

Prices have dropped the most for bonds issued by SOEs in Hebei, Henan, Chongqing, Yunnan, and Xinjiang. Deteriorating sentiment may spread to other provinces that have seen increased stress in their SOEs.

For example, entities from Tianjin may face refinancing challenges if the weak recovery in their SOEs' businesses leaves little room for adequate debt servicing. Relying on fresh financing to repay existing debt exposes such entities to the risks of weakening investor support and rising funding costs.

Risks Rise From Coastal To Inland Provinces

Among the thousands of Chinese local government-owned SOEs, 213 issuers have issued 295 international bonds totaling US$100 billion. The average tenor of these bonds is short, at about two years. About one-quarter (US$25 billion) of these bonds will mature this year.

The level of economic development and per capita income tend to decrease the further one moves from China's coast to its inland regions. Investors often see geography as indicative of a local government's credit strength and the resources they have to support their SOEs. As a result, SOEs' market access and funding costs vary widely across regions.

SOEs from China's four tier-one cities (Beijing, Shanghai, Shenzhen, and Guangzhou) are able to issue longer-term debt, at an average of about 2.2 years. The firms also get the lowest average interest cost among regions (2.8%). Coastal provinces pay nearly 100 basis points more for similar tenors (see chart 2).

SOEs in inland provinces of the central region issue shorter-tenor debt--about 1.7 years, on average. They also pay nearly a fifth more in interest costs than their peers along the coast. Lastly, the provinces of the western region issue similarly short-dated debt and pay the highest rate of all: 4.8%.

Shorter tenors of the western and central regions reflect lower investor willingness to buy longer-term bonds from SOEs in those provinces, in our view. Likewise, we believe market access will be limited for entities from fiscally weaker provinces, given the recent price drop on debt issued by local-government SOEs, and the eroded confidence stemming from the three default events described above.

Chart 2

Regions' Maturity Walls Vary Widely

The largest groups of Chinese state-owned issuers with the most U.S.-dollar bonds outstanding are from Shandong (27 names, US$14.4 billion), Beijing (13 names, US$12.6 billion), Jiangsu (29 names, US$9 billion), Zhejiang (23 names, US$7.9 billion) and Sichuan (17 names, US$6.9 billion). These make up just over half of the market and 57% of the bonds due this year (see chart 3).

Chart 3

Among these top-five issuer regions, only Jiangsu SOEs have a relatively low proportion of their U.S.-dollar debts coming due this year (at 17% of the total; see chart 4).

Chart 4

The other four regions have a significantly higher portion of their offshore debt coming due this year. The maturity wall could expose SOEs with weak credit quality to refinancing risk as credit conditions tighten and funding costs rise. An unexpected distress event within this group might hit sentiment for the entire market.

Other regions may encounter distress events given the large, looming maturities for their SOEs amid heightened funding costs. About 30% of Tianjin SOEs' U.S.-dollar debt is due this year, while about one-third of such debt for SOEs in Chongqing, Gansu, and Shaanxi will be also coming due. Fully 71% of the U.S.-dollar debt issued by Hubei SOEs will mature this year.

Weaker fiscal positions of Hubei and Shaanxi in particular could complicate the refinancing of their SOEs. (see "China Provincial Governments' Risk Indicators," published on RatingsDirect on Sept. 22, 2020).

Default Events Reveal Provincial Patterns

The three key defaults described above hit the SOE sector in quick succession. Yongcheng rattled investors from September to December 2020, CFLD then took over and triggered more sell-offs from January to February 2021, with CQEG following in March to deliver the third round. The serial impact pummeled investor faith in state support.

Significantly, the events hit debt prices for entities that are not directly related to these three names. Bond prices for local government SOEs dropped one to five cents on the dollar in the aftermath of the defaults (see chart 5), while yields jumped 100-300 basis points (see chart 6).

Chart 5

Chart 6

The bonds issued by SOEs of provincial governments associated with Yongcheng, CFLD, and CQEG were hit most severely. These include firms owned by Henan, which owned Yongcheng; Hebei, which tried but failed to avert CFLD's default; and Chongqing, which owned CQNE.

The large price swings were also observable throughout the SOE sector, particularly for regions perceived as weaker, such as the more inland and lower-income Xinjiang and Gansu provinces. SOEs owned by provinces with a history of SOE defaults were also colored by these events. This includes Tianjin, which owned the default ted Tewoo Group Co. Ltd. and Tianjin Real Estate Group Co. Ltd.

Finally, SOEs of provinces that own other troubled or distressed firms were pulled into the sell-off. Examples include Hebei, which owns Jizhong Energy Group Co. Ltd. and Yunnan, which owns Yunnan Health & Cultural Tourism Holdings Group Co. Ltd. and Yunnan Provincial Investment Group Co. Ltd.

As Transparency Grows, So Does The Possibility Of Contagion

The events suggest that second-order effects are emerging and liquidity is improving in a market that has been known for having little of either in the past. In other words, China's overseas bond market is becoming liquid and transparent enough to experience an old-fashioned contagion effect.

We note further that many SOEs of provinces most affected by the Yongcheng default were hit again by the failures of CFLD and CQNE. This supports the idea that certain provinces are more sensitive to these events than others. State-backed firms based in fiscally weaker regions with a high number of faltering SOEs may be more vulnerable to sentiment hits when more defaults arrive. They may also face higher refinancing risks in the coming year.

The combination of tightening credit conditions, large looming maturities, and emerging contagion effects elevate refinancing risks this year. This raises the prospect of more and larger SOE defaults to come. Credit analysis focused on the stand-alone credit profile and an entity's self-debt servicing will be more important than ever as government support becomes increasingly more selective.

Related Research

• No Hiding Off-Budget Risks For China's Local Governments, Dec. 1, 2020.
• China Provincial Governments' Risk Indicators, Sept. 22, 2020.