What do China’s SOE bankruptcies, debt issues and reforms mean?

By Shivani Singh

Singapore 21/12/2016 – The recent China state-owned enterprise bankruptcies – Guangxi Nonferrous Metals Group and Dongbei Special Steel – signal Beijing is gradually allowing market forces to play out even as they sound a warning to others to clean up their act.

The bankruptcy of Guangxi Nonferrous – the first collapse of a base metals producer in Guangxi, with the company defaulting on debts of $2 billion, has cast a shadow over industry as the government is pushing for the reforms of debt-burdened SOEs.

Meanwhile, Dongbei Steel, the Liaoning provincial government-owned special steel producer in northeast China, was the first Chinese steel company to go bankrupt. The steelmaker faces a $10 billion debt claim as it undergoes bankruptcy proceedings and a restructuring of the main company and its subsidiaries.

These may not be the last SOE bankruptcies we hear about as Beijing tries to find a way to balance achieving 6.5% growth in 2016-2020, combined with socio-economic and political stability and reforming its struggling industries.

A pilot case

The International Monetary Fund has warned that China needs to address its corporate debt problem.

“[The IMF has] encouraged the authorities to harden budget constraints on SOEs; triage and restructure or liquidate over-indebted firms; and recognise losses and share them among relevant parties, including the government if necessary. Piloting a few SOEs would make a strong start to the process.”

So allowing a “zombie company” to fail in Guangxi could be considered a pilot in that sense.

But allowing too many zombie companies to fail too quickly would be risky and excruciating, bearing in mind the social and economic repercussions the country would then face.

Looking at what’s been happening in China, one can surmise that the first SOE bankruptcy in 2016 in the metals space is a sign that the credit risk for local and regional governments is increasing, even as the central government is urging market forces to play a bigger role in the economy.

China’s total debt is 225% of GDP, while corporate debt is 145% of GDP. By the IMF’s calculation, SOEs account for 55% of corporate debt and that is far greater than their 22% share of economic output, making them less profitable than private enterprises.

China’s base metals market participants overall have been very cautious in the past couple of years when it comes to credit risk and counterparty risks.

A large SOE that runs a metals trading house had set up a second physical base metals trading desk a few years ago, but, after the Qingdao scandal, they wrapped up the extra desk, and let go of its people as shrinking liquidity and credit issues became a reality.

Central vs regional

One has to look at the tussle between Beijing and provincial governments and at the larger factors that are in play.

On one hand, there are the supply-side reforms that Beijing promotes alongside the need to move to a more market-driven economy to drive growth even as the country moves from a manufacturing-driven to a consumer-driven economy. On the other hand, the regional and local governments need to protect workers as some of these troubled or debt-laden companies are very large sources of employment.

In the Chinese steel industry, there are probably more zombie companies and bigger problems of overcapacity than in non-ferrous, where the aluminium sector has the most overcapacity.

Beijing has talked about supply-side reforms but any cuts in capacity across industries have been mitigated by new capacity coming online. In the short-term, the modernisation of capacity might have minimal impact but in the longer run will lead to competitive and efficient Chinese metal producers.

Other reform measures include the drive for the implementation of environmentally friendly measures within industries.

But the need to maintain overall employment levels by local governments remains a huge motivating factor that saves companies from going bust and hence we might see more consolidation and some bailouts in this sector.

Moody’s Investor Service has noted that the debt burdens of regional and local governments constrain their ability to provide support to ailing industry. It adds that local government SOE liability amounts to more than 35 trillion yuan ($5 trillion) nationally, which is more than 100% of revenue.

Some major cities and provinces – for example, Beijing, Shanghai and Guangdong – also demonstrate standalone fundamentals that position them much more strongly to financially support their SOEs, while less economically and financially robust regional and local governments are more constrained, Moody’s said.

Risks, rules and regulations

The fear is that if there is large-scale unemployment there could be a social uprising in a socialist country, where market forces do not have free rein.

So to keep industry going, while sticking to its overall strategy, Beijing has taken market oriented steps such as debt restructuring or encouraging mergers and acquisitions.

It has also been supporting the idea of debt to equity swaps, giving these zombie companies an easier but more expensive way out of debt repayments.

For example, Sinosteel is trying a debt-to-equity swap to restructure its 100 billion yuan loan.

“Banks, along with the government, SOEs and investors, will likely bear a large share of the costs of SOE reform, especially the costs of debt restructuring. Loans to SOEs accounted for 30% of total bank loans of RMB81.4 trillion as of year-end 2014, according to the latest People’s Bank of China (PBOC) data,” Moody’s said.

However, some of China’s large banks are not so keen on premier Li Keqiang’s plans for bad loans to be converted into equity for banks. China Construction Bank Corp chairman Wang Hongzhang said that he is not in favour of “bad debt [being converted] into bad equity”.

Also some details are unclear as to what steps the Chinese government will take including but not limited to cash injections into the banking system and easier capital rules for banks if bad loans are transferred from SOEs to “bad banks” as equity.

Meanwhile, certain corporate and bankruptcy rules in China do not help in expediting market-driven closures.

“Under China’s bankruptcy law, banks are the last in the queue to be compensated if a company is wound up, which is why many banks continue to roll over loans to businesses that may be unviable in the long run, as, should they refuse to do so, it is likely they would have to realise the whole loan as a bad loan loss,” Macquarie analysts said in a note in August.

In November, the trading of complex financial derivatives such as credit default swaps started in China after more than 20 local bonds missed payments this year. The CDSs provide insurance and are used as a hedging tool against bond failures.

So 2016 did see some watershed moments, including the first SOE metal producer bankruptcy, and we can safely say bailouts going forward will be on a case-by-case basis.

With China standing by a market-oriented approach not all SOEs will be saved, and lower-tier enterprises with provincial government backing could still go bust if they are not able to manage their debts and restructure in time.

In this environment, where risks of contagion run high, it would be good to remember that governments usually try to protect the ones that are “too big to fail”, fearing that any such failures could be catastrophic for the wider economic system.

We saw this in the USA during the global financial crisis of 2007-2009, when some banks and financial institutions were given government bailouts while others, such as Bear Stearns, were not. The world is still emerging from that meltdown almost a decade later.

So if the threat is of a large-scale bankruptcy that could cause systemic turmoil, it is likely that Beijing will not let it happen. But if the firm in trouble is a smaller SOE in a smaller province, you might not see that bazooka bailout.

(Editing by Wei Jun Lau)