In the latest sign that corporate debt levels in China pose a threat to the broader economy, Chinese regulators on Friday were forced to halt trading in bonds issued by Evergrande, the country’s second-largest property developer. Concerns that the company will be unable to continue making payments on its obligations prompted a huge sell-off by investors, overwhelming exchanges.
The rush to unload bonds issued by the company — some were selling for as little as 26% of their face value — came after a report from Bloomberg that said two major trust companies that have made large loans to Evergrande had demanded immediate repayment.
The crisis at Evergrande comes just days after another major Chinese firm, China Huarong Asset Management, released a long-delayed earnings report showing it had lost $15.9 billion last year and that its debt-to-equity ratio at one point totaled an eye-popping 1,333%.
State-owned financial firms engineered a bailout of Huarong late last month to avoid a collapse that could have been catastrophic for the economy. However, there has been no indication of a similar soft landing for Evergrande, which has been selling off assets in a rush to raise the cash needed to satisfy lenders.
The companies’ response
Huarong told investors last Sunday that it believes it will be able to continue paying its creditors, and that in the "near future" it will begin selling off non-core business units to raise additional cash and replenish its capital. The company had already sold off more than half of its non-financial subsidiaries.
Evergrande, earlier this week, was forced to warn investors in an earnings statement that the group “has risks of defaults on borrowings and cases of litigation outside of its normal course of business,” adding, “Shareholders and potential investors are advised to exercise caution when dealing in the securities of the group.”
Nevertheless, a company statement said, "The group will do its utmost to continue its operations and endeavor to deliver properties to customers as scheduled.”
Debt defaults rising
The problem of unsustainable debt is not limited to huge firms like Evergrande and Huarong. In both 2019 and 2020, Chinese firms defaulted on more than $20 billion in debt, and analysts believe that 2021 is on pace to set a new record.
“Debt, whether public or private, does seem to be an Achilles heel for China, and accounting practices and reporting are murky,” said Doug Barry, a spokesperson for the U.S.-China Business Council.
“The state-owned enterprises are huge, with some of them hugely inefficient. It’s a problem that has caught the attention of government regulators, an important first step in fixing it,” Barry said. “The private sector is important to China’s future growth and care must be taken to avoid clamping down too hard on it.”
Beijing cracking down
In one sense, the spate of defaults can be seen as good news, insofar as it signals that the Chinese government has recognized that past practices were unsustainable. For years, large money-losing Chinese companies have been kept afloat by waves of new loans, often issued with the government’s blessing.
For the past several years, regulators in China have been trying to crack down on these so-called “zombie” companies, which divert assets from profitable enterprises, creating a drag on the economy.
Beijing’s increasing willingness to let firms default and go out of business, while painful in the short term, could be laying the groundwork for a stronger economy in the future. However, weak transparency requirements for onshore debt issuance make the real depth of the debt problem hard to discern.
‘China has a serious zombie problem’
“The Chinese economy has been suffering from excessive non-financial corporate debt for a long time,” said Tianlei Huang, a research fellow at the Peterson Institute for International Economics. “As a result, China has a serious zombie problem. Across the country, there are probably tens of thousands zombie firms that are persistently making losses but kept alive only by continuous bank credit and government subsidies.”
According to the Bank for International Settlements, at the end of 2020, the total debt issued to non-financial corporations in China equaled 161% of the country’s GDP. That was significantly higher than the average for G-20 countries (102%) and even the average for emerging market economies (119%).
“Excessive non-financial corporate debt may pose a threat to the stability of the broader financial system,” said Huang, who corresponded with VOA by email.
Bankers getting nervous
Over the years, Chinese banks, sometimes with the encouragement of government officials, have issued hundreds of billions of dollars in loans to Chinese firms. As defaults increase, banks’ ability to absorb loan losses will deteriorate.
There are signs that bankers are getting nervous. In July, China Guangfa Bank moved to freeze some of Evergrande’s assets out of fear that the company would be unable to satisfy a loan set to come due next March.
Evergrande’s struggle is particularly worrisome to banks because of what it says about the real estate development sector more broadly. Loans to real estate ventures make up a large share of the loan portfolios of Chinese banks, so if Evergrande is unable to service its debts, that will call into question the quality of the other real estate-based assets on bank balance sheets.
Difficult balancing act
Until recently, there had been an implicit assumption among many lenders and investors that large distressed companies in China were considered “too big to fail” and would be bailed out by the government.
By allowing a number of these firms to default on their obligations over the past few years, said Huang, “Beijing was attempting to signal to all credit market participants that ‘too big to fail’ no longer holds and that it intends to allow more ill-managed state firms to default on their bonds.”
The bailout of Huarong this summer shows that, at least in some cases, Beijing will still feel the need to step in.
“The approach the Chinese regulators are taking is to expose risks in bond defaults gradually and at the same time to avoid anything that may explode abruptly, threatening financial stability,” said Huang. “This means there will be fewer government bailouts going forward, but for companies viewed as systemically or strategically important, bailouts will probably continue.”