Brace for more defaults by China state-owned businesses, analysts warn.

A huge bond default by a large state-owned business spooked investors last week, prompting experts to question if it’s a sign that Chinese government bailouts may be dwindling.

“We believe bailouts will be increasingly selective, leading to more defaults by SOEs,” said ratings agency S&P Global Ratings in a note, referring to state-owned enterprises in China.

The remarks came after Chinese commodities trader Tewoo Group — owned by the Tianjin government — failed to repay its U.S. dollar-denominated debt last week, in what has become the largest default among SOEs in the country in about 20 years. It was the first state-backed company to default since 1998.

Some have even predicted that China may increasingly withhold bailouts to its state-owned enterprises, and instead, allow distressed companies to rely on markets-based solutions.

China’s ‘de-risking’ campaign

Assessing the recent defaults in China, Nathan Sheets, chief economist at PGIM Fixed Income told CNBC on Wednesday: “I interpret this from the perspective of President Xi (Jinping)’s ongoing de-risking campaign, trying to increase the financial discipline in the system.”

He said it was significant that Chinese leaders now “feel comfortable enough about the outlook that they’re willing to let some firms fail.”

“It’s discipline, that’s the way it’s supposed to work,” said Sheets, who was Under Secretary of the Treasury for International Affairs under the Obama administration from 2014 to 2017.

Chinese corporate debt has been under the spotlight recently, as analysts warned of record levels of defaults.

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Moody’s Analytics told CNBC on Tuesday that Chinese corporate debt is the “biggest threat” to the global economy. In addition, Fitch Ratings said last week that a record high of 4.9% of China’s private issuers defaulted on onshore bond payments — or yuan-denominated bonds — in the first 11 months of 2019. That’s a jump from 0.6% in 2014, Fitch said.

Investors “will start realizing that state intervention isn’t always happening,” Tuuli McCully, head of Asia-Pacific economics at Scotiabank, told CNBC on Wednesday.

While the increasing level of defaults is concerning, there is also “a certain need for this,” McCully said. “I think the pricing of risk in the Chinese economy has not been adequate … Investors will start realizing state intervention is not always happening.”

So far, defaults by state-owned entities (SOEs) have been relatively rare in China’s bond market. Just six government-owned companies have defaulted this year, compared to 42 private companies, according to a Reuters calculation of official data.

Markets-driven restructuring

In its debt restructuring effort, Tewoo offered its investors a repayment that made them take huge discounts that were as deep as 63%.

Among its investors, 57% accepted that offer, while 22.6% opted for the second route: to exchange their debt for new bonds issued by a state asset manager — also a Tianjin-based state enterprise — which offered much lower coupons.

It has crushed the long-held myth by many market participants that SOEs no matter how weak will be bailed out by their government masters.

In a report following that announcement, S&P Global Ratings said it considered Tewoo’s dollar-debt restructuring to be a default, and called it a “landmark case.”

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“(It) demonstrates a growing tolerance for defaults by distressed SOEs,” S&P Global analysts wrote, adding that this will apply to both onshore and offshore markets.

S&P pointed out that local governments “simply don’t have the means” to support all SOEs amid a weakening economy as well as falling tax revenues.

The Tewoo case, it said, reflects the Tianjin government’s willingness to adopt “market-driven” debt restructuring rather than “unconditional bailouts.”

“Tewoo’s debt restructuring may set the framework for other distressed SOEs with large offshore debt. More importantly, it has crushed the long-held myth by many market participants that SOEs no matter how weak will be bailed out by their government masters,” said S&P Global in its report.