Over the past two decades, a handful of private entrepreneurs transformed Zouping county in China’s Shandong province from a rural backwater best known for its yams into an industrial hub home to one of the world’s largest aluminium producers.
But the years of aggressive, highly leveraged expansion have also turned Zouping and several neighbouring counties into a hotspot for corporate defaults, most recently with privately held corn oil producer Xiwang Group’s failure to repay a Rmb1bn ($143m) bond.
The distress in Shandong has become a harbinger for financial risk across the country this year. A wave of defaults on corporate bonds has pushed China’s private sector default rate to a record 4.9 per cent as of the end of November, according to Fitch Ratings, up from 0.6 per cent in 2014.
With economic growth at its slowest in three decades and financial pressure on companies increasing, investors are questioning how much Beijing will continue to cushion distress among private companies in places such as Shandong.
“A lot of people are betting that the government will support these companies because they are big taxpayers and employers,” said Edmund Goh, Asia fixed-income investment director at Aberdeen Standard Investments in Shanghai. “But we think there are too many for them to all be bailed out.”
Defaults on corporate bonds are relatively new to China. Before a 2014 default by a Shanghai-based solar company, the country had gone more than a decade without one.
Value of China’s corporate bond market
That semblance of stability was a byproduct of a flood of credit that ensured unpaid debts were rolled over or refinanced. The excess credit also made it cheaper for large companies to expand rapidly and hire more workers, fuelling economic growth.
But the situation has changed. Economic growth has cooled by about 1.5 percentage points, to 6 per cent in the most recent quarter. In step with that, the previously easy credit has turned into troublesome bad debt, paralysing many small banks with unmanageable piles of non-performing loans. Liquidity has become tight in the past two years.
“You were too aggressive in expansion but now you don’t have the same access to credit,” a senior strategist at a global investment management group said of the mentality at many private sector companies that are now facing defaults.
The government‘s strategy has been to allow controlled defaults with the aim of maintaining a sense of stability in China’s $4.4tn corporate bond market. But Beijing’s recent lack of support for several prominent state-owned companies has unnerved some investors.
Last week, state commodities trader Tewoo Group forced creditors to take deep discounts on a $300m dollar-denominated bond. That followed state-backed technology conglomerate Founder Group’s failure to repay a Rmb2bn bond in early December.
With government support waning for large state-owned groups — traditionally the first on the list for rescue — the outlook among analysts for China’s private sector has deteriorated.
“It’s more likely for private enterprises to face defaults [compared with state-owned companies] when there is a tightening of liquidity and an economic downturn,” said Jenny Huang, director of China corporate research at Fitch Ratings. “The support for private enterprise has been selective because local governments have limited resources.”
Zouping and Shandong province are a microcosm of China’s private sector pain.
Shandong has a high concentration of large industrial groups that used the past decade of easy credit to grow to a massive scale. Many of those industries — petrochemicals, aluminium and steel — are now suffering from overcapacity, and the economic slowdown has strained their profitability and ability to repay debts.
Zouping’s Xiwang Group embodies the problem. It bought Kerr, a Canadian sports nutrition company, in 2016 for $500m — an acquisition that contributed to a doubling of its debt to Rmb27bn between 2013 and 2017. As access to credit dried up this year, Xiwang was forced to borrow Rmb3bn from a local government bailout fund but nevertheless defaulted on a Rmb1bn bond in late November.
Shandong Ruyi, a textile group based in Jining, about 200km south of Zouping county, amassed a vast portfolio of overseas fashion brands in the past five years, including 248-year-old Savile Row tailor Gieves & Hawkes. In the process it inflated its debt to five times its core earnings as of 2018, prompting investor concerns over its future stability.
“We view the plight of Shandong privately owned enterprise as indicative of China’s wider challenge: the difficulty of transitioning to a higher value-added economy, while managing high debt and slowing growth,” S&P Global Ratings said in a recent report.
To make matters worse, many Shandong-based companies have arrangements with peers in which one company guarantees a loan for another to convince banks to lend more.
In theory, this helps spread the risk if a single company faces repayment problems but when entire industries come under fire, a network of such cross-guarantees can threaten the stability of all involved. It has also made Shandong a hotbed for risk.
Xiwang Group’s default last month sparked a sell-off of dollar-denominated bonds at Zouping-based Hongqiao Group, one of the world’s largest aluminium producers, underlining concerns over financial contagion in the region.
Getting financial risks under control has been a top priority for Xi Jinping, China’s president, who views market disorder as a threat to Communist party rule. Distress at large corporations is also likely to result in higher unemployment, often a trigger for social instability.
But financial experts have also interpreted the higher bond default rate as a sign that regulators are more confident in China’s ability to weather market turmoil, and are seeking to weed out weak companies by letting them collapse.
“So why now? I think it is partly because they know they have no choice but to get debt under control,” said Michael Pettis, a professor of finance at the Guanghua School of Management at Peking University in Beijing. “Maybe now they feel that the risk of a chaotic repricing [in the corporate bond market] is not as great as it used to be.”