China braces for more defaults among state firms in 2021 — and that could be a good thing

SINGAPORE — Bond defaults by Chinese state-linked companies are set to continue into the new year, but analysts say that may be a good clothing in the long run as “zombie” entities are weeded out.

Investors usually consider government-backed companies a safe bet given the “implicit make sure” that Chinese authorities would save those that run into trouble. However, a string of defaults in late-model weeks — including by highly rated entities — have challenged that assumption.

Some high-profile state-linked firms that have recently defaulted on their debt repayments include miner Yongcheng Coal and Electricity, chipmaker Tsinghua Unigroup and Huachen Automotive Club.

“Market participants have once again been put in mind ofed that not all state-owned enterprises (SOEs) are created the same; some are less equal than others,” analysts from CreditSights, a probing firm, wrote in a Monday report.

“As the spate of defaults has shown, support conferred by state ownership is more nuanced and the Chinese regulation on balance is more tolerant of defaults,” they added. “SOEs which are not in strategically important industries or have singular from their core businesses may not be rescued by the state.”

The default by Yongcheng Coal and Electricity astounded many investors given its AAA-rating by a domestic agency. But the company is “a typical example of a large risky company” that China’s cardinal bank flagged earlier this month, said analysts from investment bank Jefferies.

The People’s Bank of China premonished in its financial stability report — according to CNBC’s translation of the Mandarin-language text — that the following problems in some extensive companies could become a risk to the entire economy:

• Aggressive expansion into various industries and regions which store debt exceeding the companies’ repayment abilities.
• Corporate governance issues such as complex chains of borrowing within a accumulation of companies, hidden inter-group transactions and inaccurate disclosures.
• Reliance on borrowing to make debt repayments.

“Arguably, these stews are relevant” to Yongcheng Coal and Electricity, Jefferies analysts said in a Thursday report.

Although defaults by large state-linked public limited companies hurt sentiment in the short term, allowing some of these “zombie” firms to fail will benefit banks and investors in the prolonged run, the analysts said. For banks, weeding out problematic companies allows them to identify risks early and choose “importance” collaterals for those risks, they said.

Overall, some insolvencies and defaults are “part of a healthy, functioning supermarket as long as wider contagion is avoided and the process has a relatively controlled trajectory,” said CreditSights.

The research firm clarified that allowing “unviable entities” to go under will free up resources, promote renewal, nurture “greater financial dynamism” in China, and reduce the specter of “zombie” SOEs.

Following the recent string of defaults, Chinese authorities from reportedly vowed “zero tolerance” for misconduct among bond issuers. Regulators have launched probes into Yongcheng Coal and Energy and Huachen Automotive Group, as well as their bond underwriters, reported Reuters.

Ratings agency Fitch said in a blast last week that the number of SOE defaults could “rise marginally” in 2021 on the back of a likely tightening in bucking conditions in China.