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As China’s debt risks grow, here are 3 warning signs to watch

Signage illuminated at the China Huarong Asset Management Co. headquarters on Financial Street in Beijing, China, on Wednesday, May 19, 2021.

Yan Cong | Bloomberg | Getty Images

BEIJING — Weak spots are emerging in China’s growing debt pile.

National debt levels have climbed to nearly four times of GDP, while an increasing number of corporate bonds have defaulted in the last 18 months.

Although the latest defaults represent a fraction of China’s $13 trillion onshore bond market, some high-profile cases have rattled investors since the common perception has been that the Chinese government will not let state-supported firms fail.

The case of Chinese bad debt manager Huarong has also spooked investors, causing a market rout this year when the firm failed to file its earnings in time and its U.S. dollar-denominated bonds plunged.

Analysts said cases like these signal how the state’s so-called implicit guarantee is changing as the government tries to improve the bond market’s quality — weeding out the weaker firms, and allowing for some differentiation within the industry.

As China’s growth slows, authorities are looking to strike a better balance between maintaining control and allowing some market-driven forces into the economy in order to sustain growth in the long term.

In the first half of this year, the total number of defaulted corporate bonds in China amounted to 62.59 billion yuan ($9.68 billion) — the most for the first half of a year since 2014, according to data from Fitch Ratings. Of that, defaults by state-owned companies contributed to more than half that amount — about 35.65 billion yuan.

For the whole of 2020, bond defaults amounted to 146.77 billion yuan, a huge leap from just six years ago in 2014, according to Fitch. That year, defaults totaled 1.34 billion yuan, and there were no defaults by state-owned firms, the ratings agency said.

As investor fears ramp up, here are three important developments to watch, economists say.

1. Bond default in a grey area of local government

A major milestone to counter the idea of implicit guarantee in China’s market would be a default of a bond issued by a local government financing vehicles (LGFV).

These companies are usually wholly owned by local and regional governments in China, and were set up to fund public infrastructure projects. Bonds issued by such firms have been surging amid an infrastructure push as the Chinese economy improved.

“Many LGFV are even worse than so-called Zombie companies, in the sense that they could not pay the interest, not (to) mention the principal on their own,” Larry Hu, chief China economist at Macquarie, said in a June 25 note. Zombie companies are those that are heavily indebted and rely on loans and government subsidies to stay alive. “They could survive only because of the supports from the governments.”

“The year of 2021 is a window to break implicit guarantee, as it’s the first time in a decade that policymakers don’t have (to) worry about the GDP growth target. As a result, they could tolerate more credit risk,” Hu said, noting it’s only a matter of time before an LGFV bond default occurs.

In 2015, electrical equipment manufacturer Baoding Tianwei became the first state-owned enterprise to default on its debt, following the first default in China’s modern onshore bond market a year earlier.

Nomura said LGFVs are a “major focus” of China’s tightening drive, and noted that bonds issued by the sector surged to a record 1.9 trillion yuan ($292.87 billion) last year, from just 0.6 trillion yuan in 2018.

2. Huarong’s ‘big overhang’ on the sector

For investment-grade bonds in China, a major factor for future performance is how the case of Huarong Asset Management is resolved, Bank of America analysts said in a note last month, calling the situation a “big overhang.”

China’s biggest manager of bad debt, Huarong, has been struggling with failed investment and a corruption case involving its former chairman, who was sentenced to death in January.

After missing its March deadline to publish its 2020 results, the firm also said “auditors will need more information and time to complete” the audit procedures. It added, however, that failure to provide the results does not constitute a default.

Huarong’s biggest backer is the Ministry of Finance. China’s economy will need to grow quickly enough to ensure the central government budget isn’t strained further.

If there is a disorderly default of Huarong’s dollar bond, we could see a broad sell-off of China credits, especially (investment grade) credits.

Bank of America

If Huarong’s case is resolved with government support, it should boost China’s asset management sector, as well as other Chinese government-linked entities, says Bank of America.

However, the bank added: “If there is a disorderly default of Huarong’s dollar bond, we could see a broad sell-off of China credits, especially (investment grade) credits.”

Regulators are pushing Huarong to sell non-core assets as part of a revamp, according to a Reuters report in early June.

In the event of a Huarong defa