VSHINA A has been trying to clean up bad debts for years. Although it made some progress before the pandemic, the task often seems interminable, it remains crucial for the long-term economic development of the country and for the growing ranks of global investors exposed to Chinese stocks and bonds. The government insists it wants more market discipline and a transparent process to let companies default without blowing up the financial system.
Today, those claims are put to the test by the crises of Huarong, a state-run financial conglomerate, and Evergrande, the country’s largest real estate company. Together, they have some $ 540 billion in liabilities, which they will struggle to repay. Their contrasting destinies show that China’s approach is still driven by politics and improvisation and not by market forces and the rule of law.
The level of debt is staggering. The non-financial private sector owed the equivalent of 222% of GDP at the end of 2020. Most of this goes to businesses. In comparison, America’s private non-financial debt is 164% of GDP. Tensions in the real estate and interbank markets often intensify.
The government has urged the courts to play a bigger role in debt restructuring, as they are doing in the United States, with its Chapter 11 procedure. Yet in China, the culture of “extend and pretend” is deeply rooted. The default rate on bonds is artificially low and is unlikely to exceed 1% this year, well below the global corporate default rate of around 2.7% last year. Chinese state-owned banks may be willing to express their admiration for Xi Jinping’s thinking, but they are reluctant to confess their failed loans.
The shortcomings of all of this are exposed by two debt monsters. Huarong was established in 1999 as a bad bank for bad loans, but has grown into a conglomerate. On August 29, he announced delayed results showing a liability of $ 238 billion in June, a loss of $ 16 billion last year and a leverage ratio of 1,333 times. Two days later, Evergrande, with real estate projects in more than 280 cities, reported a liability of $ 304 billion and made a profit selling subsidiaries. The companies have the second and fourth largest piles of debt of all Chinese listed companies (excluding banks) and together account for 3.9% of the total. As the duo faltered, their bond prices hovered. Investors are trying to determine whether companies will default, bail out, or stagger like zombies.
They now have an answer for Huarong. After a tough negotiation at the top of the Communist Party, he will be rescued by other state enterprises because he is considered too big to fail. The company is buying 30 to 40 percent of non-performing loans in the banking system, according to PineBridge Investments, an asset manager, and its bonds have been used as high-quality collateral in Chinese markets until early this year. A collapse would risk destabilizing the banking system.
And Evergrande? The government could let the mostly foreign owners of its $ 21 billion in foreign currency debt go to the wall. But the majority of its liabilities belong to other creditors, including suppliers and home buyers who pay for properties before they are built. Rather than risk disrupting supply chains and enraging homebuyers, the government is likely to find white knights to ensure the survival of Evergrande’s core business.
Both episodes show that the hierarchy of creditors in China is based on state policy and priorities. It is difficult to know in advance which instruments are guaranteed by the state, let alone guess the opaque process by which this is decided. The accounting for bad debts is grossly inconsistent. This year, Ping An, a successful insurance company with many foreign shareholders, admitted bad real estate investments of $ 5.6 billion and faced government investigations, even as state-owned banks in charge of bad debts remained silent.
A better bad debt management system would allow China to improve the efficiency of capital allocation in its economy and reduce moral hazard and corruption. But when bankruptcy threatens, Chinese leaders often play for time. Global investors have increased their exposure to Chinese debt and the country’s weight in global indices is increasing. Some believe that China is making great strides in modernizing its giant debt markets. Huarong and Evergrande remind us that there is still a long way to go. ■
This article appeared in the Leaders section of the print edition under the headline “The Poisonous Twins of China”