China: The wider implications of Huarong’s woes

China’s financial markets have been rattled lately by the woes of Huarong Asset Management, one of China’s biggest distressed debt Asset Management Companies (AMCs)[1]. In early April, Huarong delayed the issue of its financial statements for 2020. When rumors arose of a potential financial restructuring at Huarong, the company’s outstanding USD bonds plummeted to almost 60 cents on the dollar (figure 1), essentially indicating that investors were pricing in a potential default.

[1] Huarong is one of China’s four original AMCs, which were set up in the late 1990s to clean up China’s banking system by taking over bad loans from its big state owned banks. The other three AMCs are Great Wall, Orient and Cinda. Since December 2020, a fifth AMC (Galaxy) has been added to the list.

The turmoil prompted Chinese regulators to issue a statement that Huarong has ample liquidity, after which its bonds recovered to about 85 cents on the dollar. Then, on 26 April, Fitch downgraded Huarong’s bonds credit rating to BBB (from A), which pared back some of the recovery.

Huarong was, however, able to fulfill its immediate financial obligations, namely the repayment of CNY 960mn and USD 600mn in offshore bonds that matured on 27 April 2021. Nonetheless, Huarong’s USD bonds are trading at around 79 cents on the dollar at the time of writing, which indicates that financial markets are still pricing in some sort of haircut.

Huarong’s situation has a number of important broader implications. First and foremost, it is a test case for Beijing’s willingness to bail out state owned firms that are important and struggling, yet poorly managed. Huarong has been known to be badly managed and is indeed quite important, it is (i) China’s second largest AMC by assets, (ii) majority owned (60%) by China’s Ministry of Finance and (iii) it has many ties with other Chinese financial entities, which makes it systemically important. As such, Beijing’s decision to (fully) bail out Huarong or not says something about how strong the government backing of other important state-owned entities (SOEs) in China is.

In addition, the Huarong situation indicates that there might be more hidden pain for Chinese SOEs and corporates down the line.

Markets have already been pricing in more defaults from Chinese corporates (many of which are state owned, or have strong government links), since December last year when Yongcheng Coal and Electricity (China’s state owned coal mining company) defaulted and sent corporate bond spreads soaring (figure 2), an issue we flagged here.

However, there might still be more pain to come, as Chinese corporates will face increased scrutiny.

For example, part of China’s plan to open up its financial market is to deregulate the market for foreign credit rating agencies (such as Fitch and S&P). Moreover, China’s gross external debt has been rising in recent years (figure 3), and will likely continue to do so with China’s plans to open up its financial markets and the addition of China to the FTSE World Government Bond Index over the coming three years.

Although most of China’s debt is currently domestic, the trend indicates that an increasing amount of Chinese assets could be held by foreigners over time. If that happens, China’s debt position will become more vulnerable to swings in global market sentiment, despite the fact that China, on a net basis, is still a foreign creditor. The growing share of Chinese bonds held by other countries also means that financial instability in China could more easily spill over to other countries. As an example, of the USD 42bn in local and offshore bonds issued by Huarong and its subsidiaries, almost half (USD 22bn) are held by global investors according to Bloomberg.

With increased scrutiny from external rating agencies and foreign investors, it seems plausible that more bad debt will come to the surface. Moreover, with high credits spreads and China’s government eyeing a reduction in credit growth (as part of its Five Year Plan), Chinese corporates are facing higher costs and less liquidity when refinancing their loans. That is a problem because Chinese corporate loans tend to have relatively short maturities. As an example, almost half (47%) of outstanding Chinese corporate bonds mature in 2 years or less (based on data from China Central Depository & Clearing). Flushing out bad debt is good for China’s long-term economic and financial stability. The question, however, is whether China’s financial system can stand the short-term instability from adjusting to a new normal with more market scrutiny, less liquidity and less backing from the government.

Finally, the Chinese government is stuck between a rock and a hard place. If it bails out Huarong, that will induce moral hazard down the line. If not, the financial instability caused by Huarong’s default could arguably prove even more costly, at least in the short term. Whatever the case may be, it has become less certain who Beijing will or will not save. That uncertainty will continue to weigh on investor sentiment in the coming months.