Troubles in Tianjin are unnerving capital markets. The large industrial and port city, adjacent to China's capital of Beijing, has long pursued a debt-funded investment growth model. This is true for the megacity as well as many of its state-owned enterprises (SOEs). S&P Global Ratings believes a slowdown in Tianjin's economic growth is testing the municipal government's ability to continue to support its SOEs.

Tianjin has had a number of credit-related scares in the past couple of years, including in the past two months (see table 1). Investor confidence is crumbling in part due to the declining competitiveness of the city's SOEs. Most of the pillar industries in Tianjin are investment-driven and debt funded, including "old economy" sectors such as heavy industry and commodities. Low profitability and cash flows on key projects could stretch the ability of SOEs to service their financial obligations. Also, SOEs comprise a high proportion of the city's economic activity.

Tianjin has a larger debt burden and slower economic growth than that of many other metropolitan areas. Still, similar problems exist elsewhere in China and this constitutes a credit vulnerability for weaker SOEs.

Slowing Growth Sheds New Light On Old Habits

In our view, the government of Tianjin will become more selective toward providing support to troubled enterprises. The city's weakening fiscal position limits the prospects of bailouts for uncompetitive or overextended SOEs.

Tianjin's economy has been growing at a low-single digit rate, well below the national average, causing revenue headwinds. The government is taking proactive countercyclical measures, including fee cuts and continued large spending commitments, to mitigate the growth slowdown. As a result, the municipality's deficit widened in 2018. Its debt burden is rising, and is even larger when considering sizable contingent liabilities.

Chart 1

Weak profitability and inadequate debt-servicing capability at Tianjin's SOEs add to the overall strain. Tianjin Real Estate Group Co. Ltd. (Tianfang Group) the municipality's wholly owned real estate developer , had debt of more than Chinese renminbi (RMB) 120 billion (around US$18 billion) in 2017, equivalent to more than 80% of the city-level adjusted operating revenue of RMB144 billion at the end of 2017. In 2018, the municipality's 100% owned steel producer--Bohai Steel Group Co. Ltd.--officially filed for bankruptcy, having defaulted on its debt in 2016. Other companies have also raised concerns or suffered credit events (see table 1).

Table 1

While the support for less strategically important SOEs may be wavering, we believe the support for the largest infrastructure and construction development companies will remain solid—though on a relative weakening trend as these entities commercialize. Local government financing vehicles (LGFVs) are the most important SOEs for the municipality due to their public policy role and a long track-record of receiving support. Our recent revision of the outlook to negative on three LGFVS mainly reflect the weakened capacity of the Tianjin municipality to provide extraordinary support (see Related Research).

Reforms Weaken Governments' Ability To Support Uncompetitive SOEs

The Tianjin government is hamstrung by a debt ceiling imposed by the central government. Measures to control local government off-balance-sheet debt have also constrained the municipality's ability to continue to provide financial support to its SOEs.

Without credit support, many of these financially weak SOEs could lose their ability to meet their financial obligations. This is especially so for companies with limited prospects of a turnaround. In late 2018, the central government gave local governments three months to identify a first batch of "zombie enterprises" (those with unsustainable business models), with debts dissolved and assets liquidated. Based on the mandate, the debt situations of these companies have to be resolved by the end of 2020.

China is pushing for more self-sustainability of SOEs and less dependence on government support. We believe that as SOEs and LGFVs increasingly operate on a more commercial basis, the links with government will gradually weaken. For example, policies now prohibit local governments from explicitly committing to provide support to LGFVs. Mixed-ownership programs will also dilute government influence. And we believe demands from the U.S on the Chinese government subsidies to SOEs will also play a factor in increasing commercialization.

Chicken And Egg: What Comes First In Market-Based Reforms?

Ironically, market-based reforms might have trouble progressing without government support. Weak investor confidence could stall mixed ownership reform in which private or state capital provide fresh capital to SOEs for efficiency improvements or deleveraging. Without private sector support, governments have fewer options to recapitalize and reduce the debt burden of their SOE sector.

However, without the security of a government backstop, both private-sector and state-owned players seem wary of participating in such deals.

Tianjin has been aggressively pushing a mixed-ownership program in recent years. One example is the effort to sell more than 50% of government holdings in Tianfang Group to third-parties. This recapitalization bid has thus far failed to make any material progress after prolonged negotiation. We believe the government's failure to provide timely support for its debt payment, despite Tianfang's recent financial troubles, has deterred potential investors.

Ultimately, investors may not be willing to invest in SOEs with legacy burdens such as high debt, loss making non-core business, and large unfunded liabilities in staff pension and employee severance. Local governments like Tianjin, on the other hand, may not have the capacity or willingness to provide support to SOEs with these problems, and instead hope the magic of the market-based reforms--and outside capital--can resolve these issues.

Tianjin May Not Be An Exception

Other local governments with weak and deteriorating fiscal profiles might see an eroding support for their SOEs. Our analysis shows that Tianjin has the highest tax-supported debt burden among other mega-cities or provinces, at 423.7%, though this burden is partly offset by higher per-capita GDP. The weak SOEs in provinces with high debt burdens relative to their economic position have relied on government support for funding in the credit market for refinancing and expansion. That support might not be there forever.

Table 2

Related Research

• Tianjin Infrastructure And Tianjin Rail Transit Group Outlook Revised To Negative; Ratings Affirmed, April 1, 2019
• Tianjin Binhai New Area Construction & Investment Outlook Revised To Negative; 'BBB' Rating Affirmed, April 1, 2019
• China's SOEs Can't Guarantee Timely Government Support, March 1, 2019
• The Big Chill In China: Weaker Profitability To Hit Corporate Debt Servicing, Jan. 21, 2019
• Chinese LRG Risk Indicators By Province, Oct 16, 2018
• Seven LGFVs Downgraded Due To Changing Dynamics Between China's Local Governments And Their Financing Vehicles, Sept. 11, 2018