Many signs point to more defaults by China's state-owned enterprises (SOEs). Corporate leverage is rising amid tough operating conditions and policy-guided investment spending. Funding costs are diverging, with investors demanding much-higher coupons for weaker SOEs. S&P Global Ratings believes tighter monetary conditions could also speed the journey to default.

China's domestic markets provided a refuge during the peak of the COVID-19 outbreak, when offshore markets saw significant volatility. However, weaker companies paid high rates for tapping onshore markets. Our data show widening yield spreads and deepening pricing differentiation for new issuance by SOEs. This trend could keep funding costs high for weaker SOEs, and hurt their access to the domestic bond market.

As China's economy normalizes in the wake of the COVID-19 shock, monetary policy is tightening and macro-prudential targets on deleveraging might be coming back as policy goal. Against this backdrop, local governments will likely become more selective in their support for state-owned firms. Recent policy to speed up debt restructuring could accelerate the path to default for many weak SOEs. We believe companies with higher average funding costs, worsening leverage, unclear ownership and shareholding structures, and fading policy-oriented business models will be most vulnerable to credit-event risk.

Investors Are Differentiating Among SOE Credit Risk

Pricing differentiation is on the rise. One indication of the trend can be seen in the onshore bond costs for SOE borrowers. About 20% of one-year bonds freshly issued by SOEs face a 100-basis point premium over median SOE yields, a trend that has been growing since 2018. SOE issuance with this higher-than-peer funding costs has risen above Chinese renminbi (RMB) 74 billion in the first half, the highest since 2018.

Chart 1

This divergence reflects increasing default risk expectations. Since mid-2019, a number of high profile SOEs have defaulted, including Tewoo Group and Qinghai Provincial Investment Group (QPIG) (see "Landmark SOE Default In China Sets Stage For More," published on RatingsDirect on Dec. 11, 2019). Early this year, Peking University Founder Group Co. Ltd. (PUFG) defaulted on US$2.7 billion in offshore bonds, making it the largest China offshore bond default in the past 20 years. Last month, Tianjin Real Estate Trust Group failed to repay onshore debt, a reminder of the pronounced credit risk for indebted Tianjin SOEs.

Trends in the perpetual bond market provide another sign of SOE funding stress. We note cases where SOEs have surprised the market by not calling back their perpetual bond. Investors have expected issuers to call when they can due to the steep rise in coupon if they don't. Failure to call such instruments could signal tight liquidity, or could restrict capital market access as investors turn cautious, in our opinion.

Our data show that at least four SOE issuers have not called their perpetual bonds since 2018; instead they accepted a step-up in coupon rates. The largest step-up involved a jump in the coupon by 300 basis point (see table 1). Investors are increasingly aware of the heightened credit risk of SOE issuers that opt to take the hit on their funding cost (see "'Non-Call Risk' Rears Head For China's LGFV Issuers," Sept. 16, 2019).

Table 1

'Selectivity' Will Resume

Rising economic uncertainty is one key factor behind increased selectivity in government support to SOEs. Trade tensions cloud the outlook on export growth, manufacturing recovery, and supply-chain redirection. Banks facing surging bad loans due to the pandemic. We expect Chinese local and governments to be increasingly tolerant of SOE default, in both onshore and offshore markets. Central authorities have guided for allowing the market exit of "zombies," or companies that are continuously loss-making.

In our view, unconditional bailouts that have high socio-economic costs will be least favored by authorities. The pandemic has strained the fiscal power of local governments and this could undermine their capacity to support and lead to more selectivity of them.

We expect investors will face more debt restructuring following SOE defaults or negative credit events. The government encourages more market-oriented resolution of distressed corporates to shave their debt burden (see "China Paves Way For Better Default Resolution Systems," July 27, 2020). Debt restructuring is often the preferred option for many stakeholders as it preserves the business as a going concern without hurting tax revenues and local employment, and provides a higher recovery rate for lenders and investors.

Our data show that the median cash recovery rate for resolved debt restructuring of publicly issued bonds by all corporates is about 20% versus 1.8% for liquidations since the first bond default in 2014.

We note that even in richer provinces, central and local governments have relied on market-oriented methods, including debt restructuring and bankruptcy reorganization, to resolve some indebted zombie SOEs, even they have the enough capacity to provide bailouts. Therefore, investors are increasingly paying more attention to companies' stand-alone credit quality, rather than counting on the local government's support. Borrowing-cost trends show that some weak SOEs in economically developed regions, including Tianjin, Beijing, and the coastal Shandong provinces, can also be deemed higher risk by the market.

Chart 2

China's state-owned universe is quite wide, with varying degrees of policy roles. Some types of SOEs have unclear ownership and shareholding structure or linkages with (such as limited supervision) their government owners. We view these SOEs as unlikely to receive much or any support in the event of distress. This has proved to be the case in past credit risk events including PUFG this year, and China Huayang Economic and Trade Group Co. Ltd. in 2018.

Defaults Will Rise If Scorched Credit Metrics Do Not Recover

The pandemic will likely derail SOE deleveraging efforts, an important initiative to reduce systemic risks in the Chinese financial system. Even before the COVID-19 shock, SOEs were struggling to reduce leverage, as measured by ratios of debt to EBITDA (see chart 3). Not only has the health crisis disrupted cash flows, but companies had to borrow to plug cash flow deficits. Meanwhile, policy stimulus has also required some SOEs to expand investment, reversing efforts to contain debt leverage. For example, SOEs raised investments in all sectors by 14% year on year in July 2020 compared with 3% for private firms. Indeed, SOEs have been investing at a faster pace than private firms for some time now, stretching back to 2019 (see "China's Rate Rise Puts Recovery At Risk," Aug.17, 2020).

We expect a slow path to recovery for Chinese corporates. For most Chinese sectors, it will take up to two years for credit metrics to return to the 2019 levels (see "Asia-Pacific Corporate And Infrastructure Midyear Outlook 2020," July 30, 2020). Recovery is likely to be pushed to 2023 or beyond for the autos, oil and gas, and chemical sectors.

Chart 3

Funding costs have been increasing since May, and real interest rates have risen (see "China's Rate Rise Puts Recovery At Risk," Aug. 17, 2020). This tightening in funding markets could make credit differentiation more pronounced and add to the refinancing woes for riskier SOEs.

Chart 4

Related Research

• China's Rate Rise Puts Recovery At Risk, Aug.17, 2020
• Asia-Pacific Corporate And Infrastructure Midyear Outlook 2020, July 30, 2020
• China Paves Way For Better Default Resolution Systems, July 27, 2020
• Landmark SOE Default In China Sets Stage For More, Dec. 11, 2019
• 'Non-Call Risk' Rears Head For China's LGFV Issuers, Sept. 16, 2019