At Crossroads, China’s Reforms Stall

At Crossroads, China’s Reforms Stall

By Brad Gibson, Jenny Zeng, Anthony Chan, Fixed Income AllianceBernstein

August 22, 2016

Issues coming to a head in China’s corporate sector require its government to decide how much freedom to allow the markets and private business. The risk? That policymakers will duck the issues, leaving the economy to drift.

Let’s take a deeper dive into three notable developments that serve as a guide to the direction of China’s economy and its reform agenda.

Default Dilemma

Dongbei Special Steel (DSS)—a steelmaker majority-owned by the Liaoning provincial government—recently defaulted on a RMB64.4 million (US$9.6 million) interest payment on a privately placed RMB870 million bond issue. DSS is a serial offender: the company has defaulted on seven bonds, totaling RMB4.8 billion in principal.

Such events in themselves are no longer unusual in China. Since 2014, there have been 18 notable defaults in the public market. Of these, seven—all of them involving privately owned companies—have made a full recovery, while none of the state-owned enterprise (SOE) defaults has been resolved.

In this case, however, something unusual has happened. Frustrated bondholders have called on regulators to suspend all fundraising by corporate and government entities in the province, and on institutional investors to boycott such entities’ debt, as a way of putting pressure on the provincial government to bail out DSS.

Bondholders’ frustrations are compounded by China’s lack of a clear debt-resolution process and the fact that the Liaoning government is in no position to fund a bailout.

This presents the central government with a dilemma: Should it help the provincial government to rescue the company, or should it allow DSS to fail?

The first choice would raise the moral hazard of “too big to fail” to a new level, encouraging other SOEs to take risks that would be shunned by companies with no recourse to government support.

It would also undermine the credibility of the government’s supply-side reforms, which aim to make the economy more responsive to market forces.

Allowing DSS to fail, however, could spark risk aversion on the part of investors, which, in turn, could lead to a liquidity squeeze and exacerbate the country’s economic problems.

In light of these undesirable alternatives, the government appears to be choosing to do nothing. This is one instance in which we see the potential for policy indecisiveness to increase the risk of economic drift.

Murky Mergers

Like corporate defaults, SOE mergers are something of a trend in China. Take, for example, Shenhua Group, China’s biggest coal power company, which is seeking a merger with China General Nuclear Power.

So far this year, mining company Minmetals has merged with infrastructure and mining construction group Metallurgical Corporation of China; China National Building Material with Sinoma, parent of China National Materials Group; Baosteel with Wuhan Iron and Steel; building materials supplier BBMG with Jidong Cement; and food company COFCO with textile and grains trading group Chinatex.

Business logic has played little part in these mergers, all or most of which have been at the behest of Beijing. The mergers appear to conform to the government’s stated objective, as part of its supply-side reforms, to halve the 112 SOEs it owns.

But that’s not real reform.

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