BEIJING — Weak spots are emerging in China’s growing debt pile.

National debt levels have climbed to nearly four times of GDP, while an increasing number of corporate bonds have defaulted in the last 18 months.

Although the latest defaults represent a fraction of China’s $13 trillion onshore bond market, some high-profile cases have rattled investors since the common perception has been that the Chinese government will not let state-supported firms fail.

The case of Chinese bad debt manager Huarong has also spooked investors, causing a market rout this year when the firm failed to file its earnings in time and its U.S. dollar-denominated bonds plunged.

Analysts said cases like these signal how the state’s so-called implicit guarantee is changing as the government tries to improve the bond market’s quality — weeding out the weaker firms, and allowing for some differentiation within the industry.

As China’s growth slows, authorities are looking to strike a better balance between maintaining control and allowing some market-driven forces into the economy in order to sustain growth in the long term.

In the first half of this year, the total number of defaulted corporate bonds in China amounted to 62.59 billion yuan ($9.68 billion) — the most for the first half of a year since 2014, according to data from Fitch Ratings. Of that, defaults by state-owned companies contributed to more than half that amount — about 35.65 billion yuan.

For the whole of 2020, bond defaults amounted to 146.77 billion yuan, a huge leap from just six years ago in 2014, according to Fitch. That year, defaults totaled 1.34 billion yuan, and there were no defaults by state-owned firms, the ratings agency said.

As investor fears ramp up, here are three important developments to watch, economists say.

1. Bond default in a grey area of local government

A major milestone to counter the idea of implicit guarantee in China’s market would be a default of a bond issued by a local government financing vehicles (LGFV).

These companies are usually wholly owned by local and regional governments in China, and were set up to fund public infrastructure projects. Bonds issued by such firms have been surging amid an infrastructure push as the Chinese economy improved.

“Many LGFV are even worse than so-called Zombie companies, in the sense that they could not pay the interest, not (to) mention the principal on their own,” Larry Hu, chief China economist at Macquarie, said in a June 25 note. Zombie companies are those that are heavily indebted and rely on loans and government subsidies to stay alive. “They could survive only because of the supports from the governments.”

“The year of 2021 is a window to break implicit guarantee, as it’s the first time in a decade that policymakers don’t have (to) worry about the GDP growth target. As a result, they could tolerate more credit risk,” Hu said, noting it’s only a matter of time before an LGFV bond default occurs.

In 2015, electrical equipment manufacturer Baoding Tianwei became the first state-owned enterprise to default on its debt, following the first default in China’s modern onshore bond market a year earlier.

Nomura said LGFVs are a “major focus” of China’s tightening drive, and noted that bonds issued by the sector surged to a record 1.9 trillion yuan ($292.87 billion) last year, from just 0.6 trillion yuan in 2018.

2. Huarong’s ‘big overhang’ on the sector

For investment-grade bonds in China, a major factor for future performance is how the case of Huarong Asset Management is resolved, Bank of America analysts said in a note last month, calling the situation a “big overhang.”

China’s biggest manager of bad debt, Huarong, has been struggling with failed investment and a corruption case involving its former chairman, who was sentenced to death in January.

After missing its March deadline to publish its 2020 results, the firm also said “auditors will need more information and time to complete” the audit procedures. It added, however, that failure to provide the results does not constitute a default.

Huarong’s biggest backer is the Ministry of Finance. China’s economy will need to grow quickly enough to ensure the central government budget isn’t strained further.

If there is a disorderly default of Huarong’s dollar bond, we could see a broad sell-off of China credits, especially (investment grade) credits.

Bank of America

If Huarong’s case is resolved with government support, it should boost China’s asset management sector, as well as other Chinese government-linked entities, says Bank of America.

However, the bank added: “If there is a disorderly default of Huarong’s dollar bond, we could see a broad sell-off of China credits, especially (investment grade) credits.”

Regulators are pushing Huarong to sell non-core assets as part of a revamp, according to a Reuters report in early June.

In the event of a Huarong default, the cost of capital could rise “significantly” for other state-owned companies as “markets re-evaluate perceptions of implicit guarantees by the state,” Chang Wei-Liang, macro strategist at Singapore bank DBS, told CNBC via email. As risks go up, firms have to offer higher returns to draw investors.

Chang said China has enough money on hand to address Huarong’s problems.

However, “the key question is whether the state will choose to intervene by providing support with additional capital, or by imposing losses on equity holders and debt holders first to reinforce market discipline,” he added.

3. Weak points in some provinces and local banks

In an effort to find out where potential hot spots for SOE defaults might be, S&P Global Ratings analysts found that small banks concentrated in north and south-central China face deteriorating asset quality.

“City and rural commercial banks with above-sector-average problematic loans would have to write-off Chinese renminbi (RMB) 69 billion in these loans to bring their ratio to sector-average levels, with those in the Northeast worst hit,” the June 29 report said.

A fiscally weaker province is probably related to a less dynamic economic situation, (and) a weaker economic situation means there could be more corporate bond defaults.

Francoise Huang

SENIOR ECONOMIST, EULER HERMES

That could affect the ability of small banks to support local state-owned companies, potentially requiring larger banks to step in to maintain system stability, the report said.

The provinces with greater issues are those exposed to cyclical industries, S&P Global Ratings credit analyst Ming Tan told CNBC.

Authorities need to strike a balance between allowing poorer quality loans to have a riskier rating, and keeping problems from accelerating, Tan said. “There’s definitely risk of mismanagement happening down the road, but so far, what we’re seeing, is this has been managed quite well.”

China’s banking and insurance regulator disclosed last week that in 2020, the banking industry disposed of a record high 3.02 trillion yuan — or $465.76 billion — in non-performing assets. Other data released last week showed China’s GDP grew 7.9% in the second quarter from a year ago, a touch below expectations.

Some analysts have pointed to weakness at a local level. Pinpoint Asset Management analysis found that consumption declined year-on-year in May for four provincial capitals — Wuhan, Guiyang, Shijiazhuang and Yinchuan.

“A fiscally weaker province is probably related to a less dynamic economic situation, (and) a weaker economic situation means there could be more corporate bond defaults,” said Francoise Huang, senior economist at Euler Hermes, a subsidiary of Allianz.

The longer-term issue is restructuring the economy of these weaker provinces to allow more dynamic ones to grow, she said. “I don’t think the solution would be (to) continue investing into these less-performing sectors just for the sake of keeping them alive.”

CNBC