Chinese corporate borrowers defaulted on a record $25 billion of debt in 2020. For many investors, that would be worrying enough on its own. There are more causes for concern, though. These defaults included several state-owned enterprises, such as Yongcheng Coal & Electricity Holding Group, which would have been unthinkable in previous years. There is a wall of corporate debt about to mature: some RMB7.1 trillion ($1.1 trillion) of domestic bonds and $104 billion of offshore bonds are due in 2021. At the same time, local government borrowing rose by the equivalent of $565 billion in the first half of last year, according to JP Morgan, even as tax revenues were depressed by the Covid-19 pandemic. That is driving market expectations that Local Government Financing Vehicles (LGFVs) will also default on their debts in 2021.
A more nuanced picture
At first glance, this is an alarming situation. Look past the large numbers that are a product of China’s sheer scale and it becomes more nuanced, though. The government has recognised that its domestic credit markets had run out of control since the massive fiscal and monetary expansion that followed the Global Financial Crisis in 2008 and 2009. It is now taking painful – but necessary – action.
As corporate debt grew in the wake of that crisis, so too did China’s shadow banking system of so-called wealth management products, entrusted loans, peer-to-peer loans and other forms of financing. According to the China Banking and Insurance Regulatory Commission, this sector had swelled to have assets worth $12.9 trillion in 2019. The relentless rise of shadow banking added opacity and systemic risk to the credit market. In the China bond market, opacity was increased by inflated ratings that made credit differentiation much harder: two-thirds of bonds rated by China’s local agencies have a AAA or AA+ rating, including those issued by Yongcheng Coal.
Defaults by state-owned firms are a harsh medicine for investors that have long believed in an implicit government guarantee for such debts. Only a handful have been allowed to fail, though, with total defaults by state-owned firms worth $11.1 billion last year. In a market this size, that sends a meaningful message without causing much real damage.
Defaults by large companies that could have been much more destabilizing have also been avoided. China Evergrande Group, which was the world’s most indebted property developer with borrowings of nearly $120 billion last year, was able last September to secure $4.6 billion of funding from government-linked investors that averted this kind of scenario.
Nothing could be more effective in enforcing credit market discipline, though, than a rising default rate. Market-driven investors and lenders now have no choice but to conduct careful analysis of borrowers’ businesses and financial positions. A more cautious approach would clearly point towards tighter financing conditions.
China has reinforced the signal it has sent by allowing more defaults with a much stricter approach to financial regulation. Policymakers have strengthened financing rules for real estate developers like Evergrande, promised a “zero tolerance” approach to abuses in the China bond market, made a credit ratings firm compensate investors in defaulted bonds and drafted stricter regulations for its large fintech companies, which have also become major facilitators of loans.  
Chinese companies and their owners will be taking a keen interest in how more restrained credit markets and tougher financial regulation translate into borrowing conditions on the ground. The People’s Bank of China has said it will pursue a “flexible, targeted and appropriate” monetary policy that supports the country’s recovery from the impacts of the pandemic. According to a Reuters survey of economists, Chinese banks are estimated to have made a record $542.6 billion of loans in January. But this may conceal a longer-term trend of tightening credit conditions. On a monthly basis, loan growth in December fell for the seventh straight month and some analysts expect lending to contract in 2021.
Once the initial shock caused by defaults and tougher regulation has been overcome, more disciplined credit markets – and effective financial regulation – will be better able to support sustainable growth over the long term. If bank lending is indeed more constrained this year, though, Chinese firms and their investors will need to consider alternative sources of liquidity. There will be significant drivers of demand for capital, including refinancing that $1 trillion-plus of debt that comes due in 2021, and China investment opportunities as the country’s economic recovery gathers momentum. We expect private credit – including share-backed financing – to play its part in filling this gap.
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