China’s ‘zombie’ SOEs cause ripples in markets

SHANGHAI/HONG KONG, Sept 6 (Reuters) – When several large state-owned companies in China unexpectedly defaulted on their debts earlier this year, the government seemed determined to send a clear and unified message: it was time to get rid of zombie companies.

But since then, China’s signals have become increasingly contradictory and, as a result, bond market pricing suggests investors see the smallest chance in seven years that many firms will be allowed to go bankrupt.

Slimming down the bloated state sector, including allowing so-called zombie companies to go under, is critical to making the economy more efficient and allowing the private sector to thrive.

But the back and forth by Chinese authorities as they weigh the risks of just how hard to be on effectively insolvent companies confuses investors and threatens financial instability in debt markets.

"It’s the tension between short-term stabilisation and long-term restructuring," said Nicholas Zhu, a senior analyst covering local government debt at the ratings agency Moody’s.

"The direction is clear, but it’s a question of whether the implementation will be soon enough for investors to have confidence."

China’s bond markets have worked for years on the assumption that the government would not allow a default. Issuers were effectively guaranteed by the state.

Since 2014 though, Beijing has been cautiously trying to change that perception by allowing some issuers to default. It also plans to introduce more market tools for managing debt, including credit default swaps, debt securitisation and a mechanism for swapping debt for equity.

But for every step forward towards a harder stance, there seems to be a step back as policymakers worry cascading state-owned company defaults could undermine investment already at a 16-year-low or threaten financial stability.

So far in 2016, there have been a record of at least 29 defaults, but so far few companies have been allowed to fail.

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CHANGING MESSAGE

In April, the message seemed clear.

A joint statement from the central bank, the banking, securities and insurance regulators on April 21 urged financial institutions to "resolutely withdraw and compress" financing for long-term money-losing firms in legacy industries, a reference primarily to struggling coal and steel firms.

In the 10 days following the statement, short-term bond yields spiked by over 30 basis points as investors priced in a greater risk of defaults, adding to a selloff already underway after several prominent state-owned firms had missed debt payments in the weeks beforehand. Fearing a rout, the central bank injected cash to steady the market.

But from late June, bonds started to rally again, partly as foreign cash flowed in seeking China’s relatively higher yields but also as government signals changed, a shift that became more pronounced in August.

The National Business Daily reported early that month that the China Banking Regulatory Commission had asked banks not to "casually" cut off lending to firms and instead extend maturities or relend when possible.

The report was quickly followed by news that the provincial banking regulator in Shanxi province would permit seven large provincially owned coal firms to roll over their short-term debt.

And in late August, online financial magazine Caixin reported that state-run Bohai Steel Group – struggling with close to $30 billion in debt – would have access to low-interest finance from a special Tianjin government bailout fund to aid in its restructuring. Recent statements from the main agencies responsible for economic planning and managing state assets have also taken a more lenient stance on managing debt.

The change of tone between April and August helped fuel the bond rally, leaving the risk premium of one-year AA rated commercial debt over Chinese treasuries, a measure of the expected risk of default, at its narrowest since 2009.

The spread had nearly doubled in April to 180 basis points when investors thought the government was signalling a readiness to let more companies fail.

"First it’s ‘Get rid of the zombie companies, OK let’s go,’ and once you go on, you run into some difficulties, then some more practical considerations get into the discussion. And then when that practical discussion or consideration gets under way, there will be another round of pushback to continue to restructure," Moody’s Zhu said.

MARKET RISK

Underlining the concerns about market stability, the central bank intervened in money markets last week, worried that lenders were too dependent on short-term funds to finance bond positions. Following the intervention, money market rates spiked.

Afterwards, Moody’s Investor Services warned small and mid-tier lenders’ reliance on interbank funding represented a systemic risk to the banking system.

"The recent rally in bonds fuelled by leverage on the back of stable short-end funding raise concerns about potential asset bubble risks," OCBC bank analysts said in a market note.

Some analysts say similarly mixed policy signals also affect the municipal bond market. The full extent of the central government’s support for a province in the event of a real debt crisis is unclear, but the bonds of stronger and weaker regions still trade in a tight range, suggesting little difference in the perception of risk.

Bonds of the highly indebted rust-belt province of Liaoning, whose economy is contracting, yield just 30 basis points above the relatively well-off Beijing provincial debt.

And like corporate bonds, the market is vulnerable to changing signals.

"So if there are one or two stories about some local issues, etc., then you may see a market correction," said Frances Cheung, head of rates strategy Asia ex-Japan at Societe Generale in Hong Kong.

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