China’s financial bailout promotes the survival of the fittest, leaving weak borrowers to fend for themselves

The Chinese government initiatives introduced recently are designed to help smaller, private companies that are commercially sound weather short-term liquidity problems, but will not do much to help weaker firms survive, analysts say.

This Darwinian selection between strong and weak firms – whether they are private or state-owned – is part of the middle path the government is attempting to navigate, stabilising the economy on the one hand while continuing its debt reduction campaign on the other.

For now, the Chinese bond market is recovering, after the introduction of a raft of government measures to help ease credit conditions for struggling private firms, but investors are wary on whether the progress can continue much longer, analysts said.

Despite the recent help for firms facing temporary liquidity problems, credit conditions for the weakest firms are likely to tighten, causing their corporate debt defaults to rise.

The People’s Bank of China (PBOC) said last week that it had established new tools to reduce credit risk, including the provision of new funding to financial institutions to support the issuance of corporate bonds.

The PBOC boosted its relending and rediscount quotas by 150 billion yuan (US$21.7 billion). Eligible financial institutions can apply for funding from the short-term liquidity facilities to increase their lending to small, privately owned enterprises.

Bond guarantee firm China Bond Insurance will also receive 10 billion yuan in funding, which will be used to sell credit risk hedging instruments to investors to encourage them to buy more bonds. The hedging tool would effectively insure the investor against the risk of default on the underlying bond, making the bond purchase more attractive.

Commercial banks, security houses and insurers may also develop the same type of instrument, said the Chinese central bank’s deputy governor Pan Gongsheng.

“Investors buying the credit risk hedging tool would be equivalent to buying a bond and at the same time buying credit default protection,” said Pan, without further providing actual implementation details.

The steps are the latest in a series of government measures aimed at encouraging banks to expand lending and increase their investment in bonds issued by private sector enterprises as well as other entities, such as local government financing vehicles.

In September, China exempted interest income from microloans to smaller firms from the country’s value-added tax. It also has been making sure lenders have ample liquidity by using its medium-term loan facility to support banks that have invested in bonds rated AA+ and below.

Chinese corporate bonds of average quality that are AA-rated and maturing in five years saw yields soar 241 basis points between October 2010 and January 2018, reflecting surging funding costs amid an official clampdown on risky lending, according to Shanghai Wind, a financial data vendor. The yield has since retraced 72 basis points as authorities implemented their targeted easing measures.

Corporate bond yields have fallen because government policy has shifted to stabilising growth, including the targeted policies the PBOC has introduced, said Liu Dongliang, capital markets analyst at China Merchants Bank in Shenzhen.

“However, it is uncertain whether the market can continue its recovery because banks cannot keep increasing their risk profiles in the current environment,” Liu said.

Given the negative impact on the Chinese economy from the trade war with the US, policymakers have signalled that they are ready to increase policy stimulus if things get worse.

The Communist Party’s top policymaking body, the Politburo, said last week that there was “growing downward pressure” on the economy due to “profound changes” in the external environment.

But the extent of the new policy measures and their effectiveness in helping the financing needs of small enterprises remain unclear, analysts said.

So far, overall fiscal stimulus and monetary policy easing measures have been modest, while the implementation details of PBOC’s planned credit-risk hedging tools remain vague, they said.

While easing measures should facilitate the refinancing of more debt issued by average Chinese entities, Chinese authorities will continue to tolerate bond defaults of weaker issuers, said Ivan Chung, associate managing director at Moody’s Investors Service. They were unlikely to revert to their former practise of “automatic bailouts” of distressed bonds.

Bond default cases in recent years have helped build up the credibility that China’s market is being developed based on market principles. Differentiation is emerging between high-rated and low-rated onshore bonds as the default cases are changing investors’ perception of the government’s willingness to support weak firms. In the past, weak – so called “zombies” – state-owned companies typically would obtain automatic bailouts on their distressed bonds.

Reflecting investors’ diverging perception between strong and weak Chinese companies, yields on AA+ rated corporate bonds have fallen this year at a faster pace than lower rated bonds with the same maturity, showing that companies with stronger fundamentals are the main beneficiaries of falling funding costs.

Yields on AA+ rated five year corporate bonds have fallen 114 basis points from their January peak, while yields on the AA- rated five year corporate bonds rose by a further 40 basis points this year, as investors avoid investing in bonds issued by weak firms.

“Fundamentally weak state-owned enterprises will be more vulnerable to default risks in the next 12-18 months. They are unlikely to receive much government support if they experience financial distress,” said Moody’s Chung.