On 11 May, China Energy Reserve & Chemicals Group (CERCG) defaulted on $350m of US dollar bonds issued in Hong Kong and Korea.
The company, which processes, stores, transports and sells natural gas and oil, is owned by local governments and state-owned entities.
The Beijing Municipal Commission of Commerce, a local government agency, owns 30%; China National Petroleum Corporation (CNPC) owns 28%; a subsidiary of China State Construction Engineering Corporation (CSCEC) owns 27%; and China Economic Cooperation Centre, a central government agency, owns 15%, according to data compiled by SCMP.
The ownership structure seems to have led investors and credit agencies to believe that CERCG had state backing and would not be allowed to default on its debt.
On 8 May, three days before the default was announced, a Korean subsidiary of CERCG was able to print bonds, with two local credit agencies giving them high ratings, according to The Korea Herald. In response to criticism that has ensued, the agencies said they had considered the company state-owned.
The default is an example of a qualitative shift in the corporate debt landscape of China. “More credit defaults occurred this year in the domestic market,” Niki Wu, senior manager research analyst at Morningstar, who covers fixed income funds in China, told FSA. “Even some bonds issued by listed or local government owned companies, which are often thought to be safer, have been in default.”
China has had 19 bond defaults already this year, exceeding the 17 that occurred during the full year 2017, FSA reported earlier.
The record defaults come at a time when China is encouraging foreign investors to enter its onshore bond market. Foreign ownership of Chinese bonds amounts to around 6.3% of of China’s RMB 60trn ($9.10trn) bond market.
Credit tightening
The most common cause of defaults is also different. “Unlike most of the credit defaults in the past two years, which were primarily caused by the deterioration of the companies’ business conditions, the defaults that happened this year were more related to the deterioration of external financing conditions,” Wu said, referring to Chinese authorities attempts to reign in rising corporate credit.
In an announcement distributed to bondholders, CERCG cited “the tightening in credit conditions in the PRC over the last two years” leading to “restricted access to financing channels in the PRC, including bank loans and onshore bond issues.
“As the cash flow and capital requirements… have continued to increase, this has resulted in a liquidity crunch,” the statement said.
The firm added that it will continue business operations as usual, but is also planning to divest certain assets in order to resolve cash flow difficulties, and will be appointing independent external advisors.
Ken Hu, fixed income CIO for Asia-Pacific at Invesco, told FSA that investors should prepare themselves for more defaults in China. “The rising defaults are a fallout from China’s deleveraging efforts and the cut in shadow banking activities,” he said.
While some investors will be hurt, the overall outcome will be positive for the market structure. “More defaults will weed out weaker companies and hence will create a healthier environment for the market in the long run,” Hu said.
“There could be a knee-jerk reaction to China default news in the short term,” he added. “[However] the easing monetary policy will help liquidity conditions for companies.”
Keepwell provision
The CERCG default is particularly worrisome to offshore investors, as the bonds issued by the CERCG subsidiary in Hong Kong are not, in fact, guaranteed by the onshore parent company, according to analysis by Bloomberg.
Instead, they carry a “keepwell” provision, a commitment of the parent company to keep the subsidiary solvent. The provision, however, stops short of a payment guarantee and has never been tested in court.
A failure to enforce the keepwell deed would put in doubt the safety of much of China’s offshore debt, as about $100bn, or 80% of US dollar-denominated offshore bonds issued by Chinese companies carry the provision, according to Bloomberg.
