A DOCUMENT CIRCULATING among Chinese banks in early July has caused unease among investors and local officials. Known as “Document No. 15”, the regulatory directive says that banks should stop lending to heavily indebted local-government financing vehicles (LGFVs), companies set up by city or provincial governments to finance building projects and public works. The groups, which have not so far been allowed to default, have about 48.7trn yuan ($7.5trn) in debts, 11.9trn yuan of which is held in fixed-income securities. They routinely use bank loans to pay interest on bonds. Ending the steady stream of credit is a recipe for turmoil. “If banks don’t give them a blood transfusion”, a local investor told Chinese media, “LGFVs will face a default crisis.”

Then the circular vanished, along with most references to it in state media. Some investors believe it may have been released prematurely and that another, less severe version will eventually replace it. Others say banks are carrying out the orders, but fear that the first LGFV default will unleash chaos in the bond market, of which securities issued by LGFVs make up about 10%.

Such is the dilemma China’s financial regulators face. They must stop poorly managed groups from hogging capital and allow the worst of them to fail. But they must do so without causing panic or cutting off healthy companies’ access to finance. LGFVs are just one of many cases testing their resolve.

Defaults in China’s onshore bond market have climbed to a record, with companies missing payments on about 97bn yuan in principal in the first half of 2021, up by almost 50% compared with the same period last year, according to Wind, a data provider. China Fortune Land defaulted on a $530m bond in February, in what was the country’s largest-ever default by a property developer; Chongqing Energy Investment, a state-run firm that produces most of the city of Chongqing’s coal, defaulted in March, denting confidence in local authorities’ support for state-owned groups.

More worrying, however, are the size and profile of some struggling companies. Defaulting groups had on average about 1bn yuan in outstanding onshore bonds in 2015, a year after China experienced its first default in recent times. That figure has climbed to nearly 9bn yuan this year, reckons S&P, a rating agency. Evergrande, a troubled property giant, is on the hook for more than $100bn in interest-bearing offshore and onshore debt. A series of missteps and growing regulatory pressure has led to a collapse in investor confidence. Its offshore bonds have traded at less than 50 cents on the dollar, indicating that many investors expect a default.

Groups controlled by the central government used not to be allowed to face collapse. But now Huarong, a state asset manager with more than $40bn in offshore and onshore debt, seems to be in trouble. Once among the most powerful financial conglomerates in China, it has not published its results for 2020, leading investors to guess at the poor shape of its books and bet on its demise.

These risks threaten to shatter the calm portrayed by technocrats in Beijing. But regulators may be more willing to countenance defaults than they were in the past. They have seized control in two key areas that make defaults easier. One is a tighter grip over unruly companies owned by municipal and provincial governments. Upon defaulting these groups were often allowed to make inside deals that benefited well-connected creditors but excluded others. Investors involved in such situations say that this is changing.

Take, for instance, the default of Yongcheng Coal in November. A probe after the default showed that the company had shifted assets round in an attempt to pay less to some creditors. Regulators promptly stepped in to make clear to all investors, including foreign ones, that accounting tricks would not stop the company from paying out as much as it could. That lessened investors’ concerns about how they might be treated in a default and, crucially, kept markets liquid even as more firms face distress.

Regulators have also grabbed more control over the restructuring process. State-backed restructurings used to be mired in opacity. That has changed; after Peking University Founder Group (PUFG), a conglomerate linked to China’s top university, defaulted in 2019, many of the terms of its restructuring were made public. A deal was worked out in just 581 days, compared with an average of 679 in China, noted S&P. After a court-led restructuring, the recovery rate on PUFG’s assets was 31.4%, beating the average recovery rate of 23.7% in 50 other Chinese restructuring deals. Such efficiencies are attracting more market-based investments and reducing the need for state-mandated ones, says Charles Chang of S&P.

These cases will guide officials as they take on more daunting problems. If Evergrande’s problems persist, many investors believe it could be allowed to default and move into restructuring. Huarong, with its sprawling business, is seen as carrying more systemic risk than Evergrande, says Edmund Goh of Aberdeen Standard Investments. This means a state-brokered bail-out, as opposed to a market-based one, could lie ahead.

LGFVs may pose the biggest risk of all. The first default “is going to cause a lot of market turbulence”, says Larry Hu of Macquarie, an investment bank. If regulators enforce Document No. 15, a bellwether default could occur in the coming months. A softer stance, by contrast, would suggest that they are not quite ready to face up to the challenge.

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