China default risks flare on scrutiny of company accounting

The latest salvo came last month, when the top economic planning body said it will step up scrutiny of the public works-related assets held by companies seeking to sell bonds. The National Development and Reform Commission, or NDRC, also said it would further regulate bond sales by public-private partnership projects.

President Xi has vowed to make controlling financial risks a priority, and former central bank governor Zhou Xiaochuan warned last year of a Minsky Moment, where asset values plunge following an era of unsustainable credit growth.

The attempts to cut leverage already slowed expansion of the corporate bond market to 4.6% last year from 21% in 2016, according to data from the People’s Bank of China.

After the most recent moves, the yield premium on AA rated five-year debt from local government financing vehicles over sovereign notes climbed earlier this month to the highest since 2015 at 229 basis points.

The steps will have a “fairly big impact” on the issuance of securities approved by the NDRC, according to Pengyuan Credit Rating. Such notes account for about a third of all corporate bonds issued in the local market.

A further slowdown may spark more repayment failures after refinancing costs surged, and could lead to the first LGFV default. The PBOC followed the Fed Reserve to tighten monetary policy on Thursday, fueling speculation there will be more rate hikes this year.

“Some companies which previously relied on external support to meet the criteria for bond issuance won’t be able to do so given the latest requirements,” said Qi Sheng, chief fixed income analyst at Zhongtai Securities.

“It should be much more effective this time compared with similar notices before, as the current policy environment won’t allow any counter measures or a loosening in implementation.”

Default risks have also been mounting as higher interest rates make it more likely that investors will opt to exercise options on some bonds allowing them to sell them back before maturity.

The NDRC and the Ministry of Finance have issued several notices over the last couple of years to tamp down the perception that companies, particularly LGFVs, would always be bailed out.

But the latest steps will have a bigger impact because the NDRC “gave a lot more detailed requirements in terms of issuers’ assets calculations, sources of repayments, credit rating methodology as well as punitive measures," analysts led by Ji Jiangfan at China International Capital wrote in a note earlier this month.

The broader deleveraging measures have already dragged on debt financing. Sales of corporate notes have fallen to 6.3 trillion yuan ($995bn) this quarter, compared with an average of 7.2 trillion yuan last year, data compiled by Bloomberg show. Among those, LGFVs offered 204 billion yuan, headed for the lowest quarter in three years.

Debentures approved by the NDRC constituted half of outstanding LGFV notes at the end of last year, making them prone to a drop, according to China Lianhe Credit Rating.

The new rules will also have a spillover impact on such securities approved by other regulators, Lianhe analysts wrote in a report.

“The uncertainties around financing could result in credit events among some LGFVs,” said Sun Binbin, fixed income analyst at Tianfeng Securities. “There could be more regulatory documents as such going forward that could eventually affect the refinancing of existing debt.”