At Crossroads, China’s Reforms Stall by Brad Gibson, Jenny Zeng & Anthony Chan

Issues coming to a head in China’s corporate sector require its government to decide how much freedom to allow the markets and private business. The risk? That policymakers will duck the issues, leaving the economy to drift.

Let’s take a deeper dive into three notable developments that serve as a guide to the direction of China’s economy and its reform agenda.

China's Growth

China’s Growth

Default Dilemma

Dongbei Special Steel (DSS)—a steelmaker majority-owned by the Liaoning provincial government—recently defaulted on a RMB64.4 million (US$9.6 million) interest payment on a privately placed RMB870 million bond issue. DSS is a serial offender: the company has defaulted on seven bonds, totaling RMB4.8 billion in principal.

Such events in themselves are no longer unusual in China. Since 2014, there have been 18 notable defaults in the public market. Of these, seven—all of them involving privately owned companies—have made a full recovery, while none of the state-owned enterprise (SOE) defaults has been resolved.

In this case, however, something unusual has happened. Frustrated bondholders have called on regulators to suspend all fundraising by corporate and government entities in the province, and on institutional investors to boycott such entities’ debt, as a way of putting pressure on the provincial government to bail out DSS.

Bondholders’ frustrations are compounded by China’s lack of a clear debt-resolution process and the fact that the Liaoning government is in no position to fund a bailout.

This presents the central government with a dilemma: Should it help the provincial government to rescue the company, or should it allow DSS to fail?

The first choice would raise the moral hazard of “too big to fail” to a new level, encouraging other SOEs to take risks that would be shunned by companies with no recourse to government support.

It would also undermine the credibility of the government’s supply-side reforms, which aim to make the economy more responsive to market forces.

Allowing DSS to fail, however, could spark risk aversion on the part of investors, which, in turn, could lead to a liquidity squeeze and exacerbate the country’s economic problems.

In light of these undesirable alternatives, the government appears to be choosing to do nothing. This is one instance in which we see the potential for policy indecisiveness to increase the risk of economic drift.

Murky Mergers

Like corporate defaults, SOE mergers are something of a trend in China. Take, for example, Shenhua Group, China’s biggest coal power company, which is seeking a merger with China General Nuclear Power.

So far this year, mining company Minmetals has merged with infrastructure and mining construction group Metallurgical Corporation of China; China National Building Material with Sinoma, parent of China National Materials Group; Baosteel with Wuhan Iron and Steel; building materials supplier BBMG with Jidong Cement; and food company COFCO with textile and grains trading group Chinatex.

Business logic has played little part in these mergers, all or most of which have been at the behest of Beijing. The mergers appear to conform to the government’s stated objective, as part of its supply-side reforms, to halve the 112 SOEs it owns.

But that’s not real reform.

Most market commentators expected to see the government let the weaker SOEs fail while redistributing their resources to the private sector, even as the state retained ownership of strategically important entities. They did not expect a crude mathematical rationalization of the sector. Nevertheless, it is consistent with President Xi’s recent statements indicating that he wants to bring the state sector under tighter control of the Communist Party.

From an investment perspective, this raises serious questions, given that the SOEs’ inefficiency is one of the economy’s most deeply rooted problems.

When China faces a recession or financial crisis, the economic viability of this approach will become clear. In the meantime, in the absence of popular pressure for change, it’s likely the Party will maintain this approach, increasing the risk of the economy lapsing into drift.

Cashed Up, but Why?

Against this backdrop, a buildup of leverage among China’s listed companies appears to make little sense. Why borrow money when the economy offers little incentive to invest in productive enterprise?

On closer inspection, however, the rise in leverage seems to be driven by other considerations.

Rather than borrowing to boost capital expenditure on fixed assets, companies are hoarding the proceeds. At the end of the first quarter of 2016, listed companies held around RMB6 trillion in cash and other investments—an increase of RMB1 trillion over the previous period and enough to pay back 60% of their total balance-sheet debt.

Perhaps the increase in leverage reflects optimism on the part of business owners, who wish to be ready to take advantage of opportunities as they arise. On the other hand, parking loan proceeds in cash or financial instruments suggests uncertainty about the economy’s short-term prospects.

The question is, to what extent will such fence-sitting add to the risk of economic drift we’ve already noted?

Policy Risk Is Acute

We’ve always maintained that policy risk is one of China’s biggest uncertainties in its historic transition from an economy driven largely by investment, manufacturing and exports to one in which consumption and services play a greater role.

Now, as the country’s slowdown weighs increasingly on the government’s ability to implement reforms, that risk has become acute.

Finding themselves at a crossroads, China’s policymakers have come to a stop: reluctant to move forward, disinclined to modernize, averse to clarifying corporate solvency laws, loath to let companies fail. Rather than opening the SOE sector to private enterprise as initially suggested by their desire for reform, they are retreating to the familiar and bringing it further under Party control.

All this spells uncertainty—uncertainty for cashed-up Chinese companies, for global bond buyers and for China’s economy. And the longer the uncertainty lasts, the greater the risks become.

This article appeared previously in the Financial Times.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.