Beijing is going to have to start making a lot of life or death decisions about the Chinese economy
- Tightened credit conditions has one Chinese manufacturer with $7 billion in debt begging for help. It won't be the last one to do so.
- Beijing will have to start deciding who lives and who dies in China's corporate sector.
- Investors shouldn't just worry about who gets bailed out, they should also worry about how. In China, healthy companies can easily be conscripted to save sick ones.
A private Chinese manufacturer, DunAn Group, has sent a letter begging the Chinese government to help it out with its $7 billion of debt.
Expect to hear more companies cry for help as the government attempts to ween the country off of the easy credit that has lubricated its corporate sector since the Global Financial Crisis in 2008.
Watch the government's response to this closely. On the one hand, if Beijing doesn't bail out companies like DunAn, it could strike fear into C-suites across the nation and send stocks roiling.
On the other hand, if Beijing bails out companies like DunAn, it will remove the moral hazard of bankruptcy. Everyone will expect a bailout. Investors would do well to pay attention to how exactly companies are bailed out (if they are so lucky) too. A healthy Peter could get robbed to pay for an ailing Paul.
That's how the system works.
Damned if you do, damned if you DunAn
"If a credit default happens, it will deliver a serious blow to many financial institutions in Zhejiang and may even cause systemic risks," said DunAn's letter according to the Financial Times. The letter also blamed the company's troubles on China's tepid effort to tighten credit conditions and rein in corporate debt.
According to analysts at Standard & Poor's, the credit profiles of manufacturers like DunAn have deteriorated significantly over the last two years. This is just the beginning of companies finding their situation going from dire to desperate.
Banks, once quick to extend more credit no matter what, are being given different marching orders from the top. And while the Chinese economy has been stable so far this year, Societe Generale analyst Wei Yao said in a note to clients last month that it's too early to expect any easing of policy or credit conditions, especially not with the possibility of a trade war on the horizon.
"In particular, the RRR cut last week should not be interpreted as the beginning of an easing cycle," Yao wrote. "As we explained in our previous note, the PBoC is performing a balancing act in maintaining stable liquidity conditions for banks to sustain formal loan growth, as the financial regulatory tightening continues to exert pressure on shadow banking activities. Indeed, the liquidity conditions have not become easier after the cut. Granted, the PBoC will have to do more to help mitigate the pain of financial deleveraging - in the form of rising funding costs - felt by the corporate sector."
It's unclear how much Beijing is willing to do to "mitigate" pain in the corporate sector. So the future for companies that find themselves in DunAn is uncertain and without precedent. Back in 2015, as the Chinese stock market was blowing up left and right, investors convinced themselves the government would step in. But this problem is different, China's robust shadow banking sector makes it difficult to tell how much debt is really on every company's books.
This puts regional officials in a tough position. They don't want companies to go under. They don't want to lose jobs and tax revenue.
Alternative methods in the People's Republic
And now, a warning.
Inarguably, the Chinese government under Xi Jinping has the power to do whatever it wants with its corporate sector, public and private. One tool that it has used in the past to bail out companies is called "mixed ownership reform."
In a nutshell, it's when the government forced healthy companies to invest in struggling companies. Last summer, China Unicom, a flailing state-owned telecommunications company, was bailed out to the tune of $10 billion in cash from private investors Alibaba, Baidu Inc., JD.com, China Life Insurance Co., and Tencent, among others. Together they bought a 35% stake.
Tencent, Alibaba, and Baidu are all names that sound familiar to American investors. They're the giants of China's tech sector - a sector that will be unleashing around $500 billion worth of initial public offerings on the world over the next year and change. "China's Biggest Tech Unicorns Stampede to Go Public" exclaimed the Wall Street Journal earlier this month.
Consider this, though, to play in China you must play the government's game. In that context, the New York Times' spin on this story may be more apt - "Tech Giants Feel the Squeeze as Xi Jinping Tightens His Grip." The article discusses the many ways the government is using its relationship with tech companies to police the internet, but as I said above, the relationship goes beyond that.
The Chinese government can use tech companies to police its people, and it just as easily can use tech companies as piggy banks.
You've been warned.