More companies default on their debt in China as the government prints money to bail them out

China is increasing the number of government loans it hands out even though the number of defaults on those loans is increasing, according to Bank of America Merrill Lynch.

There are only two ways this can play out, according to BAML analyst David Cui and his team in Asia, and both of them are awful:

• China can let the defaults take their course, which risks " a chain reaction" that may spread ... who knows where.
• China can continue printing money to bail out dysfunctional companies, putting downward pressure on the renminbi. That will make China's foreign non-RMB debt more difficult to pay, creating "financial system risk."

BAML's note comes on the back of a RMB 4 billion ($600 million) default by property investment company Shaanxi Xinsheng yesterday. "As large as Xinsheng's sounds, it pales against some of the other recent defaults in the lightly regulated P2P and private wealth management product markets," Cui writes. He then lists these other recent defaults

• July 2015, Fanya (a commodity exchange) defaulted on RMB 43 billion ($6.6 billion)
• November 2015, Caifu Milestone (P2P platform) defaulted on RMB 5 billion ($770 million)
• December 2015, eZubao (P2P platform) defaulted on RMB 50 billion ($7.67 billion)
• January 2016, Rongzicheng (P2P platform) defaulted on RMB 1.5 billion ($230 million)
• January 2016, Shengshi Caifu (P2P) defaulted on RMB 2 billion ($310 million)

Here is what that looks like in a chart:

While the number of defaults has declined of late, the total RMB amounts have become larger:

The context here is that China's economic growth is slowing, making it more difficult for the country and its public and private enterprises to pay off their debts. At the same time, China's central government is pouring more money into the market in hopes of spurring growth. January was a record month for new RMB loans.

The problem is that this new money is in the form of debt. Debt that some companies don't want, and some can't pay back. "Today, 21st Century Business Herald cited a manager of a local government funding vehicle (LGFV) in a Western province as saying 'the situation is completely different from last Jan's - the banks are now chasing us to grant us loans,'" Cui writes.

This is what BAML says the endgame looks like:

In a scenario in which investors are not bailed out and thus become more cautious, eg, rolling over some of the debt instruments in the shadow banking sector, some borrowers may struggle to obtain credit, for example, developers and coal miners. Whether this scenario would trigger a chain reaction is a key risk we would need to monitor. Moreover, given the default pressure in the trust and bond market markets as detailed in Appendix 1, cases may emerge there eventually, in our view ...

If shadow banking investors continue to be bailed out, this would imply a further strengthening of the implicit guarantee, and potentially, put pressure on growth, increase the debt burden and hurt RMB stability. We re-iterate our view that financial system risk is arguably the most important risk facing market this year ... Until the debt issue is addressed, we believe it is unlikely we will see the bottom of the market.