Recent bond defaults by state-owned enterprises (SOEs) have roiled China’s typically calm onshore corporate bond market. Regulators acted quickly to provide liquidity and calm market jitters. But should investors be worried?

Policymakers Have “Zero Tolerance” for Corporate Misbehavior

Historically, China’s local governments intervened to prevent defaults, bailing out weak issuers to avoid job layoffs and ensure market stability. This created the effect of an implied guarantee on corporate bonds and allowed SOE total debt to balloon to nearly 130% of GDP today (Display).

Stacked bars show the growth of each major sector of China’s bond market from 1999 through midyear 2020.

But the perception of an implied guarantee had been eroding over the last several years, as China shifted to a policy of bad-debt cleanup. The cleanup began in 2014 when China allowed its first onshore corporate bond default: Shanghai Chaori Solar Energy. Its first SOE default—Baoding Tianwei Group—took place in 2015. Over the next few years, China’s cleanup policy slowly gained momentum—that is, until the Covid-19 pandemic forced policymakers to shift into forbearance mode in support of economic recovery.

Now that China’s recovery is strong and broad, policymakers are again allowing orderly defaults, but this time there’s a twist. When Yongcheng Coal & Electricity, a local SOE in Henan province, missed its November coupon payment, market reaction reflected concerns that SOEs might be purposely evading their debts. In other words, Yongcheng’s default appeared to be a case of unwillingness to pay, rather than inability to pay.

The Financial Stability and Development Commission (FSDC), a high-level coordinating body chaired by Vice Premier Liu He, publicly declared that it had “zero tolerance” for illicit corporate behavior. A chastened Yongcheng subsequently announced that it had reached an agreement with its creditors to repay half the principal owed up front and the remaining principal and interest owed nine months later.