A rebound in global coal prices became one of the biggest stories in commodities during the second half of 2016. A more than 90 percent increase since mid-year in the benchmark Australian thermal coal prices has lifted stocks of international coal producers.
But don’t tell that to Chinese coal producers. The recent rally in coal prices hasn’t reversed the fortunes of many Chinese coal producers still wallowing in overleveraged balance sheets, high debt burden, and weak demand.
Recent bond market travails of these companies signal more defaults may lie ahead for Chinese onshore issuers as trillions of yuan in bonds become due in 2017.
Sichuan Coal Default
State-owned Sichuan Coal Industry Group missed a bond payment on Dec. 25. A total of 1 billion yuan ($150 million) in principal plus interest were due.
It was the second default for the coal company this year. Sichuan Coal also missed an interest payment in June but that default was ultimately resolved after the Sichuan government stepped in. Bond investors were paid at the end of July with loans from state-owned Sichuan Provincial Investment Group and a consortium of local and national banks.
Other Chinese state-owned enterprises (SOEs) are experiencing similar liquidity issues. China’s biggest lender—the Industrial and Commercial Bank of China—on Dec. 30 agreed to invest in Taiyuan Iron & Steel Group, Datong Coal Mine Group, and Yangquan Coal Industry Group via debt-to-equity swaps. Such swaps have been a key tool of Beijing to reduce leverage amongst SOEs by exchanging debt for equity. The swaps instantly eliminate debt and reduce leverage ratios at the cash-strapped firms.
Steel, coal, and other heavy industries have languished on weak global and domestic demand. Beijing also launched a program to shut underperforming mines and plants and reduce its coal producing capacity. China’s Shanxi Province in the northeast is its biggest coal-producing area, accounting for more than 25 percent of the country’s coal production last year.
Trillions of Yuan Becoming Due
Historically, bond defaults have been unheard of in China. But in 2016, 55 corporate defaults were recorded, more than double the number for 2015. And 2017 will likely see even more defaults.
More than 5.5 trillion yuan ($800 billion) in bonds will mature in 2017, or 1.8 trillion yuan more than 2016, according to China Chengxin International Credit Rating Group. That’s a significant amount of cash Chinese companies must come up with during the next year.
Sichuan Coal’s default—assuming the local government declines to extend another bailout—could signal that Chinese Communist authorities are willing to allow more bond defaults going forward. In truth, analysts have expected massive bond defaults for years, while Beijing has been selective in choosing which SOEs to bail out. Regardless, the number of such bailouts has decreased, underscoring authorities’ increasing comfort level with letting companies fail. With the significant amount of bonds due in 2017, a spike in bond defaults will likely result.
Furthering the challenge facing Chinese companies is the economic backdrop, which doesn’t look friendly for the Chinese bond market.
Like the rest of the global bond market, Chinese bonds have already been under pressure from the U.S. Federal Reserve’s plans of raising short-term interest rates. This has raised yields across the globe. China’s 10-year government bond yield settled at 3.07 percent on Dec. 30, slightly lower than mid-month but far higher than the 2.8 percent range at the beginning of 2016 (bond yields and prices move in opposite directions).
Faced with increased risk of capital flight, China may elect to guide its own rates higher. But in such a scenario, raising new debt would become prohibitively more expensive during a time when many Chinese companies are facing liquidity problems amidst slowing economic growth. The central bank’s actions would further squeeze Chinese borrowers in need of new debt to roll over existing debt.
China’s rickety financial system is built entirely on overleveraging with cheap debt. It is especially susceptible to rate hikes and without the type of economic growth required to withstand such rate increases.
With so much debt becoming due and armed with few options to raise new capital, 2017 could spell disaster for cash-strapped Chinese companies.