Perils Mount As Debt Costs Swell in China; Dangers Include Slower Growth, Weaker Profits and Potential Defaults

Perils Mount As Debt Costs Swell in China

Dangers Include Slower Growth, Weaker Profits and Potential Defaults


Feb. 10, 2014 5:29 p.m. ET


SHANGHAI—Borrowing costs for Chinese companies are rising strongly, a shift that could herald weaker corporate profits, slower economic growth and even the first defaults by indebted corporations on the mainland.

Driven by a surge in borrowing in recent years, Chinese companies amassed an estimated $12.1 trillion of debt at the end of last year, according to Standard & Poor’s. That compares with an estimated $12.9 trillion for U.S. businesses, now the world’s most indebted. The ratings company estimates that debt at Chinese companies is poised to exceed the U.S. total this year or next.

“The leverage in the corporate sector is already very high and does pose a latent risk to the entire economy,” said Shuang Ding, an economist at Citigroup Inc. C -0.04% Challenges for companies are mounting as the government tightens credit and investors demand higher interest rates to fund borrowers.

Evergreen Holding Group Co., a private shipbuilding and marine-engineering company in eastern China, exemplifies the challenges. Its borrowing costs have more than doubled in the past 20 months as profits tumbled.

In June 2012, Evergreen paid 4.64% when it borrowed 400 million yuan ($66 million) for one year. Seven months later, issuing one-year debt cost it 6.13%. In December, it had to pay 9.90% to borrow the same amount, giving Evergreen the distinction of paying the highest rate for any new short-term corporate bond since the government launched the market in 2005, according to WIND Info, a data provider.

“The double whammy of an economic slowdown and rising borrowing costs will cause problems for companies already struggling with sliding profit margins,” Mr. Ding said.

Evergreen is in a particularly vulnerable position as Beijing moves to contain the growth in debt. It is a private company so it doesn’t get the preferential treatment, such as cheap loans, that state-owned companies receive. And it is in a sector, heavy industry, that China is de-emphasizing as it tries to boost consumption and reduce its dependence on investment as a source of economic growth.

The company, which promotes its “entrepreneurial passion,” accumulated its debt in a rapid expansion that included acquiring MagIndustries Corp., a Canadian mining company that hopes to dig for potash in the Republic of Congo.

China’s corporate debt has risen more rapidly than its economy has expanded over the past five years. According to J.P. Morgan Chase JPM +0.21% & Co., China’s corporate debt was 124% of gross domestic product in 2012, up from 111% in 2010 and 92% in 2008. J.P. Morgan economist Haibin Zhu said the number likely rose further in 2013.

Corporate debt in comparable emerging economies is 40% to 70% of GDP, while in the U.S. the figure is 81%, according to J.P. Morgan.

While heavy debt loads can hurt companies, there is also concern about the impact on lenders. In China, banks tend to hold loans on their balance sheets and are the biggest buyers of corporate bonds.

“High corporate debt is the biggest vulnerability for the Chinese financial sector, followed by shadow banking and local government debt issues,” Mr. Zhu said.

Rates have even risen for some of China’s most important borrowers. China Development Bank, a state-owned lender charged with helping to develop the nation’s economy, saw the rate it pays on five-year bonds rise to 5.75% this month from 4.97% in late October and 4.16% in January 2013.

For the Export-Import Bank of China, which helps finance the flows of goods into and out of China, the rate on its three-year bond rose to 5.44% in February from 4.80% in October and 3.62% in February 2013.

The increase in borrowing costs was driven in part by a rise in rates on government bonds. The yield on China’s benchmark 10-year government bond reached 4.75% in late November, the highest since January 2005 and up from 3.68% at the end of 2012, according to WIND Info and Thomson Reuters. The yield has since fallen to 4.51%. For short-term bonds like the ones sold by Evergreen, the average interest rate on new issues now stands at about 6.26%, up from 4.38% at the beginning of this year and 2.77% in 2005.

With a rate of 9.90%, Evergreen’s latest debt issue is effectively a junk bond, said Wang Ming, a partner at Shanghai Yaozhi Asset Management, which oversees two billion yuan in assets. “If [Evergreen’s interest rate] rises above 10% next year, how will they be able to honor repayment?” Mr. Wang said.

Evergreen declined to comment on the interest rates it is paying or its ability to repay its debt. “The bill sale was a market exercise. We do everything according to the rules of the market,” said an official at Evergreen’s finance department, who declined to comment further.

Evergreen said in the prospectus for its December bond issue that if the shipbuilding industry stays weak, “the company’s profitability will likely keep sliding, which will affect the issuer’s repayment ability.” Evergreen’s net profit dropped to 45.9 million yuan in the first nine months of 2013 from 324.7 million yuan a year earlier.

The slide has made Evergreen’s debt situation worse. At the end of 2010, the firm’s earnings equaled 33% of its outstanding debt, while a year later the figure fell to 12% of its debt. At the end of 2012, Evergreen’s earnings equaled just 7% of outstanding debt. Figures for 2013 aren’t publicly available.

No corporate bond in China has ever failed to pay off, though some issuers have been bailed out. “We keep guessing when we will see the first bond default in China, and I think it might be possible to see one or two cases this year,” said Yaozhi’s Mr. Wang. He declined to comment on his own portfolio, but advised investors to avoid “bonds issued by risk-prone small companies, especially those in sectors burdened by overcapacity, such as the shipping and solar industries.”

Even if there are no defaults, if many companies are forced to cut spending to raise cash for debt repayment, that could cause the economy to slow.

Rising money-market rates and bond yields have also translated into higher rates on bank loans, which account for the bulk of corporate lending in China. Smaller, private firms have been hit the hardest. According to Lily Li, financial director of a medium-size, privately owned pharmaceutical firm in Shanghai, banks are now charging at least 8% for a one-year loan, compared with a little over 6% a year ago. “The cost of borrowing from banks is becoming really unbearable now. We won’t die, but it’s really too much pressure for us,” Ms. Li said.

Jason Lee, who runs a Taiwanese-owned electronics supplier based in Jiangsu province, has kept his costs low by borrowing in currencies such as the yen or by borrowing from his bank in Taiwan, an option not available to most Chinese companies.

“I’ve been watching the credit crunches very closely, and I would definitely lose money if I took yuan-denominated loans,” Mr. Lee said.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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