By Houze Song
For anyone who thinks that China’s government can control its state-dominated economy by diktat, the chaotic financial story unfolding in northern Liaoning province is proof that the state-owned sector, and even provincial governments, don’t always fall into line. The struggle over the collapsing finances of Dongbei Special Steel, a failing state-owned enterprise, has sparked a battle between two state-owned companies, China Development Bank and Dongbei Special Steel, and a virtual mutiny against the provincial government by Dongbei Special Steel’s lenders, many of which themselves are state-owned.
Dongbei Special Steel, a state-owned steel conglomerate that produces special alloys, has defaulted on $700 million worth of bonds since the start of this year. Dongbei Special Steel is wholly state-owned, and the Liaoning provincial government is its biggest shareholder. As the steel sector collapsed over the past couple of years and Dongbei Special Steel continued to borrow to cover its losses, by late 2015, it had accumulated an debt-to-asset ratio of 85%—meaning the firm will be insolvent if its assets depreciate by a mere 15%.
Dongbei Special Steel’s biggest lender, the lead underwriter of its defaulted bonds, is state-owned China Development Bank (CDB), China’s largest policy bank. Despite the fact that both are owned by the state, Dongbei Special Steel and CDB are on opposite sides of the financial battle. As the majority shareholder, the Liaoning government wants creditors to bear the majority of the loss. However, the creditors, led by CDB, want the provincial government to bail them out.
The fact that both are state-owned doesn’t seem to make any difference: they are clearly not on the same team. As the underwriter of the now defaulted bond, CDB wants Dongbei Special Steel and its shareholders to do whatever they can to avoid default. CDB contacted the Liaoning government and offered to help prop up Dongbei Special Steel. According to its proposed deal, CDB would repay Dongbei Special Steel’s debts, provided that the Liaoning government agreed to pay CDB in case Dongbei Special Steel eventually failed to do so.
But the Liaoning government, apparently interested in protecting its own majority stake in Dongbei Special Steel, quickly rejected CDB’s financial offer and instead proposed a debt-for-equity swap to the company’s creditors. It was an unattractive proposition: The government pledged to repay only 30 percent of Dongbei Special Steel’s debt and to cover the rest with new shares—of questionable market value. Dongbei Special Steel’s creditors were not pleased.
In the process of pursuing of its own financial interest, the Liaoning government has created a significant problem for Beijing and the central financial regulator. Many of the creditors are so-called wealth management products (WMP), a type of unregulated short-term investment product that offers returns above bank deposit rates. Although these wealth management products often hold risky assets like the Dongbei Special Steel bonds, they usually offer investors guaranteed returns. But Dongbei Special Steel’s default by definition means there will not be enough cash to pay all investors their promised return. The unlucky investor who withdraws last will have to bear the entire loss.
Once investors realize this calamitous situation, there could easily be a run on the wealth management products that invested in Dongbei Special Steel, as investors try to withdraw their money before others. Across China, some $3 trillion is currently invested in wealth management products, many of which own questionable assets, such as bonds issued by failing SOEs. In a worst-case scenario, panicked investors could start an indiscriminate run on all wealth management products. If this happens, it would create a problem for Beijing that is bigger than last year’s stock crisis.
To prevent a run from happening, a few wealth management product underwriters have already announced that they will cover losses associated with the defaulted Dongbei Special Steel bond with their own capital. But they are not quietly absorbing the loss. Instead, in a blackmail-like negotiating tactic with the Liaoning government, Dongbei Special Steel’s creditors openly called for all Chinese institutional investors to boycott all Liaoning municipal and corporate bonds. Though the threat is not very credible (creditors were later forced to drop the call for a boycott from their public statement), Liaoning has seen its borrowing costs rise in recent weeks as investors now demand a premium for holding Liaoning municipal bonds. So far, it is still unclear whether Liaoning will compromise and offer a better deal to the creditors.
As the drama was unfolding in recent weeks, China Financial News, a People’s Bank of China-owned outlet, published an editorial arguing that the Dongbei issue should be resolved through “market mechanisms”, suggesting that some financial policymakers in Beijing think that Liaoning shouldn’t pay in full and that creditors should suffer some losses. In theory, that approach is a good one, because it would teach the Chinese investors a lesson on risk management, perhaps making them more cautious in making future investment decisions. However, at the end of the day, this matter is about economic interests. It clearly won’t be resolved through market mechanisms, which would inevitably lead to Dongbei Special Steel’s bankruptcy. The Liaoning government simply doesn’t want to let the firm go through a bankruptcy procedure, resulting in the loss of all its equity. Most likely, there will be a lengthy bargaining between Liaoning, the Dongbei Special Steel creditors, and CDB. How much each side is willing to compromise is still unknown.
The boycott threat is also something new. Conventional wisdom says that, in a state-controlled financial system, Beijing can allocate credit as it wishes. But suddenly, it seems there is the possibility that a major provincial government could be cut off from bond financing. Of course, Beijing could still order a state financial institution to lend to Liaoning by fiat. But the broader lesson here is that, even in a state-controlled financial system, individual players place their own interests above the interest of the entire state sector.
The rivalry between various state players has been a longstanding theme in China. But during the past few decades of double-digit growth, infighting has been attenuated, as there have been abundant economic opportunities for everyone. However, as the economic pie now grows at a much slower rate, or even shrinks in some sectors and regions, the infighting has resumed. It seems that the process of cleaning-up China’s current debt mess will not be as orderly and smooth as many believed.