Why banks are wary of Beijing plea to back private companies

Pity the Chinese state-owned bank trying to obey ever-changing instructions from policymakers in Beijing.

For years, banks preferred to lend to giant state-owned enterprises — both because of the implicit government guarantee that such debt has traditionally carried, and because SOEs were seen as national champions that deserved support.

But now the script is shifting as China’s economy slows. Many foreign investors are focused on the impact of the trade dispute with the US, but the effect of a domestic crackdown on shadow banking — which has closed off access to credit for privately owned companies that relied on non-bank channels — is probably more important. Private companies generate 60 per cent of China’s economic growth and 90 per cent of new jobs, according to an industry association that represents them.

That is why China’s cabinet last week issued guidelines urging banks, among other intermediaries, to step in to the void to increase support for private companies. Yet it is doubtful whether moral suasion alone will do the trick. After a string of bond defaults by private groups, lenders are hesitant.

Sarah Xu, analyst for rating agency Moody’s in Shanghai, says the prospect of continued government support for private groups is positive only for “fundamentally sound” companies, “of which there are only a few”. As for the weaker ones, the “increased availability of credit will not significantly affect [their] overall financing situation”, she says.

Some 124 bond issues with principal worth Rmb121bn ($18bn) defaulted last year, compared with only Rmb34bn a year earlier, according to data from Wind Financial Information. Among the defaulting issuers, about four-fifths were private groups, even though SOEs comprise a majority of all bond issuers.

Banks may be wary of backing private groups because they lack confidence in the reliability of their financial statements.

Last month Shenzhen-listed Kangdexin Composite Materials, for example, defaulted on a Rmb1bn onshore note. Yet the company’s most recent quarterly report showed the group held Rmb15bn in cash and near-cash assets at the end of September — raising doubts about the accuracy of its reported accounts.

“It could be that the financial statement was fabricated. A typical technique is to obtain cash temporarily” so that it can be recorded on the balance sheet, says Shi Min, chief credit officer at Lakefront Asset Management, a Beijing-based hedge fund. He adds that the disclosure from Kangdexin, a manufacturer of laminating films, could have omitted the fact that these were “restricted” cash holdings, not available for immediate use.

The company has denied issuing false financial statements and said in an exchange filing that an internal investigation had revealed a “situation in which large shareholders occupied funds”, without providing further detail. China’s securities regulator is also investigating the company, according to the filing.

But Kangdexin is not an isolated case. Bright Oceans Corp, a commodity trading group, has defaulted on at least seven bond payments since late 2017, despite reporting Rmb4.8bn in cash and equivalents on its balance sheet in June 2017. Lianhe Credit Rating, a Chinese agency, rated the company AA that month, before downgrading it to single-C in January last year. Bright Oceans did not respond to requests for comment.

Market participants say that rather than simply urging banks and investors to increase lending to private groups, regulators should cultivate market-based mechanisms that can allow banks and bond investors to appraise credit risk and default recovery ratios more accurately. That includes developing auditors, rating agencies and bankruptcy courts.

“Regulators can’t check everything themselves. They don’t have the personnel or the expertise. What the market needs are institutions to help supervise,” says the China head of a large European bank. “If [regulators] were to punish a few accountants harshly [for enabling fraud], that would send a great message.”

But Drew Bernstein of Marcum BP, an accounting firm that specialises in helping Chinese companies list in the US, says it is unrealistic to expect auditors to expose fraud.

“Let’s say I’ve got 25 years of experience and have audited 50 manufacturing companies. Do you really think I know much compared to a guy that has been in the manufacturing business for 25 years, every day of his life? Don’t you think he’d know enough to perpetrate a fraud sophisticated enough to beat me?” he asks.

Instead, Mr Bernstein says short-sellers are the group most able to detect and expose financial fraud. But short selling is virtually nonexistent in China’s corporate bond market.

“I’ve spent a lot of time learning from the shorts because it’s just not really within the accounting world,” he says.

A partial solution may come with the imminent entry of foreign credit rating agencies to China’s domestic bond market. Foreign groups are expected to hand out top ratings less frequently than their local competitors. But at least in the medium term, foreign groups are likely to occupy only a small niche in the Chinese market.

“Rating agencies’ follow-up reports often feel like they’re written off a template, so people don’t have any way to verify the information put out by the company,” says Qi Sheng, chief fixed-income analyst at Zhongtai Securities in Shanghai.