HONG KONG/SHANGHAI Credit warning signs are flashing for heavily indebted Chinese semiconductor, software and commodities firms as the government cautiously steps aside to let market forces play a bigger role in deciding winners and losers.
China's first-ever domestic bond default this month - a missed interest payment from Shanghai Chaori Solar Energy Science and Technology Co (002506.SZ) - shattered the belief that Beijing would always bail out struggling companies.
"The Chaori default goes to show the government will begin to let the market decide the fate of weak borrowers," said Standard & Poor's analyst Christopher Lee in Hong Kong.
Lee said defaults would be "incremental but controlled" with sectors including shipbuilding, metals and mining, and materials among those showing the highest risk as China's economic growth slows and banks tighten lending.
Chinese companies owe just over $1 trillion in domestic bonds, of which 15.8 percent is coming due this year, Thomson Reuters data showed.
While companies contacted by Reuters were confident they could obtain credit, Chinese rating agencies have stepped up the pace of downgrades. There were 77 companies downgraded in 2013, more than triple the previous year's tally, according to ratings agency China Chengxin.
A Reuters analysis of more than 2,600 Chinese companies found credit metrics worsening across a range of industries. The software sector was shouldering the heaviest credit burden with an average of 3.4 times more debt than equity. Semiconductors - a category which includes solar companies such as Chaori - had a debt-to-equity ratio of 2.6.
Across all listed Chinese companies, the average debt-to-equity ratio was 0.85 in 2013, according to Standard Chartered.
It is unclear where China's government will draw the line on letting market forces prevail. Premier Li Keqiang said in a news conference on March 13 that Beijing was "reluctant to see defaults of financial products but some cases are hard to avoid.
But social stability has traditionally trumped market reforms. If a major employer or a high-profile company were to slip into distress, the government is all but certain to intervene. The municipal government of Wuxi, for example, threw a $150 million lifeline to struggling solar company Suntech Power Holdings Co Ltd in October.
Local governments will be keen to protect companies that are important tax payers and employers, but would be willing to let smaller ones like Chaori fail, according to a Hong Kong-based analyst with a U.S. bank, who declined to be identified.
18 YEARS TO REPAY
Materials companies look vulnerable as weak commodity prices hurt profitability, leaving less money to repay debt. Although the metals and mining sector's average debt-to-equity ratio is a manageable 1.4, bond holders see rising risk and have demanded higher yields for holding the debt.
Xinyu Iron and Steel Co Ltd (600782.SS) for example, would need almost 18 years to repay its total debt at the present rate of cash generation. Its bonds due 2016 saw yields rise 160 basis points this month alone to around 10 percent.
Xinyu did not immediately respond to emails and a phone call seeking comment.
As a state-owned company, Xinyu would likely get government help if it struggled to repay. Indeed, if Beijing failed to step in when any state company faltered, that would set off louder alarm bells among creditors.
Privately owned Nanjing Iron & Steel Co Ltd (600282.SS), which has 4 billion yuan in bonds coming due in 2018, said it had many funding channels available, including U.S. dollar debt, stock holdings and bank loans.
"The bond is due in 2018. Our company has not made any repayment plan since the time has not arrived yet," said Xi Siwei, an official in the securities department at Nanjing.
Packaging materials company Zhuhai Zhongfu Enterprise Co Ltd 000659.SZ, which has 590 million yuan in bonds due 2015 and an equal amount coming up for repayment in 2017, said the coming months were a boom season for its business and cash flow would pick up, easing debt servicing strains. If necessary, it could also sell some assets.
"The industrial land held by us is worth more than a billion yuan ($161 million)," said board secretary Lishang Chen. "So selling one or two plots of this land is sufficient to pay our debt."
Shandong Molong Petroleum Machinery Co Ltd (002490.SZ), which owes 500 million yuan bonds due in 2016, said rising bond market yields were of little concern because it had no plans to issue new debt and bank interest rates were not as high.
"The yield has nothing to do with our ability to repay the debts," said board secretary Zhao Hongfeng. "We have no problem in repaying the short-term debts."
WHAT IS NEXT
Beijing will continue to support companies that fit its policy goals, which suggests large state-owned enterprises would be rescued if they got into debt trouble, according to Steve Wang, head of China research at Hong Kong-based boutique investment bank REORIENT Group.
"We will not see a big-bang collapse but rather small fire crackers in a 'no pain, no gain' process," Wang said.
Other credit problems may be lurking in harder-to-read areas such as bank loans. News last week that a Chinese property developer owing 3.5 billion yuan was at the edge of insolvency highlighted that risk. About a third of Zhejiang Xingrun Real Estate Co's borrowings came from individual investors.
While the better known property developers have access to offshore markets, there may be more casualties among the smaller players.
"Banks in any case aren't eager to provide loans and trust loans are under scrutiny so the channels for smaller developers are limited," said Manjesh Verma, Credit Agricole head of credit research and strategy in Hong Kong.
Some 80 percent of China's 60.3 trillion yuan in total corporate debt comes from bank loans. Trust loans and microcredit accounted for 4.8 trillion.
China's big banks favour large, state-connected firms, which leaves smaller companies more reliant on informal lending.
"Do we see more defaults in the near future? Yes, with a move towards market-based pricing that is inevitable but, in the near term, the scale of defaults will be relatively small and this process will be managed throughout the process," said Mark Capstick, a fund manager at FFTW in London.
(Additional reporting by Grace Li in Hong Kong, Adam Rose in Beijing and the Shanghai newsroom: Editing by Emily Kaiser)