Cross guarantees between companies a significant risk in certain parts of China, according to S&P
Cuts in capacity and tightened liquidity could trigger domino of defaults
Cross guarantees between companies are a source of significant risk in certain parts of China, analysts from rating agency Standard & Poor’s said on Monday. As Beijing pushes ahead with cuts in capacity and top-down financial market clearing leads to tightening in liquidity, it is the smaller private companies that have been hit hardest, which has increased the chances of a domino of defaults.
A cross guarantee essentially means that two or more companies provide guarantees for each other’s
debt. Since 2013, external debt guarantees have increased by 15 per cent each year among the issuers surveyed by S&P, and represent up to 25 per cent of their total adjusted debt.
Most their external debt guarantees are cross guarantees, according to a report issued by the rating agency on Monday.
“It is more prevalent in some regions, like Shandong and Zhejiang, as local banks may have been encouraging these to enhance the credit profiles of some private companies. Although, we could not rule out the involvement of local governments,” said Cliff Kurz, an S&P Global ratings credit analyst.
Smaller companies that experience funding gaps could set off a chain effect by triggering
guarantees on their debt, which are likely to lead to redemptions spreading from one company to another.
“For companies already burdened by short-term debt, such redemptions could pose a material
liquidity risk,” he said.
In a case study conducted by S&P, the rating agency presented the example of Shandong Yuhuang Chemical Company, the second-biggest company in Heze city in Shandong.
In mid 2017, its biggest guarantee counterparty, Hongye Chemical Group Holdings, another local company, was unable to meet its debt obligation and risked triggering the guarantees
provided by Yuhuang, which already had low liquidity buffers.
Instead of allowing the situation to worsen, the Heze city government asked the commercial banks involved to not pull back outstanding loans from the company.
In addition, the government set up a guarantee company whereby the guarantors of Hongye’s debt
would inject capital over a number of years to fund the liability, but the amount was less than if the guarantee were to be exercised.
Hongye was also forced to sell assets to pay down a portion of its debt obligation. With the help of the government, the guarantees for its debt were not exercised.
“However, the government bailout in this case remains an isolated one,” S&P analysts said during a webcast on Monday.
The risk that these guarantees could be exercised all at once is “not remote”, the report said. “The likelihood may be increasing that some of these guarantees will be exercised since capacity cuts in some manufacturing industries have hit small enterprises the hardest. Moreover, liquidity is tightening in the broader market,” said the report.
Beijing has started a grand campaign to rein in debt and has been clearing up the quickly expanding shadow lending market since last year, which has made borrowing costlier. This has made it harder for smaller companies to source capital from the once freewheeling shadow lending market.
DunAn Group, which employs about 29,000 people in the eastern province of Zhejiang, was last week caught up in a debt crisis worth as much as 45 billion yuan (US$7 billion), after it reported to the provincial government that it would “face difficulties” in repaying a 1 billion yuan short-term debt due this Thursday, according to Caixin.
And, although companies and governments have become aware of the risk brought by cross guarantees, these need to be dismantled “gradually and slowly”, said Kurz, citing the difficultly in determining the true extent of cross guarantees due to their off-balance-sheet nature, insufficient disclosure by companies and the complicated relevance to counterparts and banks.