A cross default is a clause in a loan or bond contract that puts a borrower in default for breaching another of its debt obligations. For example, a cross default contract may state that a person automatically defaults on a car loan if they default on their mortgage.

Chinese companies in recent years have included cross default clauses in debt agreements for their subsidiaries and affiliates as a means to secure easier funding. Essentially, the clauses allow less creditworthy companies to borrow on the strength of their parent company. The practice is especially common in industries with overcapacity issues, such as coal and steel, among lower quality private companies, as well as local government-linked companies.

Jiang Chao, chief economist at financial services firm Haitong Securities, warned that such clauses can intertwine financial structures between companies, thereby amplifying the risk of non-payment.

When one company defaults on a repayment, it also reneges on the debt it has guaranteed for other companies, setting off a chain reaction of corporate defaults, and subsequently aggravating market risks. Moreover, when the cross default clause is triggered, it also puts short-term repayment pressure on the borrower, meaning it has less capacity to refinance its debt. Thus, cross default clauses can create a domino effect in which an insolvent borrower may be in default on loans from multiple contracts, if all lenders include cross defaults in their loan documents.

While the number of cross defaults in China is still relatively low, it is growing rapidly. Total bond issuance containing cross default covenants that were due in 2016 stood at 3 billion yuan (US$446 million), before rising to 119 billion yuan (US$17.7 billion) in 2017 and 539 billion yuan (US$80.2 billion) in 2018, according to Shanghai-based information provider, Wind Financial.

In the same vein, the number of cross defaults that were actually triggered rose to 20.4 billion yuan (US$3 billion) in 2018 from 1.26 billion yuan (US$187 million) in 2017.

Cross defaults originated under US and British law, when they were used to anticipate breaches of contract. As such, they are more commonly used in international bond and loan markets as a means of speeding up debt repayments, Jiang said.

Their use in China is relatively new, and only became common after the National Association of Financial Market Institutional Investors (NAFMII) promoted their use in bond contracts in 2016. The aim was to ensure that individual creditors have the same rights, should a borrower default on multiple debts.

The borrower, if it has signed a cross default agreement, is responsible for organising meetings and disseminating information among various lenders, if it misses repayments. NAFMII rules stipulate the conditions under which a cross default is triggered, and how that would be subsequently handled.

There were three factors that caused the cross defaults to be activated.

Minsheng Investment said in the stock filing that its repayments on an outstanding private placement note of 904 million yuan (US$135 million) had to be pushed back to April 19 from April 8.

“The [operating] style of these private companies as well as certain local regions are too aggressive, resulting in these problems,” said Ding Wenjie, economist at CMB International. “China’s risk of cross defaults is likely to keep rising.”

Lenders to its subsidiary Yida China Holdings were subsequently expected to demand repayment on 4.3 billion yuan (US$640 million) in outstanding loans.

Meanwhile, Chinese courts froze about 15 billion yuan of Minsheng Investment’s shares in its subsidiary businesses.

These factors combined triggered two cross defaults by Minsheng Investment and its subsidiaries on a US$300 million bond listed in Hong Kong and a US$500 million bond in Singapore, denying it the right to access those funds, the stock filing said.

Minsheng Investment’s cross default announcement added to a recent string of private enterprise defaults. Hi-tech material firm Beijing Kang Dexin, which supplies optical film products to Apple and carbon fibre materials to Mercedes-Benz, cross defaulted on bond payments topping 2 billion yuan in January.

Landscape designer Beijing Orient Landscape & Environment, meanwhile, was late with an interest payment on a 500 million yuan bond in February, thereby entering “technical default”.

The rising number of debt default cases may suggest Chinese authorities are stepping away from the practice of bailing out poor quality private sector companies, even large conglomerates, that had diversified away from their core businesses or had too fast asset growth, analysts said.

“Looking to the future, private enterprises will benefit from policy support and improved earnings. But debt defaults should stay high for the worst kind of private enterprises,” Jiang said.

Overall, China’s scale of bond defaults remain low, but the pace of growth is developing rapidly. This year so far, there have already been 18 new credit defaulting entities, exceeding the whole of last year, according to Jiang. Of the new default entities, 17 were private enterprises.

Rabobank’s Every said that in general, Chinese firms’ ability to service their debt was a growing concern as nominal gross domestic product (GDP) growth slowed to its lowest levels seen back “in the bad old days” of 2015, when it bottomed out at 7 per cent.

China’s nominal GDP growth – that is, growth not adjusted for inflation – slumped to 7.8 per cent in the first quarter of 2019 from a year earlier, down from 9.7 per cent in the fourth quarter and 10.3 per cent in the first quarter of 2018, respectively.

Despite high corporate debt levels, defaults remained at a low 0.4 per cent of outstanding bonds at the end of July 2018 because state-owned enterprises enjoy implicit guarantees from the government.