China is bracing for its second bond default by a central government-owned company, offering one of the biggest tests yet of Beijing’s willingness to impose market discipline on lossmaking state groups.
A unit of one of the elite club of 112 big enterprises directly owned by the central government, China National Erzhong Group employed a workforce of more than 13,000 in 2012, when it had assets of Rmb25bn. But a slowing economy saddled with industry overcapacity has hobbled the heavy industry group, leading to losses of Rmb8.4bn in 2014.
Its looming default comes just a week after Beijing unveiled guidelines for an overhaul of state-owned enterprises aimed at improving their financial performance. SOEs control broad swaths of the economy but are heavily indebted and trail their privately owned counterparts in efficiency and profitability.
China National Erzhong Group, which makes smelting and forging equipment for use in the power generation and aviation sectors, is a case in point. A subsidiary was delisted from the Shanghai Stock Exchange in May after four straight years of losses.
“Under the influence of the macroeconomic environment, the demand for the company’s main products remains depressed, and our industry is suffering from severe overcapacity, making competition unusually fierce and causing the price of our products to slide lower,” Erzhong said in a filing late on Monday.
The company suspended trading of Rmb1bn in five-year notes sold in 2012, citing “uncertainty” about whether it could meet a Rmb56.5m ($8.9m) interest payment due next week.
China is on track for its slowest economic growth in a quarter of a century amid a slowdown in construction and manufacturing. Policymakers want to shift the economy away from smokestack industries towards consumption and services; the SOEs are concentrated in heavy industry, which thrived under the old growth model.
For years, banks and bond investors paid scant attention to company fundamentals when lending to SOEs, assuming that the government would prevent any default. High-profile bailouts strengthened this perception. Economists say that has led to moral hazard, enabling state groups to rack up ever more debt and engage in wasteful investment.
But in April Baoding Tianwei Group, which makes power generation equipment, became the first state-owned company to default on bonds when it missed a Rmb86m interest payment. Tianwei is still in bankruptcy and it remains unclear if bond investors will end up taking losses.
Beyond the debt issue, Erzhong is also a test case for the vision of SOE reform that calls for increasing efficiency by merging state groups to create even larger companies. In 2013 China’s cabinet approved a takeover of Erzhong by China National Machinery Industry Corp (Sinomach) but the merger failed to stem losses.
The reform guidelines released this month appeared to be a compromise between conservatives who favour consolidation of state-owned companies and liberals who advocate a more market-oriented approach based on bringing in private investors.
The plan called for classifying state groups between commercial and non-commercial entities. While commercial businesses should strive to maximise profits, those with a national security or public service function may continue to enjoy state support. It is unclear where a company such as Erzhong, with its connections to the defence industry, would fall.
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