A surge in Chinese corporate bond defaults this year has been concentrated in the state-owned sector, revealing the way in which squeezed local governments are turning a cold shoulder to corporate subsidiaries beset by unsustainable debt burdens.

A total of 41 default cases have hit China’s domestic debt markets in the year to mid-September, more than the previous two years combined, according to Wind Information, a Shanghai-based financial data company. Some 70 per cent of defaults by end-July were by state-owned enterprises, according to IHS, a consultancy.

Thus a persistent question over the next few years is likely to be: “Who’s next?”

Ivan Chung, associate managing director at Moody’s, the credit rating agency, sees a clear pecking order emerging to govern what sort of company is likely to be cut loose by debt-ridden local governments and what sort may be saved.

“If you look forward three to five years, it seems more and more probable that local government entities will need increasingly to stand on their own and the likelihood of substantial government support will gradually recede for those (companies) not providing public goods or a service linked to national priorities as their sole or predominant purpose,” said Mr Chung.

Moody’s has compiled key metrics from local governments and the companies they own to suggest which areas of the country are most exposed to financial distress. As overseas investors grow increasingly interested in the mainland’s corporate bond market, such distinctions are of material significance.

In the chart below, the enterprises owned by administrations named closer to the bottom right portion of the chart are generally in poorer shape than the ones closer to the top left. So, for instance, state-owned enterprises in Tianjin have liabilities that are 613 per cent of those companies’ revenues, implying a hefty debt burden, according to Moody’s research.

But Tianjin is better off than the province of Heilongjiang — which has a smaller overall debt load — inasmuch as the state-owned enterprises owned by this northeastern province made losses on assets between 2011 and 2014, impinging upon their ability to service debts from current profits.

Similarly, Yunnan, Shanxi, Chongqing and Inner Mongolia are administrations which exhibit differing measures of financial frailty either because of high debt loads relative to revenues or poor returns on assets, or a mixture of both. These administrations tend to cover parts of China where overcapacity industries such as steel, coal, aluminium, glass, cement and others are prevalent.

The big picture behind China’s local government debt problem is stark. The liabilities of well over 100,000 companies owned by local governments across the country grew at an average annual rate of 14.1 per cent from 2012 to 2015 to reach Rmb35.4tn ($5.3tn), according to Moody’s research.

These are treated as contingent liabilities — or potential liabilities — because although local governments do not guarantee the debts of their corporate subsidiaries, they nevertheless are responsible for generating local economic growth, employment and public services so they would be loath to let an important contributor to such goals go under.

But in recent years, some local governments have built up such hefty direct debt burdens that even if they would like to bail out an important local employer, they may not be able to. Total direct local government debt, according to Moody’s, was Rmb16tn in 2015. Thus direct and contingent liabilities come to Rmb51tn — more than the GDPs of Japan and Germany combined.

The chart below shows the relative abilities of local governments to step in to rescue companies that fall into financial distress. Guizhou, for instance, had direct debt of Rmb913bn in 2015, equal to 200 per cent of the province’s revenue. Liaoning, Inner Mongolia and Yunnan were similarly vulnerable, whereas Gansu appears to have ample coverage of revenue relative to debt.

However, Tianjin — which owns heavily-indebted companies that make averagely poor returns — has a good level of revenue coverage to direct local government debt, meaning the local authorities’ ability to bail companies out is relatively strong.

Nicholas Zhu, vice-president at Moody’s, describes a clear hierarchy of debt vulnerability. The most likely to default would be lossmaking, indebted companies owned by lower-tier governments — at the prefectural, city or county level — that have little revenue and large debts. The problem, however, with lower-tier administrations is that they often publish sparse statistics, so it is difficult to know the true state of their financial health.

But there are other considerations too. Higher per capita GDPs tend to be correlated with broader economic diversification, insulating an area from the wild swings in fortune created by the commodity cycle. Thus, wealthier parts of China such as Beijing, Tianjin, Shanghai Jiangsu and Zhejiang display greater diversification and have much larger service sectors, meaning these regions are better able to weather downturns in cyclical industries.

Thus, as the chart below shows, Guizhou, Yunnan, Hunan, Shaanxi, Anhui, Qinghai, Guangxi and Ningxia are relatively exposed on this measure.

But even such financial considerations do not tell the whole story of which companies — once under duress — would be allowed to go to the wall.

The value to the local government of the work a company does can also be important, suggesting that if a company is involved in building highways, metros, bridges, railways and other essential infrastructure, the local government is less likely to let it default. But if it is involved in a non-essential industry, or more pertinently an industry which the authorities are keen to strip capacity from, it would be much more likely to be cut loose.

One important sub-category of state-owned enterprise is local government financing vehicles (LGFVs). These are not only owned, supervised and managed by local governments, they are often also involved in providing public services — making it highly unlikely that a local government would allow them to go bust, Mr Zhu said.

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