Chinese debtors have never faced such hard times paying interest

[HONG KONG] Just as monetary easing is pushing Chinese bond yields to record lows, the ability of listed companies to service their debt has dropped to the weakest on record.

Firms generated just enough operating profit to cover the interest expenses on their debt twice, down from almost six times in 2010, according to data compiled by Bloomberg going back to 1992 from non-financial companies traded in Shanghai and Shenzhen.

Oil and gas corporates were the weakest at 0.24 times, followed by the metals and mining sector at 0.52. The People's Bank of China has lowered benchmark interest rates six times since 2014, driving a record rally in the bond market and underpinning a jump in debt to 247 per cent of gross domestic product.

Yet economic growth has slumped to the slowest in a quarter century and profits for the listed companies grew only 3 per cent in 2015, down from 11 per cent in 2014.

The mounting debt burden has caused at least seven firms to miss local bond payments this year, already reaching the tally for the whole of last year.

"We will likely see a wave of bankruptcies and restructurings when the interest coverage ratio drops further," said Xia Le, chief economist for Asia at Banco Bilbao Vizcaya Argentaria SA in Hong Kong.

"Return on assets for Chinese companies has been declining due to rising debt. Profitability is also slowing due to overcapacity in many sectors, which has weakened the ability of companies to repay their debts."

China will probably report economic growth slowed to 6.7 per cent in the first quarter from 6.8 per cent in the previous three months, according to a Bloomberg survey of economists.

A tale of two Chinas is emerging as the country transforms, said Henk-Jan Rikkerink, Fidelity International's London-based global head of research. Regions focused on innovation or local consumers are flourishing, he said, while those "very heavily dependent on resources" are struggling as demand declines.

The strongest sector was life sciences, which has boosted operating profits, or earnings before interest and taxes, to 34 times interest expenses. Software companies also saw the ratio improve to 8.5 times.

Commodities companies are showing the strain with coal miner Henan Dayou Energy Co reporting operating losses 33 times its interest expenses, while the ratio for Qinghai Jinrui Mineral Development Co, a strontium miner, was a negative 3.8 times, the data show. The firm has 69 million yuan outstanding on 7.9 per cent bonds due next year, data compiled by Bloomberg show.

Henan Dayou didn't immediately reply to an e-mail seeking comment. Two calls to the firm's media department went unanswered. Two calls to Qinghai Jinrui Mineral's general line went unanswered.

Dongbei Special Steel Group Co defaulted on securities a second time in two weeks on April 5. The Shanghai Clearing House said on April 6 it hadn't received funds from Chinacoal Group Shanxi Huayu Energy Co to pay holders of its 600 million yuan (S$125 million) 6.3 per cent notes.

As credit stresses mount, China is drafting rules to make it easier for lenders to convert bank loans into equity stakes of debtor companies, a person with the knowledge of the matter said in March. Another person said last week China may approve as soon as this month a plan allowing banks to convert as much as 1 trillion yuan of soured debt into equity.

'VICIOUS CYCLE'

The defaults have had a muted impact on financing costs. The Chinese central bank's monetary easing has pushed yields on five-year AA- rated corporate yuan notes down 1.3 percentage points in the past year to 6.13 per cent, near a historic low of 5.96 per cent in March.

China's high savings rate and foreign-exchange reserves should help prevent the worsening credit fundamentals at companies from leading to systemic risks, said Tommy Xie, a Singapore-based economist at Oversea-Chinese Banking Corp. Still, credit events may spread further, he said.

That could lead to a "vicious cycle," said Raymond Yeung, a Hong Kong-based senior economist at Australia & New Zealand Banking Group Ltd. "More defaults will cause credit conditions to tighten so more companies will run into cash flow problems."

With borrowing costs so low, the temptation is to turn to creditors for more cash and kick the can down the road. Total social financing, China's broadest measure of new credit, rose to an all-time high in January. Local yuan bond issuance has surged 67 per cent this year to 2.8 trillion yuan.

"For some firms the rising leverage is a result of lower earnings," said Iris Pang, senior economist for greater China at Natixis SA in Hong Kong. "Many companies now need to pay their debts via new borrowings, or structure existing loans so that they can repay in a much longer maturity."

BLOOMBERG