China firms have found a way to cut debt, at least on paper

Shanghai - Under pressure to trim borrowings, China’s companies have found a way to reduce their lofty debt burdens - even if some of the risk remains.

Sales of perpetual notes - long-dated securities that can be listed as equity rather than debt on balance sheets given that in theory they could never mature - have soared to a record this year as Beijing zeros in on leverage and the threat it poses to the financial system.

The bonds are so popular that issuance by non-bank firms has jumped to the equivalent of 433 billion yuan, more than seven times sales by companies in the US.

“Chinese issuers love perpetual bonds because they are under great pressure to deleverage,” said Wang Ying, a senior director at Fitch Ratings in Shanghai. “Sophisticated investors should do their homework and shouldn’t be misled by the numbers in accounting books.”

Accounting rules stipulate that companies can book perpetual bonds as equity, a serendipitous ruling for Chinese companies that are struggling to rein in their reliance on credit at the behest of regulators. But firms still have to pay interest on the notes and in China, companies typically redeem them within five years to avoid big jumps in coupon rates.

They’re also more expensive than regular debt, with the average coupon on Chinese  perpetuals this year 5.83%, more than 20 basis points above the cost of ordinary five-year notes.

Built up after the global financial crisis as the country borrowed its way to a steady growth rate, China’s overall debt burden is more than double gross domestic product, a situation the central bank’s media mouthpiece calls a “financial mess.”

People’s Bank of China chief Zhou Xiaochuan recently renewed his call to tackle leverage in an essay, and while he didn’t single out perpetuals, he did identify “debt finance disguised as equity” as a source of risk to the system.

Ironically, state-linked companies have been some of the biggest issuers of perpetual bonds, with more than 60% of the notes sold in 2017 from firms owned by central and local governments, according to data compiled by Bloomberg.

While many state-owned or connected companies are trying to deleverage, actually reducing debt can be tough, says Ivan Chung, head of Greater China credit research at Moody’s Investors Service in Hong Kong. A lot of firms aren’t listed so can’t raise cash by issuing shares.

“By selling perpetual bonds under Chinese account treatment they can present lower debt ratios to SASAC,” Chung said, referring to the State-Owned Assets Supervision and Administration Commission of the State Council.

SASAC generally uses the ratio of total liabilities to total assets to measure the leverage of China’s state-owned enterprises against their performance, according to Christopher Lee, managing director of corporate ratings at S&P Global Ratings. That means perpetuals wouldn’t appear as part of the tally.

New phenomenon

Finance ministry data shows growth in Chinese SOEs’ total liabilities is decelerating. The average year-on-year monthly growth rate was 11% for the eight months through September this year, compared with 17% for the same period of 2016.

Two calls to SASAC weren’t answered and the body didn’t respond to faxed questions about why perpetual sales were increasing and whether the practice helped SOEs to conceal their true leverage burdens.

State firm China Datang has sold 15 billion yuan of the securities this year, making it the country’s top non-financial issuer. The company also didn’t respond to emailed questions on the sales.

Even as the government cracks down on leverage, Chinese firms still need to raise money to repay the huge amount of bonds due. The maturing amount is $723bn in 2018, the third highest on record.

Local issuance of perpetual notes only started in 2013, while offshore dollar-denominated perpetuals from China dates back to 2010. The finance ministry didn’t issue the regulation saying accountants can classify the securities as equity until 2014.

“The fact that most perpetual bonds are booked as equity may give some investors and institutions the wrong impression about leverage,” said Huo Zhihui, Beijing-based general manager in the rating technology department of China Bond Rating, a local agency. “But institutions with strong research capacity should be able to see through surface appearances.”

Risk factor

Rating firms sometimes classify perpetuals as debt when assessing Chinese companies’ creditworthiness. Fitch does this if the call date on the note is within five years of issuance and the coupon step-up is 100 basis points or more. S&P does the same if the jump in the coupon is at least 200 basis points.

But because of the way they work, perpetuals can pose particular problems for firms facing financial difficulties, said Tan Chang, an analyst at China Chengxin International Credit Rating’s research institute in Beijing.

“If a company faces capital shortages on the call date and can’t redeem the bonds, they must accept a surge in future interest payments,” she said. That “may worsen the company’s financials and increase credit risks.”

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