China Huarong Is a Test for Beijing’s Financial Reform Drive
Someone has to take big losses. Will it be foreign or domestic investors?
The Chinese government controls valuable assets in strategic areas through state-owned enterprises. But SOEs are also inefficient, prone to corruption, and heavily indebted. As of 2019, the latest year for which data are available, SOEs had 126 trillion yuan ($19.4 trillion) of debt, or about 40% of the nation’s total government, corporate, and household debt, helping to make China one of the most heavily indebted countries in the world.
China has been trying to get its SOEs to slim down. Although this is mostly a domestic affair, once in a while, its reform agenda can clash directly with foreigners’ interests. China Huarong Asset Management Co., majority-owned by the Ministry of Finance, is a prime test case.
Set up two decades ago to buy bad debt from commercial banks, Huarong was also granted licenses that allowed it to branch into fields such as brokerage, private equity, and shadow banking. The company took full advantage. At the end of 2016, distressed debt assets—Huarong’s core mandate—accounted for only 26% of the total, while other financial assets made up 40%.
As of June 2020, Huarong held 1.7 trillion yuan in assets and 1.6 trillion yuan of debt. The company has about $22 billion in dollar bonds outstanding. Prices on the bonds tumbled in April, with some issues at one point trading as low as 55¢ on the dollar, after the company delayed the release of its 2020 annual reports. Most of the bonds are guaranteed by China Huarong International Holdings Ltd., a strapped overseas subsidiary, not by the Beijing-headquartered parent.
When foreigners bought the bonds, it appears they didn’t look carefully at the subsidiary’s financials. As of last June, Huarong International had only $2.2 billion of cash. It has $3.8 billion in bonds to redeem this year. Instead, investors relied on the hope that the bonds would get “very strong government support,” the primary justification S&P Global Ratings used for assigning these bonds an investment grade.
Three years ago, Beijing tried to rein in Huarong and arrested its former boss Lai Xiaomin. This January, Lai was given a death sentence—unusually harsh for a financial crime. He was executed within weeks. Yet Huarong’s problems remain. China has been trying to offload the company’s noncore assets for three years, with little progress. More than half of these assets are shadow banking products that are hard to value and divest. The endgame might just have to be a full writedown.
So will China pay off the dollar bond investors to save face on the world stage at its own banks’ expense? Or will it go by the books and cut off its overseas arm? SOE reform in China has been going at a snail’s pace, often met with resistance from entrenched local interests. With Huarong, even foreigners are now getting dragged in. They want the status quo. They don’t want reform. They want to be repaid.