Bond defaults by Chinese state-linked companies are set to continue into the new year, but analysts say that may be a good thing in the long run as “zombie” entities are weeded out.

Investors usually consider government-backed companies a safe bet given the “implicit guarantee” that Chinese authorities would save those that run into trouble. However, a string of defaults in recent weeks — including by highly rated entities — have challenged that assumption.

Some high-profile state-linked businesses that have recently defaulted on their debt repayments include miner Yongcheng Coal and Electricity, chipmaker Tsinghua Unigroup and Huachen Automotive Group.

“Market participants have once again been reminded that not all state-owned enterprises (SOEs) are created the same; some are less equal than others,” analysts from CreditSights, a research firm, wrote in a Monday report.

“As the spate of defaults has shown, support conferred by state ownership is more nuanced and the Chinese government on balance is more tolerant of defaults,” they added. “SOEs which are not in strategically important industries or have strayed from their core businesses may not be rescued by the state.”

‘Zombie’ companies

The default by Yongcheng Coal and Electricity surprised many investors given its AAA-rating by a domestic agency. But the company is “a typical example of a large risky company” that China’s central bank flagged earlier this month, said analysts from investment bank Jefferies.

The People’s Bank of China warned in its financial stability report — according to CNBC’s translation of the Mandarin-language text — that the following problems in some large companies could become a risk to the entire economy:

*  Aggressive expansion into various industries and regions which accumulate debt exceeding the companies’ repayment abilities.

*  Corporate governance issues such as complex chains of borrowing within a group of companies, hidden inter-group transactions and inaccurate disclosures.

*  Reliance on borrowing to make debt repayments.

“Arguably, these problems are relevant” to Yongcheng Coal and Electricity, Jefferies analysts said in a Thursday report.

Although defaults by large state-linked companies hurt sentiment in the short term, allowing some of these “zombie” firms to fail will benefit banks and investors in the long run, the analysts said. For banks, weeding out problematic companies allows them to identify risks early and choose “quality” collaterals for those risks, they said.

Overall, some insolvencies and defaults are “part of a healthy, functioning market as long as wider contagion is avoided and the process has a relatively controlled trajectory,” said CreditSights.

The research firm explained that allowing “unviable entities” to go under will free up resources, promote renewal, nurture “greater economic dynamism” in China, and reduce the specter of “zombie” SOEs.

More defaults to come

Following the recent string of defaults, Chinese authorities have reportedly vowed “zero tolerance” for misconduct among bond issuers. Regulators have launched probes into Yongcheng Coal and Electricity and Huachen Automotive Group, as well as their bond underwriters, reported Reuters.

That won’t stop more defaults among state firms.

“This is not the first time that onshore defaults have sparked worries and it will not be the last — ultimately we have confidence that China has the political will and policymaking capacity to steer the market back into calmer waters,” said CreditSights.

Ratings agency Fitch said in a report last week that the number of SOE defaults could “rise marginally” in 2021 on the back of a likely tightening in funding conditions in China.

“China’s central bank has shifted towards a more neutral policy stance, with economic growth recovering from the impact of the coronavirus pandemic, and we expect tighter funding conditions in 2021 than in early 2020,” the agency said.

“Weaker SOEs in sectors with overcapacity or commercialised sectors face higher default risk due to a lower probability of receiving state support,” it added.

But the average default risk of SOEs remains lower than that of private companies, said Fitch. The agency pointed out that 20 private firms defaulted on their onshore bonds from January to October this year, compared with five state companies that did so in the same period.