G3 bond issues by Chinese corporates last year amounted to a staggering $72.5bn, 19 times the level seen in 2009. With $47.2bn already printed this year, 2014 is well on its way to clocking up another record, and is likely to take China's share of this year's global emerging market G3 issuance well above the current 20.5%.
Coupled with skyrocketing RMB-denominated debt, this thirst for liquidity has translated into mounting leverage at Chinese companies. Corporate debt levels in China had averaged around 90% of GDP between 2003 and 2007, according to data from CEIC Data, a research firm.
By 2013 that had soared to around 150% — eye-watering in comparison to the 90% average for developed economies.
And with good reason. China's economic growth has averaged 8.9% over the last five years and borrowing costs are at all-time lows. In those conditions, taking on leverage to fund aggressive capex spending and M&A made good sense to borrowers. Loading up with debt magnifies profitability and shareholder returns.
But there's a flipside when conditions change. Leverage can quickly become an overwhelming burden if the environment becomes less pleasant – something that is soon likely to be the case. Economists expect GDP growth in China to decline to about 7.3% this year and 7.2% in 2015.
At the same time, the cost of borrowing is set to increase if US rates rise and domestic financial reforms send onshore rates spiralling upwards.
That creates a two-pronged assault on solvency. And the higher a borrower’s debt levels, the stronger these blows will be.
Two hits
The first hit will come as profitability weakens because of slowing economic growth. The second will be delivered by increased borrowing costs when the time comes to roll over debt. That matters, given that there are hefty maturities on the way. Chinese corporates will already need to roll over or repay more than $200bn of bonds in 2016 (see chart).
There's a vicious circle at work too: credit spreads will also widen as borrowers' interest coverage ratios deteriorate, further weakening solvency and hurting their ability to refinance. Investors are treading more carefully, paying more attention to leverage and future solvency, which will ratchet up the pressure on any that are badly positioned.
The warning signs are already appearing. Last week, Jingrui Holdings was forced to shelve a dollar issue after the deal was said to have launched with $100m of anchor orders but failed to gain further traction. The B3/B rated Chinese developer had funded its growth mostly through debt and has a debt to equity ratio of 2.6.
For highly leveraged issuers, getting a deal done in the future might mean having to opt for equity accounted hybrids and offering a hefty premium, as illustrated last week by Yanzhou Coal Mining’s perpetual non call two year. The borrower had paid a 290bp pick-up on its 2017s for an issue that was pretty much structured to limit investor exposure to two years. But at least the deal got done, unlike the company's stab at a five year non call three last year.
And Yancoal offers a salutary reminder of how quickly things can change. Three years ago the Chinese coal industry was at the peak of a three year boom. Mining towns prospered and the industry was ramping up leverage to support heavy investment. But economic growth began to slow and coal prices tumbled. Yancoal, which had more than doubled leverage from 0.77 in 2009 to 1.63 in March 2014, is now a junk rated credit at all three of the big ratings firms.
Leverage can be hard to resist — owners of businesses all over the world tend to fret that they are not doing enough to take advantage of favourable conditions. But with rising interest rates and slowing economic growth on the way, borrowers would do well to remember that sunshine has a nasty habit of being followed by rain.