A debt crackdown in name only.
A debt crackdown in name only.

Odd as it may sound, the fact that Huatong Road & Bridge Group dodged a default on July 23 is bad news.

Until Wednesday, markets had been buzzing about the possibility the Shanxi-based builder might become the second mainland company in four months to renege on a bond payment. Then, Huatong beat the odds, repaying all principal and interest on a $65 million bond. How? Some aggressive fundraising, along with a little help from local government bodies. According to press reports, municipal officials intervened to prevent the company's collapse.

Two immediate worries spring to mind. One, China's moral-hazard bubble continues to swell as public officials insulate companies from the effects of bad business decisions. For all the talk of epochal reform in China, there's still no price to pay for questionable borrowing and lending. Two, local government debt is growing even as Communist Party leaders pledge to reduce public liabilities.

China’s Pain Points

A key pillar of President Xi Jinping's plan to avoid a Japan-like bad-loan crash is reining in credit and the opaque shadow-banking industry. The effort includes dissuading local governments from risking their own defaults should growth markedly undershoot Beijing's 7.5 percent target. But as Bloomberg News reported on July 15, more and more regional governments are upping stimulus efforts to help Beijing meet that goal. Northern Hebei province alone is pumping a fresh $193 billion into areas including railways, energy and housing.

A more recent Bloomberg analysis shows that as of July 23, 20 of 25 provinces and provincial-level cities reported a pickup in growth in the first half of the year. Some of the gain, of course, is the result of central-government stimulus: expedited railway spending and tax cuts. Most of it reflects local fiscal pump-priming, funded by untold billions of dollars of fresh debt.

The People's Bank of China has also eased curbs on bank lending and distanced itself from a November projection that the economy might experience an unwinding of debt. Credit outstanding rose to 206 percent of gross domestic product last quarter from 202 percent in January-to-March. Beijing's talk of downshifting to a "new normal" to rebalance the economy toward services is belied by July's surge in manufacturing to an 18-month high.

The big worry is that we just don't know how bad China's debt profile really is. As of June 2013, local government debt had swelled to about $3 trillion. Given efforts since then to meet growth targets, it's a pretty safe assumption that the figure is now considerably higher -- and poised to rise further.

Beijing's directives are working at cross purposes. On the one hand, Xi and Premier Li Keqiang say they want to end the GDP-leads-to-promotion mindset that has long motivated regional officials. Yet at the same time, pressure to meet Beijing's growth target has reached obsessive proportions. Anytime GDP veers in the direction of 7 percent, China Inc. swings into action with additional stimulus.

Regional officials, it can be argued, are merely falling in line by borrowing anew. Executives, too. Last quarter alone, corporate-bond issuance surged 56 percent from the previous three months. As Michael Pettis of Peking University puts it, "analysts must recognize that an unsustainable increase in debt is embedded into China’s current growth model, and is not an accidental bit of bad luck."

China’s Managed Markets

The harder China works to avert a debt crash, the bigger it will ultimately be. "Repeated moves to shore up short-term growth may have averted fears of an economic downturn, but they haven’t boosted confidence in China’s longer-term prospects," Andrew Batson, China research director at GaveKal Dragonomics, writes in a July 24 report. "To do that requires sweeping regulatory changes that can fundamentally change businesses’ calculation of future opportunities. Xi has in fact promised such changes, but has yet to deliver."

This week's "good news" at Huatong is yet one more bad omen for financial reform. Just before Shanghai Chaori Solar Energy Science & Technology suffered China's first default back in March, many investors were betting Xi and Li would swoop in at the 11th hour and save the company with a bailout. Letting Chaori Solar miss a $15 million bond coupon was heralded as a welcome sign of discipline. Efforts to avoid a second, bigger default this week suggest officials really don’t have the tolerance for the pain needed to put China on healthier footing.

For some China watchers, the real test of Xi's determination to end China's moral-hazard culture will be letting a local government default, not some previously unknown road-builder. Unfortunately, if this pattern continues, there will soon be all too many potential candidates.

To contact the author of this article: William Pesek at wpesek@bloomberg.net

To contact the editor responsible for this article: Nisid Hajari at nhajari@bloomberg.net