Minor Tremors Still Produce Ripples

03/17/2014 10:30 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

Despite the fact that this small Chinese steel company's failure to repay loans recently doesn't seem that out of the ordinary, MoneyShow's Jim Jubak, thinks it still shows just how vulnerable China's economy and financial system are at the moment.

Another one bites the dust.

The latest default in China—the failure of Haixin Steel to repay loans due last week—isn’t an especially big deal on the surface. The company doesn’t even rank among the Top 30 steel mills in China.

But the big role that this small steel company plays in China’s financial system shows exactly why that system is so vulnerable to relatively minor tremors.

Haixin Steel is pretty typical of the smaller companies in China’s steel sector. Nobody in the industry, big or small, is making money right now because companies have used cheap loans to expand capacity well beyond market demand. Only access to new loans has kept much of the sector afloat, and with the Beijing government rationing loans in an effort to consolidate the steel sector, companies like Haixin have been forced to the wall. Last December, a report by local regulators warned banks against making new loans to steel mills that had borrowed from multiple banks—and the report cited Haixin by name. Two years ago, Agricultural Bank of China had ordered its local branch to stop lending to Haixin. In 2013, the company sold off a mining subsidiary to raise cash, but that only delayed last week’s default.

The problem for China’s financial system is that Haixin, despite its own struggles, was somehow a lead investor in a credit guarantee company that backed other companies’ debts for a fee. Haixin’s partners in this credit guarantee company were other local private companies and the credit guarantees were extended to companies—such as coal miners—with their own debt problems. The rules say that credit guarantee companies are supposed to keep enough capital on hand to cover multiple defaults from creditors. But many of these credit guarantee companies have extended so many loan guarantees that they are clearly over committed. An example, from 2012, shows the danger: Local governments and banks near Hangzhou had to offer bridge loans to 62 companies after the collapse of a single property development company that had been at the center of a local credit guarantee network.

The kind of cascade of defaults that this kind of network of guarantees makes possible is why financial markets shudder when Chinese Premier Li Keqiang talks about defaults being “unavoidable.”

No one really knows how any specific default might ripple out through China’s financial system.

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