Rolling back "too big to fail"

State-owned enterprises (SOEs) are systematically important in China's economy, helping to create and maintain millions of jobs, as well as support strategically important industries. Historically, publicly-listed SOEs have contributed up to 85% of the total sales of all listed companies in China¹, and were widely seen as being "too big to fail." But behind the impressive statistics opinion remained divided on the efficiency of the state-owned sector. In the early 2010s sentiment began to change. At the fourth meeting of the US-China Strategic and Economic Dialogue (S&ED) in May 2012, China committed to "developing a market environment of fair competition for enterprises of all kinds of ownership and to providing non-discriminatory treatment for enterprises of all kinds of ownership in terms of credit provision, taxation incentives, and regulatory policies." The winds of change seemed to be gathering force over the SOE sector. Was accountability now to be the name of the game?

Investors cling to the old belief in implicit government guarantees

Initially, investors were not too bothered. They clung to the belief that SOEs were simply "too big to fail." When these often gigantic companies were in danger of default, the government had always somehow found a way to bail them out. After all, back in 1997, when Jiangxi Radio Factory was on the verge of bankruptcy, the local government had invited Tsinghua Tongfang, a software company based in Beijing, to acquire the factory and inject capital into the merged firm. The government provided policy support for the merger and the debt repayment. Again, in 2008, the central government – in the form of the State-owned Assets Supervision and Administration Commission – had directly subsidised five state-owned electricity companies that were deeply distressed. The subsidies shared by the five companies amounted to a then massive USD 1.8 billion in total.

Such "implicit government guarantees" created a safe harbour not only for SOEs' bond investors, but also for their managers. In anticipation of a government guarantee, managers tended to borrow excessively and overinvest in inefficient projects without worrying too much about the consequences. Such implicit government guarantees were criticised as an important cause for the high financial leverage of SOEs' overcapacity and inefficient production.

The unprecedented credit boom of the early 2010s further aggravated the overleverage and overcapacity problems. According to the China Stock Market & Accounting Research (CSMAR) database, during 2011-2015, the financial leverage of SOEs averaged 54% while the average return on assets of SOEs was only 3.3%. The corresponding numbers for non-SOEs, however, were a rather more financially competitive 39% and 5.7%. To deal with these problems, Chinese regulators encouraged firms to deleverage and called for the cutting of inefficient production. A series of non-bailout events were to follow, reflecting the government's declining tolerance for non-performing firms and its attempt to allow market forces to play a more decisive role in restructuring the economy.

The historic default of Baoding Tianwei

The first major shockwave to hit was on 21 April 2015. Baoding Tianwei, a manufacturer of power transmission and distribution equipment including the strategically important photovoltaic and wind power sectors based in Hebei province, defaulted on one of its onshore bonds. Tianwei was a wholly-owned subsidiary of China South Industries Group, an SOE ranked 102nd in the Fortune Global 500 in 2016. This was the first-ever SOE default in the entire history of Chinese onshore bond market, and it came to symbolise the end of an era. The implicit guarantee had fallen through the trapdoor of history.

A series of SOE defaults followed in quick succession. In July 2015, Jilin Grain Group, a grain producing enterprise owned by the Jilin government, defaulted on its private placement bonds. In September, China National Erzhong Group, a heavy machinery company owned by the central government and located in Sichuan Province, defaulted on a medium-term note issued in 2012. In October, Sinosteel Corporation, a mineral processing and steelmaking company owned by the central government and headquartered in Beijing, failed to pay interest due on 2 billion CNY notes maturing in 2017. And in December, Tianwei defaulted again, this time on one of its private placement notes. The wave of SOE bond defaults continued in the following couple of years. In the aftermath of the Tianwei default, Moody's stated, "Recent episodes of SOE distress show that regional and local governments' autonomy to provide direct financial support to struggling SOEs is diminishing as a result of restrictive central government regulations."²

The retreat of the government's guarantee came as a shock to the corporate bond market. Investors reacted by bidding down the price of SOE bonds. Using the data provided by CSMAR and WIND, we have calculated that the average cumulative abnormal return (CAR) of SOE bonds was 1.53% lower than that of non-SOE bonds during a 60-day window around the Tianwei default.

The behaviour of SOE managers begins to change

Now the SOE managers faced a real threat of corporate failure. Would the threat discipline the managers and discourage them from making bad investment decisions? We answered this question by conducting regression analyses using a large sample of SOEs and non-SOEs from January 2013 to December 2016. We first matched SOEs and non-SOEs based on various financial metrics and then examined the change in the SOEs' investment record from before to after the Tianwei default relative to the change of non-SOEs' investment in the same period.

We found that SOEs cut their investment by 1.9% of book assets relative to non-SOEs in the first semiannual period after the Tianwei default. We further split our sample into different groups according to manager characteristics and performed an analysis for each group. Interestingly, we found that the investment reduction was mainly made by bad managers (characterised as those managers with above median misconducts or lawsuits recorded against them before the Tianwei default). Finally, we found that SOEs managers made better acquisitions after the Tianwei default, as evidenced by a better stock price reaction to their acquisition announcements. SOE acquirers' abnormal stock returns outperformed non-SOE acquirers' by 2.4% in the 5-day window around acquisitions.

The advent of financial discipline

Overall, our findings suggest that the reduction of implicit government guarantees, or the disappearance of "too big to fail," disciplined corporate managers. This finding not only confirms theoretical predictions by academia, but also has important policy implications – allowing the market mechanism to play its role in restructuring troubled SOEs has a positive effect on the real sector in the long-run, even though it may bite current bondholders.

"Too big to fail" is not a phenomenon exclusive to China. The experience of GM and Chrysler during the 2008-2009 financial crisis highlights the prevalence of US government support in bailing out systemically important corporations during severe economic downturns. Other real-sector firms that have been bailed out by their home governments include Groupe Bull SA (France), Norilsk Nickel (Russia), Bangkok Land (Thailand), Malaysian Airline System (Malaysia), Railtrack (UK), etc. In this sense, the effect we document can travel around the world.