China Rescues Tiny Firm, Shows Debt Crisis Building

China's eastern province of Zhejiang has launched an extraordinary campaign to rescue a small, indebted packaging firm to prevent a wave of regional insolvencies, a sign of what experts fear is a debt crisis stalking the country's companies.

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Zhejiang's Pujiang county, south of Shanghai, sprang to the rescue of privately owned Pujiang Hongye Ltd Co this week, worried its financial collapse could send other local businesses under. The company, with just 200 workers, had not only borrowed heavily; it had also helped provide credit to other firms, local government sources and a news report said.

Pujiang Hongye guaranteed millions of dollars in loans for other businesses, a county government source said - just one tiny part of a barely visible web of guarantees that has spread quickly across China due to Beijing's efforts to stimulate credit to smaller enterprises, the backbone of China's economy.????

"Right now the government just wants to help this business restart production," a separate source, a county government official, said when asked about local media reports that the county had made an arrangement with Pujiang Hongye's owner, Pan Shaojiang, to keep the business running and avoid default.????

The official, who declined to be named because he was not authorized speak publicly to foreign media, would not give details on the arrangement but said a recent report in a local newspaper, China Enterprise News, had given a broadly accurate description of the situation so far.????

According to this report, Pan closed his firm's production line, unable to pay his debts or stand behind his guarantees, and left for Dubai in July amid allegations he had shifted company assets to family members. Ordinarily, a small firm with so few workers would have been allowed to collapse.????

But China Enterprise News said the county instead convinced Pan to return and restart his business, with local police making a public statement that he would not be prosecuted.

The county official said he could not confirm the allegations about Pan's asset transfers.

Pan could not be reached for comment.?????

Hidden Problem????

The proliferation of loan guarantees follows Beijing's drive to throw loan lifelines to China's legions of small and medium-sized businesses (SMEs), which account for around 60 percent of China's economy, pay half of its taxes and hire eight out of 10 of its workers, and yet are struggling to stay afloat as growth slows.

There are no publicly available figures on the extent of third-party guarantees in China - those made by non-financial firms for other, unrelated companies - but economists believe they are now widespread in the SME sector.????

They point to the well-known popularity of such guarantees as a financing tool among China's larger borrowers, for whom more data is available. Last year, a survey of 499 Chinese bond issuers by HSBC's research department found 41 percent of issuers had provided guarantees to external parties.????

"It's very unusual to have an essentially unrelated third party be a guarantor on loans, but it is common in China," said James Antos, banking analyst at Mizuho Securities in Hong Kong.

The guarantee system allows banks to lend to smaller, riskier clients provided they can find a third-party guarantor who will repay the loan if the borrower defaults.

This helps small companies stay solvent and allows state-controlled banks to meet their policy targets, but economists fear such guarantees can spread risk instead of prevent it.

Third-party guarantees have flourished as China's economy has slowed, helping small, struggling firms secure bank loans that would otherwise have been denied. But economists fear many of the guarantees are not worth the paper they are written on.

Even professional credit-guarantee firms, which offer higher-quality assurances to lenders compared with third-party guarantors, are showing signs of trouble: almost half of Beijing's 134 credit-guarantee firms lost money in the first half of 2012, according to Beijing Guarantee Association data.???????

Amplifying Risk?????

Stephen Green, senior economist at Standard Chartered, has said the guarantee system is now "operating in reverse, amplifying risk rather than dispersing and controlling risk".

"The failure of one company sets off a chain reaction of insolvencies as a guarantee is called, causing other guarantees to be triggered," he wrote in a research note last week.

In a sign of the official concern over indebtedness among smaller firms, Shanghai Vice Mayor Tu Guangshao was quoted by the official Shanghai Daily on Thursday as encouraging lenders to increase their tolerance for bad loans incurred by SMEs.

He said Shanghai's recently unveiled 1 billion yuan stimulus package was designed to encourage banks to write more risky loans to smaller enterprises.? ???

Green of Standard Chartered said banks should check that a guarantor has not pledged the same assets to other lenders, but this could be difficult - especially if the guarantor has taken out its own informal high-interest loans, as Pujiang Hongye is reported to have done, or made informal loans to other firms.

"It only takes a single bad loan to wipe out their capital and ruin the usefulness of all their other guarantees," he wrote.????

Frances Cheung, fixed income strategist at Credit Agricole CIB, said policy changes giving SMEs more access to high-yield bond markets should reduce their dependence on loan guarantees, but that the situation "warrants closer monitoring".

"Should the liquidity or even solvency problem among local corporates intensify, there would be a knock-on impact on local government and banks as well," Cheung said.

A person who answered the phone at Pujiang Hongye declined to respond to questions about the company's current financial condition, but said that it had resumed operations.

By resuming production and sales, Pujiang Hongye has avoided immediate default on 316 million yuan ($50 million) in liabilities, made up of 82 million yuan in bank loans, 80 million yuan owed to informal high-interest lenders and 154 million yuan in third-party loan guarantees, the China Enterprise News newspaper said, citing information provided by its creditors.

Copyright 2012 Thomson Reuters. Click for restrictions.

Source: http://www.cnbc.com/id/48774350?__source=RSS*tag*&par=RSS

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