Three defaults in recent months have highlighted the risk of broader disclosure and governance problems among Chinese corporates, as well as the variable quality of local auditing, says Fitch Ratings. Shandong SNTON Group Co. (Snton, RD), Reward Science and Technology Industry Group Co. (Reward, RD) and Kangde Xin Composite Material Group Co. (KDX, WD) all defaulted on moderate amounts relative to their reported cash holdings.
Corporate defaults are usually driven by insufficient liquidity, but these companies’ stated cash balances cannot explain the non-payments. Snton was sued by the Hebei Bank Qingdao Branch on 25 September for CNY139 million, which included defaulted principal of two drawn facilities. It had a reported cash balance of CNY4 billion at end-June, of which we estimate roughly half was unrestricted, which should have provided a significant buffer against default. It was also able to raise CNY400 million through domestic bond issuance in 1H18, suggesting normal access to the domestic funding market, despite generally tight credit conditions.
Reward failed to repay CNY300 million of commercial paper on 6 December, despite having CNY4.9 billion in cash – just CNY548 million of which was restricted – at end-June 2018, and CNY4.2 billion at end-September, according to its management accounts. KDX failed to repay CNY1 billion of commercial paper on 15 January. It had reported available cash of CNY15 billion and a net cash position in September.
These companies did not show other typical signs of distress prior to the defaults. The rise in Snton’s leverage in 2017 was above Fitch’s expectations and drove our downgrade of the company’s rating in May 2018, but its FFO net leverage of around 3.5x at end-June 2018 did not indicate an unsustainable capital structure. Reward’s FFO interest coverage was over 3.5x in 9M18, while KDX was around 5x in 1H18.
The defaults call into question the actual availability and amounts of reported cash balances. The three companies reported their restricted cash balances in line with Chinese accounting standards – China GAAP – which mandate similar disclosures on cash encumbrances to international standards. It is unclear if there were less formal restrictions in place, such as agreements with lending institutions to keep sums in designated accounts to support facility access. In any case, Reward and KDX confirmed to Fitch shortly before their commercial paper due dates that their holdings of realisable cash were sufficient to meet obligations.
Uncertainty over the accuracy of the companies’ books and disclosure of pertinent information is ultimately related to governance and accounting quality. Governance issues – often challenging to uncover – have been a factor in Fitch’s ratings on Reward and KDX. Reward’s ratings have been constrained by its low transparency as a private unlisted company with concentrated share ownership. The company changed auditor and re-issued its 2017 accounts due to disclosure and accounting problems flagged by the regulator.
KDX is listed on the Shenzhen Stock Exchange (SSE), but an apparent problem with its disclosure of concerted party arrangements at shareholder level prompted an SSE investigation, which hampered access to funding and prompted our downgrade in December. Snton’s case demonstrates unpredictable financial management. It failed to repay domestic bank loans, but has continued to service onshore bonds.
All three companies are audited by domestic accounting firms. International bond investors have become more receptive of Chinese issuers choosing not to hire one of the “Big Four” international accounting firms over the past decade. However, the quality of domestic auditing is variable. It is not unprecedented for domestic audit firms to be reprimanded for shortcomings. The auditors of Snton, Reward and KDX have previously received reprimands, albeit not for their work on these companies.
