China’s Biggest ‘Bad Bank’ Tests Beijing’s Resolve on Financial Reform

HONG KONG — BlackRock gave it money. So did Goldman Sachs.

Foreign investors had good reason to trust Huarong, the sprawling Chinese financial conglomerate. Even as its executives showed a perilous appetite for risky borrowing and lending, the investors believed they could depend on Beijing to bail out the state-owned company if things ever got too dicey. That’s what China had always done.

Now some of those same foreign investors may need to think twice. Huarong is more than $40 billion in debt to foreign and domestic investors and shows signs of stumbling. The Chinese government, which has stayed quiet about a rescue, is in the early stages of planning a reorganization that will require foreign and Chinese bondholders alike to accept significant losses on their investments, according to two people familiar with the government’s plans.

Beijing has spent decades bailing out Chinese companies that got in over their heads, but in recent years has vowed to turn off the tap. While regulators have promised to make an example out of financial institutions that gorged on loans and waited for the government to foot the bill, Huarong is testing the limits of that resolve.

Unlike the handful of small banks and state-owned companies that have been allowed to fall apart, Huarong is a central part of China’s financial system and, some say, “too big to fail.” Its vulnerable status has left China’s leaders with a difficult choice: let it default and pierce investor faith in the government as a lender of last resort, or bail it out and undermine efforts to tame the ballooning debt threatening the wider economy.

Analysts say Huarong’s future may be the strongest indication of China’s commitment to financial reform.

“The regulator and investors are kind of playing a game of chicken,” said Zhangkai Huang, an associate professor at Tsinghua University in Beijing. “The regulator is saying there is going to be some serious reform in the financial system. The investors are saying, ‘I bet you don’t have the courage to let this default happen because there will be a crisis.’”

Mr. Huang, who teaches finance, said the false sense of security created by government bailouts in China has led to an environment similar to the one in the United States before the 2008 financial crisis, when investors made bets assuming that they were safe.

If the government goes ahead with its plan to clean up Huarong, it will be the most dramatic statement yet that in its pursuit of reform, China is willing to sacrifice the investors who lend its companies money.

The timetable for a full overhaul of the company’s operations has not yet been set, but the people familiar with the government’s plans said China is strongly committed to making sure that both foreign and domestic bondholders do not receive full repayment of their principal. The goal is to dissuade people from investing in risky Chinese companies on the assumption that the government will bail them out.

Huarong was born two decades ago when China’s state-led economy was beginning to open up. Before state-owned banks turned to the global market to raise money, they needed to get rid of debt to make themselves more attractive. Huarong took some of the ugliest loans off these banks, and for this reason was given the title of “bad bank.”

Of the four “bad banks” in China, Huarong became the biggest, expanding its empire by financing companies in energy, insurance, property and beyond. It used its access to cheap loans from state-owned banks to invest in risky deals with higher returns. It used its international arm to raise money from foreign investors, to whom it now owes more than $20 billion.

Huarong’s appetite for risk was put in stark relief under the leadership of Lai Xiaomin. Mr. Lai, the former chairman of Huarong, was stripped of his Communist Party membership in 2018 and executed in January for corruption and abuse of power, a highly unusual punishment that experts said was meant to send a message.

Mr. Lai confessed to accepting $277 million in bribes, telling state television that he had kept $30 million cash in safes around his apartment in Beijing, which he referred to as his “supermarket.”

Chinese regulators fear the corruption shown by Mr. Lai has become so embedded in Huarong’s business practice that assessing the full extent of its losses and the collateral damage from a possible default is a challenge.

“The scale and amount of money involved in Lai Xiaomin’s case is shocking,” said Li Xinran, a regulator at the Central Commission for Discipline Inspection. “This shows that the current situation of the fight against corruption in the financial sector is still serious and complex. The task of preventing and resolving financial risks is still very difficult.”

Not long after Mr. Lai was executed, Huarong gripped headlines again when it said that it would delay publishing its annual results in March. It delayed its annual results a second time last month, raising worries about the state of its financial health and its ability to repay investors.

Any situation where Huarong is unable to repay in full its investors would ripple through some of the world’s biggest and most high profile investment firms. As the international financial market grappled with that scenario, the bonds recently went into a tailspin.

This year alone, Huarong owes $3.4 billion to foreign investors. After it delayed releasing its annual results, the bonds sold for as little as 60 cents for every dollar. In Hong Kong, its stock was suspended.

It is already very late for a big corporate reorganization, said Larry Hu, head of the China economics desk at Macquarie Group. “Huarong has already become too big to fail,” he said. “It is no longer a fix to the problem, but the problem itself.”

The government’s latest plan, which has not yet been reported, is likely to roil China’s corporate market. Last month, the broader market for Chinese companies started to wobble as anxious investors began to consider a possible contagion effect.

Chinese companies owe nearly $500 billion in loans to foreign investors. A Huarong default could lead some international bondholders to sell their bonds in Chinese state-owned enterprises, and make it more difficult for Chinese companies to borrow from foreign investors, a critical source of funding.

Concerns about the company’s ability to raise fresh money prompted two ratings agency to put Huarong on a “watch” notice — a type of warning that means its debt could be downgraded, a move that would make its ability to borrow even more costly.

“There is no playbook for this,” said Logan Wright, director of China research at Rhodium Group, a consulting firm. China’s regulators are now faced with the challenge of following through with a promise to clean up the financial system while also preventing a possible meltdown, he said.

“You’re pitting Beijing’s new rhetoric that they are cracking down against the assumption that they will ensure the stability of the system,” he said.

The government is likely to inject some money into whatever reorganized company eventually emerges from Huarong’s difficulties, but it is not prepared to inject enough money to pay off all of the bonds, the two people familiar with the government’s plans said.

Even as the government crafts a plan to downsize Huarong, the company has sought to calm investors’ nerves, promising that it can pay its bills. Speaking to state media, Xu Yongli, vice president of Huarong, likened his firm to other critically important Chinese financial institutions.

“The government support received by Huarong is no different,” he said.

Alexandra Stevenson and Cao Li reported from Hong Kong and Keith Bradsher reported from Beijing.