As the world approaches a year since the first known infection of SARS-CoV-2 in Wuhan, China, another altogether different contagion is starting to concern analysts.

According to the latest financial stability report from the People’s Bank of China (PBOC), Chinese companies currently owe more than 2.5 trillion yuan worth of non-performing loans. This includes companies that are partly or wholly state-owned enterprises. 

That’s on top of more than 2.3 trillion yuan of outstanding corporate bonds that are considered non-performing (having companies already in default or at risk of failing to make interest payments in 2021). Plus, according to Bloomberg, over the past three years, the PBOC has discharged over 5 trillion yuan worth of bad loans. It’s done this by funding other Chinese state-owned enterprises’ acquisition of companies.

One of the major issues is Chinese regulators who provide bond and loan portfolio ratings often tend to overestimate future revenues for state-owned companies. Therefore, they rate Chinese companies with AAA or AA+ ratings. 

As one example, take AAA-rated Yongcheng Coal & Electricity. It’s a Chinese state-owned enterprise that recently failed to make a bond payment of 1 billion yuan, as revenues were more than 85% below expectations over the past year. 

Such dramatic misses in forecasts are endemic among state-owned enterprises. But ratings agencies and analysts live in constant fear of reprisal by the ruling Chinese Communist Party if they give more realistic and accurate ratings, as that may displease party bosses.

The Bank for International Settlements estimated that as many as half of Chinese companies are effectively “zombie” companies. The PBOC injects cash by way of quantitative easing in order to finance fresh loans to keep companies afloat.

Some economists have estimated that most of the zombie-company risk for China is onshore. That’s because most of the shareholders and bondholders are Chinese. Therefore, defaults are less likely to turn into a 1990s-style “Asian Contagion.” 

However, it’s worth noting the PBOC and Chinese state-owned businesses are big investors in overseas projects via the Belt and Road Initiative. They’ve committed more than $4 trillion to infrastructure, logistics, and mining projects in more than 75 countries around the world. 

According to the PBOC’s own figures from 2019, Chinese investment in Belt and Road projects account for more than 2 million jobs in local economies from South Africa to Scotland to Brazil.

Hence the concern about the zombie-company and zombie-bond risks in China. Remember, the PBOC is the lender of both first and last resort in China. So defaults in China end up having an outsized effect globally. 

Furthermore, remember that the Chinese economy is the second-largest consumer economy in the world – after the U.S. It has grown just under 10% per year between 2012 and 2019. If Chinese investors have to absorb trillions in bond defaults and layoffs, that could slow down their spending rate, causing the economy to slow.

However, some investors have predicted the end of China’s growth boom for some time… yet it keeps on growing. But China has never had this much corporate or consumer debt before.

We’ve seen what happens in the West when the debt cycle turns sour. We’ll now wait to see if a similar story plays out in China.