With its first ever domestic bond default, China is moving away from always bailing out struggling companies, find Umesh Desai and Gabriel Wildau of Reuters

Credit warning signs are flashing for heavily indebted Chinese semiconductor, software and commodities firms as the government cautiously steps aside to let market forces play a bigger role in deciding winners and losers.

China's first-ever domestic bond default this month - a missed interest payment from Shanghai Chaori Solar Energy Science and Technology Co - shattered the belief that Beijing would always bail out struggling companies.

"The Chaori default goes to show the government will begin to let the market decide the fate of weak borrowers," says Standard & Poor's analyst Christopher Lee in Hong Kong.

Lee says defaults would be "incremental but controlled" with sectors including shipbuilding, metals and mining, and materials among those showing the highest risk as China's economic growth slows and banks tighten lending.

Chinese companies owe just over $1 trillion in domestic bonds, of which 15.8 percent is coming due this year, Thomson Reuters data shows.

While companies contacted by Reuters are confident they could obtain credit, Chinese rating agencies have stepped up the pace of downgrades. There were 77 companies downgraded in 2013, more than triple the previous year's tally, according to ratings agency China Chengxin.

A Reuters analysis of more than 2,600 Chinese companies found credit metrics worsening across a range of industries. The software sector was shouldering the heaviest credit burden with an average of 3.4 times more debt than equity. Semiconductors - a category which includes solar companies such as Chaori - had a debt-to-equity ratio of 2.6.

Across all listed Chinese companies, the average debt-to-equity ratio was 0.85 in 2013, according to Standard Chartered.

It is unclear where China's government will draw the line on letting market forces prevail. Premier Li Keqiang said in a news conference on March 13 that Beijing was "reluctant to see defaults of financial products but some cases are hard to avoid”.

But social stability has traditionally trumped market reforms. If a major employer or a high-profile company were to slip into distress, the government is all but certain to intervene. The municipal government of Wuxi, for example, threw a $150 million lifeline to struggling solar company Suntech Power Holdings Co in October.

Local governments will be keen to protect companies that are important tax payers and employers, but would be willing to let smaller ones like Chaori fail, according to a Hong Kong-based analyst with a U.S. bank, who declined to be identified.

18 years to repay

Materials companies look vulnerable as weak commodity prices hurt profitability, leaving less money to repay debt. Although the metals and mining sector's average debt-to-equity ratio is a manageable 1.4, bond holders see rising risk and have demanded higher yields for holding the debt.

Xinyu Iron and Steel Co for example, would need almost 18 years to repay its total debt at the present rate of cash generation. Its bonds due 2016 saw yields rise 160 basis points this month alone to around 10 percent.

As a state-owned company, Xinyu would likely get government help if it struggled to repay. Indeed, if Beijing failed to step in when any state company faltered, that would set off louder alarm bells among creditors.

Privately owned Nanjing Iron & Steel Co, which has 4 billion yuan in bonds coming due in 2018, says it has many funding channels available, including U.S. dollar debt, stock holdings and bank loans.

"The bond is due in 2018. Our company has not made any repayment plan since the time has not arrived yet," says Xi Siwei, an official in the securities department at Nanjing.

Packaging materials company Zhuhai Zhongfu Enterprise Co, which has 590 million yuan in bonds due 2015 and an equal amount coming up for repayment in 2017, says the coming months were a boom season for its business and cash flow would pick up, easing debt servicing strains. If necessary, it could also sell some assets.

"The industrial land held by us is worth more than a billion yuan ($161 million)," says board secretary Lishang Chen. "So selling one or two plots of this land is sufficient to pay our debt."

Shandong Molong Petroleum Machinery Co, which owes 500 million yuan bonds due in 2016, says rising bond market yields were of little concern because it had no plans to issue new debt and bank interest rates were not as high.

"The yield has nothing to do with our ability to repay the debts," says board secretary Zhao Hongfeng. "We have no problem in repaying the short-term debts."

What is next

Beijing will continue to support companies that fit its policy goals, which suggests large state-owned enterprises would be rescued if they got into debt trouble, according to Steve Wang, head of China research at Hong Kong-based boutique investment bank REORIENT Group.

"We will not see a big-bang collapse but rather small fire crackers in a 'no pain, no gain' process," says Wang.

Other credit problems may be lurking in harder-to-read areas such as bank loans. News in March that a Chinese property developer owing 3.5 billion yuan was at the edge of insolvency highlighted that risk. About a third of Zhejiang Xingrun Real Estate Co's borrowings came from individual investors.

While the better known property developers have access to offshore markets, there may be more casualties among the smaller players.

"Banks in any case aren't eager to provide loans, and trust loans are under scrutiny so the channels for smaller developers are limited," says Manjesh Verma, Credit Agricole head of credit research and strategy in Hong Kong.

Some 80 percent of China's 60.3 trillion yuan in total corporate debt comes from bank loans. Trust loans and microcredit accounted for 4.8 trillion.

China's big banks favour large, state-connected firms, which leaves smaller companies more reliant on informal lending.

"Do we see more defaults in the near future? Yes, with a move towards market-based pricing that is inevitable but, in the near term, the scale of defaults will be relatively small and this process will be managed throughout the process," says Mark Capstick, a fund manager at FFTW in London.

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Spooked by defaults, China banks begin retreat from risk

Find Fayen Wong and Matthew Miller of Reuters

Some of China's struggling firms are finally getting the reception that regulators have been hoping for -- a cold shoulder from banks in the form of smaller and costlier loans.

Reuters has contacted over 80 companies with elevated debt ratios or problems with overcapacity. Interviews with 15 that agreed to discuss their funding showed that more discriminate lending, long a missing ingredient of China's economic transformation, has become a reality.

Up against a cooling Chinese economy and signs that authorities will not step in every time a loan goes bad, banks are becoming more hard-nosed and selective about whom they lend to.

There are signs that even state-owned firms, in the past fawned over by lenders for their government connections, have to contend with higher rates, lower lending limits and more onerous checks by banks.

"Interest rates are going up 10 percent for the entire industry," says Wang Lei, a finance department manager at PKU HealthCare Corp. "Obtaining loans is getting difficult and expensive."

PKU HealthCare, which is controlled by Peking University and makes bulk pharmaceuticals, has struggled to remain profitable. Its debt-to-EBITDA (earnings before interest, tax, depreciation and amortization) ratio exceeded 60 at the end of September, four times the average for listed Chinese companies from the sector.

To be sure, several companies with strong balance sheets and profits reported no significant changes in their funding conditions.

That in itself is a welcome sign that banks are finally differentiating between the strong and the weak, more aware that they are on the hook for losses if businesses fail.

China's first-ever domestic bond default earlier this month when solar equipment maker Chaori Solar missed its payment and regulators refused to step in, drove that message home.

"It was a wake-up call for lenders," says Christopher Lee, managing director and the head of greater China corporate ratings at Standard & Poor's. "There is no such thing as a risk-free investment."

That marks a painful, but necessary shift for the world's second biggest economy to fulfill Beijing's ambition to cut wasteful investment and secure more balanced long-term growth.

For household goods maker Elec-Tech International Co, less credit is the new reality. Its bank cut its borrowing limit by 500 million yuan ($80.79 million) to no more than 2.5 billion yuan this year, says Zhang, an official at Elec-Tech's securities department.

"Last year, the bank gave us a discount on our interest rates. This year, we probably won't get any discount," Zhang, who declined to give his full name, told Reuters. "It feels like banks are not lending and their checks are becoming more rigorous."

'Stratospheric debt levels'

Some gauges of China's corporate debt are already flashing red.

Non-financial firms' debt jumped to 134 percent of China's GDP in 2012 from 103 percent in 2007, according to Standard & Poor's.

It predicted China's corporate debt will reach "stratospheric levels" and become the world's largest, overtaking the United States this year or next.

Fearing a wave of defaults as China's economy cools after decades of rapid growth, regulators in the past two years told banks to cut off financing to sectors plagued by excess capacity such as steel and cement.

Experts say banks were at first slow to respond, but in the past few months, they have started turning down credit taps.

"We have become more prudent in issuing loans," says a spokesman for Bank of Ningbo.

He adds that the bank has intensified communication with companies in troubled sectors or borrowers deep in debt.

"Under normal circumstances, we would review company loans every quarter or every six months, but for the sensitive cases, we will step up channel checks and work closely with the companies."

Another manager at a regional Chinese bank says it is overhauling its lending in cities identified as high-risk, such as Urdos and Wenzhou.

Located in Inner Mongolia, Urdos is infamous for its clusters of empty apartment blocks that pessimists say is an emblem of China's housing bubble. Wenzhou, is China's entrepreneurial hotbed that recently lost its shine after local property boom went bust.

The bank’s problem

Companies spurned by banks find a way around it. At a cost.

A listed supplier of building materials in southwestern China that declined to be identified says banks blacklisted it after two years of losses.

The firm, which is undergoing restructuring, borrowed 10 million yuan in the underground market at an annual rate of about 15 percent this year.

And as companies bend the rules, risks shift outside the banking system into the universe of networks of seemingly unrelated firms connected by murky financial deals.

For example, trade loans subsidised by the government to help selected sectors are quietly re-directed by companies to other unrelated businesses, firms say. New financing methods also emerge as easy credit dries up.

The latest plan hatched by a cash-strapped aluminum end-user involves having banks buy the metal and re-selling it to firms who pay out monthly loan plus interest.

Others such as Xiamen C&D Inc, an import and export firm, are directly cashing in on firms' thirst for funds.

Xiamen C&D, which borrows at less than 6 percent per year is offering loans of several hundred thousand yuan to smaller firms at 7-8 percent, says Lin Mao, the secretary of Xiamen's board of directors.

For larger companies, typical loans amount to 20-30 million yuan, and are 90 percent insured by Chinese insurers, he says.

Banks are growing more aware of the risks. But rather than pulling the plug on teetering firms, some bankers say they prefer a slow exit to keep them afloat for as long as possible to claw back their loans.

"Few banks are able to retreat completely even if they should," says a banker at another regional Chinese bank who declined to be named.