By Pete Sweeney

A little-known construction firm is at risk of becoming the first borrower to default in China's largest bond market, highlighting how Beijing's anti-corruption drive could aggravate financial pressure on the struggling real estate sector.

Huatong Road & Bridge Group Co Ltd said on Wednesday it was uncertain whether it would be able to pay interest or principal on a 400 million yuan ($64.48 million) one-year bond set to mature on July 23, which it blamed on an ongoing official investigation into its chief executive.

That would be the first time China's interbank bond market - the primary platform for China's institutional fixed income investors, hosting 94 percent of the country's bond issues - has seen a public default, and the first time a Chinese company has openly defaulted on both interest and principal for a bond.

Huatong's chief executive Wang Guorui was publicly dismissed from Shanxi province's Chinese People's Political Consultative Conference (CPPCC), a political advisory body, on July 10 on suspicion he had broken the law, according to a statement on the provincial government's website.

The provincial government did not give further details. Huatong's statement to the official Shanghai Clearing House had been similarly short on details, stating only that Wang was "assisting an official investigation."

The company declined to comment when contacted by Reuters.

In China, the detention of a chief executive, who typically monopolises much decision-making power, can effectively paralyse a company if the investigation prevents the executive from using his "chop" to sign off on payments.

Worse, lenders and suppliers are also inclined to minimise exposure to companies suffering legal problems, which can cause short-term credit to dry up, said Ivan Chung, senior vice-president for Greater China Credit at Moody's in Hong Kong.

"Typically when the CEO has trouble, banks will stop issuing short-term credit lines. The company will also no longer be able to get credit from suppliers."

Hooked on short-term credit

Unfortunately, Huatong and similar firms in construction and real estate have grown increasingly dependent on short-term credit to stay afloat, as China's housing market continues to soften and revenues from new projects have stagnated.

Huatong's most recent financial statement, posted on the Shanghai Clearing House website, shows the firm had nearly 8 billion yuan in liquid assets on hand at the end of the first quarter, but nearly half of that was from accounts receivable and other yet-to-be received sources of funds presumed to be imminent.

Analysts doubted how soon Huatong would actually see that money, given that many of those invoices were for projects built on behalf of local governments that are now postponing payments as their own balance sheets come under pressure.

"Private companies are increasingly facing political risk," said one market insider who spoke on condition of anonymity. "It's quite freakish."

The Huatong bond, for example, had a tenor of only one year, with a coupon rate of 7.3 percent.

Official data in June showed that lending and off-balance sheet products surged in June, but the surge was driven by increases in short-term loans and shadow banking products, after medium- and long-term loans declined in May.

"The pick-up was led primarily by short-term loans and bills, raising concerns about the use of the funds, the potential to support growth and the extent of the recovery," wrote Jian Chang and Serena Zhou of Barclays in a research note published on Wednesday.

Many Chinese companies have been backing off from bond issuance plans ever since Beijing allowed the country's first public bond default to occur in March, when a near-bankrupt private solar power company failed to make payments on interest due on a bond trading on the Shenzhen exchange, a smaller venue serving retail investors.

A Reuters analysis of company filings on the China Foreign Exchange Trade System website showed that more than 30 companies filed to cancel their bond issuance plans in the second quarter.

At the same time bond yields on differently rated instruments have diverged as investors have grown more conscious of risk, in particular from privately held companies not considered to be operating under an implicit government bailout guarantee.

However, bond market traders and analysts did not perceive the Huatong default, if it occurs, as surprising or posing a wider risk to market sentiment in general.

"We do not expect the incident to have significant impact on the overall bond market," wrote analysts from Guoxin Securities in a research note.

"On the one hand, the key reason for the default is political ... on the other hand, this company is private, and so its risk-based pricing has always been higher than state-owned companies."