China's steelmakers have racked up $400 billion in debt, which some may struggle to repay, making them a potential drag on a banking sector already facing rising bad loans from the property sector and local governments.
Steel firms that already have soaring debt-to-equity ratios and a shortage of liquid assets in relation to their short-term debts face sliding profit margins, rising raw materials costs, overcapacity and slower growth in the world's top steel market.
They have turned to the bond markets to refinance bank loans coming due, but yields on these are soaring. Given that leading Chinese steelmakers are ultimately state owned, the country's banks, also state-run, are likely to end up carrying any losses.
Close to three dozen Chinese steelmakers raised a total of around 80 billion yuan ($12.7 billion) from the domestic bond market last year, with half saying they would use 50-60 percent of the proceeds to pay down debt.
That, together with falling share prices, has pushed the median long-term debt-to-equity ratio, or gearing, for the steel sector to around 50 percent, according to Thomson Reuters data.
A number of companies, including Shanxi Taigang Stainless Steel, have gearing of almost 80 percent — above the state-owned assets watchdog's guidance of a 75 percent ceiling.
Some of China's listed steel firms could struggle to repay their obligations this year, given a dangerously low proportion of liquid assets to short-term liabilities.
"What steel mills are doing is essentially rolling over their debt and then borrowing more, which is quite worrying, especially since some companies have become heavily geared," said Helen Lau, a commodity analyst at UOB-Kay Hian in Hong Kong.
"If profit margins continue to languish at current low levels of around 3 percent, there's a risk some of them will not be able to repay these bonds when they mature."
Plagued by chronic overcapacity, many steelmakers have had to get by on razor-thin margins, as steel prices have fallen in the wake of economic woes in Europe and China's own efforts to rein in property prices.
A host of steel firms have warned of steep profit falls or even losses for last year.
Angang Steel has said it expects to post a record net loss of around 2.2 billion yuan ($347 million) for 2011, while top-listed steelmaker Baoshan Iron & Steel (Baosteel) said profit last year slumped 43 percent to 7.3 billion yuan.
Nanjing Iron and Steel and Maanshan Iron and Steel have both said earnings more than halved last year as weak demand undermined prices.
Overall, the Chinese steel industry's average profit margin slid to just 2.8 percent in 2011, from over 8 percent in 2001-05, ranking the second-lowest among all industries in China, according to the China Iron and Steel Association (CISA).
That's not what creditors, mainly state-owned banks, want to hear.
According to CISA, total liabilities of its 77 large and mid-sized member mills rose 2 percent year-on-year to 2.52 trillion yuan ($399.23 billion) in the first 10 months of last year — equal to nearly 5 percent of total loans outstanding in China at the end of the year.
Even before weak official fourth-quarter results — due around late-March — are taken into account, some firms' quick, or acid-test, ratios were dangerously low.
The ratio measures a firm's current assets less inventories against the liabilities they have coming due within a year.
A ratio of less than 1 suggests a company will be unable to pay its current liabilities. For China's steelmakers, the median is 0.48, according to Thomson Reuters data.
Wuhan Iron & Steel has an acid-test ratio of just 0.16, the lowest among the listed firms.
Hunan Valin Steel, Bengang Steel Plate, Hebei Iron and Steel, Shanxi Taigang, Baosteel and Angang Steel all have acid-test ratios below 0.50.
Rolling It Over
Investors are still buying Chinese steelmaker bonds, but at a price.
A tranche of five-year bonds from Wuhan Steel, due to mature in March, trades at a bid yield of 5.93 percent, compared with a coupon of only 1.2 percent.
The near $1 billion yuan-denominated bond issued by Baosteel in Hong Kong last year was oversubscribed.
Such bonds appeal to offshore investors betting on an appreciation of the yuan.
Defaults on steelmaker bonds are unlikely, analysts say, as the state-owned parents of the steel firms are expected to find a way of rolling over the debt rather than face the embarrassment of failure to pay interest or principal.
"The majority of these listed companies are owned by the government — they are going to back them up," said a steel analyst with an Asia-focused securities company, who asked not to be named because she is not authorized to speak to the media.
"The government can just call up the banks and tell them to lend the money," she added.
That could saddle state-owned banks with even more non-performing loans in the medium term, preventing that cash from going to more productive uses and dragging on economic growth.
With potentially massive write-downs from loans to local governments' financing vehicles looming, China's financial system can ill afford to pile on new bad debt.
Still, analysts expect steelmakers to continue to dig themselves deeper into debt, as they face a near-term cash crunch on poor earnings.
"Some firms may have more debt maturing in the first quarter and could tap the bond market again. Banks are beginning to lend more, but some steelmakers will struggle to get funds because of their bleak outlook," said a steel analyst at an investment bank who requested anonymity as he was not allowed to speak to the media.
The challenges faced by Chinese steelmakers are reflected in the brutal 40 percent fall in their share prices last year. Despite the collapse in valuations, many analysts remain cautious about whether this is a buying opportunity.
"The sector is cheap, but will likely remain cheap given the lack of near-term catalysts," J.P. Morgan's metals and mining analyst Daniel Kang said in a research note.
"Ultimately, the sector needs to restore pricing power and while China's recent shift toward pro-growth policies could offer support, any upside will be capped from industry overcapacity."