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CvT: As Defaults Blossom, SOE Reform Wilts

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Few companies capture the scale of President Xi Jinping’s vision for an independent Chinese semiconductor industry as well as Tsinghua Unigroup. An offshoot of China’s prestigious Tsinghua University, the multi-billion-dollar state-owned enterprise (SOE) is responsible for many of China’s recent technological breakthroughs in chip-design and manufacturing.

It therefore came as a shock to many when an SOE of such stature and strategic importance to Beijing defaulted on US$2.5 billion of debt in early December. What’s more, Tsinghua Unigroup’s default follows closely on the heels of other high-profile defaults by weak SOEs in strategic sectors such as energy and automobiles. Beijing presents the rising tide of defaults as an effort to put pressure on China’s notoriously inefficient SOEs to improve their financial performance. However, unless further market-driven structural reforms of the state sector are undertaken, SOE performance is unlikely to improve.

An Emblem of Economic Development with Chinese Characteristics

Tsinghua Unigroup is a subsidiary of Tsinghua Holdings, which itself is a subsidiary of President Xi’s alma mater, Tsinghua University. Through Tsinghua University, a public institution, the state controls 51% of Unigroup. A private investment firm founded by Unigroup’s CEO, Zhao Weiguo, controls the other 49%.

The company’s mixed ownership is emblematic of Beijing’s approach to managing China’s economic evolution. In its upcoming five-year plan (2021-25), Beijing will likely reaffirm the all-important role of SOEs in shouldering political responsibilities such as job creation and maintaining economic stability. In one oft-cited example of this responsibility, SOEs facilitated Beijing’s response to the 2008 Global Financial Crisis by implementing stimulus measures aimed at boosting infrastructure spending.

The Implicit Guarantee

Investors generally believe that SOEs of strategic value to Beijing possess the implicit guarantee of a government bailout in the event of a default. The rationale behind this thinking mirrors that behind the US government’s bailout of large automakers during the Great Recession – the government should step in to support systemically important firms during periods of economic stress. However, China’s mammoth SOEs, which regularly top lists of the world’s largest public companies, claim much larger implicit guarantees. According to the IMF, as a result of implicit guarantees, SOEs benefit from interest rates that are estimated to be 150- 200 bps lower than those paid by their private sector peers for bonds with similar maturities.

The state’s de facto role as guarantor for critical SOEs eased Unigroup’s access to investors’ funds that were then used to finance an acquisition binge with the encouragement from Beijing. As Zhao himself emphasized when describing his company’s coffer-draining strategy during an interview with Forbes, “The goal is using foreign know-how as a shortcut to building an advanced chip sector for China.”

In line with this strategy, Unigroup acquired Linxens, a French smart chip components maker, for US$2.6 billion in 2018. In 2015, it bought a majority stake in HP’s China-based server business for US$2.3 billion. Around the same time, Unigroup bought a 6% stake in Portland-based Lattice Semiconductor Corporation for US$41.6 million. At one point, Unigroup even sought to acquire Micron Technologies, a leading US chipmaker, for US$24 billion.

Market forces may have demanded a higher level of capital discipline of Unigroup, but access to cheap financing, pressure from Beijing to catch up with Western capabilities, and the expectation of a government bailout in the event of a default instead contributed to a series of ill-considered acquisitions ultimately ending in a severe liquidity crunch. As the company’s cash position deteriorated, Unigroup declared on December 11, 2020 that it could not repay the principal on a US$450 million Eurobond. The Eurobond default is only the tip of the iceberg – it alone will trigger cross-defaults of off-shore bonds valued at US$2 billion.

Ongoing Reforms

After nurturing Tsinghua Unigroup into a major player in the global chip industry, the government appears ready to cut the company, and others like it, loose in an effort to let market forces rather than political considerations allocate resources in China’s economy. However, unless Beijing tackles the root causes of the implicit guarantees that SOEs receive—their overwhelming size and continued access to subsidized resources—rising SOE defaults will not lead to better run economic entities. Instead, they will simply bring to light the inefficiencies that have long plagued China’s state sector.

In one way or the other, Unigroup and subsidiaries will continue to operate. The company’s memory and mobile chips compete effectively with foreign imports, and Beijing is loath to see a strategic enterprise fail. Investors, however, will rue the day they assumed that their investments in a Chinese SOE were insured by the Chinese government.

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