Chinese state-owned companies are starting to default on their debts. It’s a problem that could ripple through the country’s financial system, threatening to slam the brakes on the nation’s economy and hobble the global recovery from the pandemic. State firms defaulted on a record 40 billion yuan ($6.1 billion) worth of bonds between January and October, according to Fitch Ratings. That’s about as much as the last two years combined. The problem has only gotten worse in recent weeks. A slew of major companies — including BMW’s\n \n (BMWYY) Chinese partner Brilliance Auto Group, top smartphone chip maker Tsinghua Unigroup, and Yongcheng Coal and Electricity — declared bankruptcy or defaulted on their loans last month, sending shock waves through the nation’s debt market. Bond prices have plummeted and interest rates have spiked, and the turmoil has even spilled over into the stock market, where shares of state-owned firms have been sinking. It’s alarming on a couple of fronts. First of all, the close relationships between these companies and local Chinese governments typically make them safe bets in times of trouble. If investors are worried that the state is no longer willing to support them, they suddenly become much riskier propositions. Second, the success of the state sector is critical to China’s financial system. While such firms contribute less than a third of GDP, they account for more than half of the bank loans offered in China and some 90% of the country’s corporate bonds, according to data from the People’s Bank of China and Chinese brokerage firm Huachuang Securities. “The credibility of government guarantees has been the most important bulwark against [financial] crisis so far. Now we are seeing signs that this credibility is eroding,” according to Logan Wright, director of China markets research at Rhodium Group. Historically, Beijing has been reluctant to let these companies fail. The Chinese Communist Party enjoys tight control over wide swaths of the economy, including business, and it believes that the ties between these firms and the government are important for maintaining that. Now, they appear to be willing to allow at least some to collapse. But too many defaults on loans and corporate bonds would leave the financial system incredibly vulnerable, making that approach fraught with risk. “Although authorities want market discipline for riskier firms, they cannot know how much credit risk might create broader contagion,” Wright wrote in a recent research note. “No one can know this line clearly, given that there is no precedent for this risk in China’s financial system.” If Beijing’s ability to manage the debt is called into question, Wright warned that the fallout could strain the financial market, reducing available credit and liquidity. Already there have been some consequences: Bond financing dropped sharply in November, according to statistics released Wednesday by the People’s Bank of China. These problems could ultimately drag on what has been a fragile recovery for the world’s second largest economy. While the International Monetary Fund expects China’s economy to grow 1.9% this year, better than its big global peers, that would be the weakest annual rate of expansion in more than four decades. The efforts to reign in risky borrowing “will weigh on the pace of non-bank credit,” wrote Julian Evans-Pritchard, senior China economist for Capital Economics, in a Wednesday research note. “While it won’t derail China’s economic recovery overnight, it will gradually weaken the recent tailwinds from policy stimulus,” he said, referring to moves by the Chinese government this year to cut interest rates and free billions of dollars worth of spending to prop up growth. ‘Inevitable’ defaults While the record amount of bond defaults this year likely has a lot to do with the coronavirus pandemic, China’s state-owned businesses have been accumulating debt for years. “We viewed these defaults as inevitable,” wrote analysts at Nomura in a recent research report. They noted that the Chinese government has been propping up the sector with trillions of dollars in stimulus since the 2008 global financial crisis. But those investments didn’t generate as good returns as expected. The shortcomings of state-owned businesses have been widely acknowledged. Such firms are often less competitive than their private peers and generate lower returns on investment, said Ning Gaoning, the chairman of the state-owned chemical conglomerate Sinochem Group, at a major political gathering in Beijing in May. At the same time, China has been historically biased toward its prized state firms and offered them far more access to financing than their private counterparts. That trend has accelerated in recent years as President Xi Jinping has called for a stronger and more dominant state sector. All of those factors now appear to be coming together this year to create a perfect storm. To help companies recover from fallout related to Covid-19, China dramatically loosened restrictions on financing — a decision authorities acknowledged earlier this year would result in an uptick in bad loans. Unsurprisingly, state-owned companies accounted for the lion’s share of credit bond issuance through the first nine months of the year. Such firms raised some 8.5 trillion yuan ($1.3 trillion), compared to the private sector’s 857 billion yuan ($131.2 billion), according to Pengyuan International, a Chinese rating agency. Defaults, meanwhile, have risen dramatically. The Nomura analysts estimated that by mid-November, companies had defaulted on some 178 billion yuan ($27 billion) worth of bonds in the mainland Chinese market. About 43% of that came from state-owned firms, more than 30% above the recent yearly average. “Most likely we will see many more such defaults in coming years,” the Nomura analysts wrote. Striking a balance Beijing has been taking some steps to help calm the market. Last month, the People’s Bank of China injected one trillion yuan ($153 billion) worth of medium-term loans into markets to ease the stress on liquidity and soothe the nerves of investors. Vice Premier Liu He, who chairs China’s financial stability committee, has been trying to boost confidence, too. During a recent meeting with financial and economic officials, he urged local governments in China to prevent worst-case scenarios by strengthening the warning systems they use to detect systemic risks and keeping sufficient liquidity. Even so, Liu and others have made it clear that not everyone should be saved. In that same meeting, he warned state-owned firms that Beijing has “zero tolerance” for “strategic defaults” — remarks that have been interpreted to mean that the government thinks some companies are deliberately evading debt obligations that they should have been able to meet. Analysts have also noted that rescuing some state-owned firms from collapse is probably a dead end, given how financially cumbersome the sector can be. Along with their other inefficiencies, such companies also employ just 10% of the workforce. Still, allowing for too many defaults could jeopardize the financial stability and near-term recovery. Analysts at Goldman Sachs recently pointed out that widespread failures in the sector could spill over into the banking system, causing banks to cut back on lending more broadly, or increase interest rates — the latter of which is already starting to happen. “Although the central government has been trying to reduce implicit guarantees in the market,” they are aiming to do so in an “orderly way,” those analysts wrote in a recent research note. “Given China’s post-Covid economic recovery is still ongoing, the bottom line is the government will try to contain” those risks, they added.