On November 8, China shocked markets with its latest targeted stimulus in the form of an "unprecedented" lending directive ordering large banks to issue loans to private companies to at least one-third of new corporate lending. The announcement sparked a new round of investor concerns about what is being unsaid about China's opaque, private enterprises, raising prospects of a fresh spike in bad assets.

A few days later, Beijing unveiled another unpleasant surprise, when the PBOC announced that Total Social Financing - China's broadest credit aggregate - has collapsed from 2.2 trillion yuan in September to a tiny 729 billion in October, missing expectations of a the smallest monthly increase since October 2014.

Some speculated that the reason for the precipitous drop in new credit issuance has been growing concern among Chinese lenders over what is set to be a year of record corporate defaults within China's private firms. As we reported at the end of September, a record number of non-state firms had defaulted on 67.4 billion yuan ($9.7 billion) of local bonds this year, 4.2 times that of 2017, while the overall Chinese market was headed for a year of record defaults in 2018. Since then, the amount of debt default has risen to 83 billion yuan, a new all time high (more below).

Now, in a new development that links these seemingly unrelated developments, Bloomberg reports that debt cross-guarantees by Chinese firms have left the world’s third-largest bond market prone to contagion risks, which has made it "all the tougher for officials to follow through on initiatives to sustain credit flows", i.e., the threat of growing threat of unexpected cross- defaults is what is keeping China's credit pipeline clogged up and has resulted in the collapse in new credit creation.

The risk of cross-defaults is what also appears to be behind the recent official directive for banks to boost lending to private corporations.

As Bloomberg explains, private companies have long had to be innovative in getting financing in Communist-run China, where state-owned enterprises have had preferential access to the banking system. Extending guarantees to each other helped businesses boost some lenders’ confidence enough to extend funding to them.

While this was not a concern when times were good, now that China is going through a record run of debt defaults, these often opaque and hard-to-follow links pose the risk of "a daisy chain of distress" with price moves are reflecting that.

Take, for example, tire-maker China Wanda Group which has seen the yield on its bonds due in 2021 soar almost threefold, from 8% to over 20% since end-September, thanks to having provided guarantees to iron-wire maker Shandong SNTON Group Co., one of whose units failed to repay a bank loan two months ago.

“Large cross-guarantees could set off a chain effect that could quickly spread from one firm to another,” said Clifford Kurz, a credit analyst from S&P Global Ratings in Hong Kong, who probably rues the day he was tasked with figuring out which company is linked to which other company in cross-default obligations.

And there's a lot of it: like pledged shares, where private companies and executives pledged corporate shareholdings as collateral for bank loans and which emerged as a major risk factor for China's financial system in late October when a flood of margin calls sparked a "liquidity crisis" and panic selling in Chinese stocks and prompted the regulators and local authorities to demand that banks ease restrictions on pledged shares, cross guarantees are a Chinese phenomenon less familiar in global markets. Last year, cross-guarantees in China amounted to nearly 4 trillion yuan ($575 billion), the China Securities Journal reported in October 2017.

Which brings us back to China Wanda and Shandong SNTON, which are both based in the eastern province of Shandong, which has an economy of about $1 trillion and benefited from a dynamic private sector; however that growth now appears to have ground to a halt, and according to Kurz, slides in a number of corporate bonds across the province “may suggest that investors are seeking to avoid the risks posed by such cross-guarantees -- regardless of the underlying performance of such companies."

And with a record pace of 83.4 billion yuan of defaults this year, both share pledging and cross guarantees have found themselves to topic of intense scrutiny

"Cross-guarantees were not built up overnight," said Li Guomao, head of financing at Shandong SNTON, which has seen its own bonds tumble 30% since October thanks to a lawsuit over a guarantee to a subsidiary that failed to repay a loan. “It is unlikely to solve this problem soon.”

There is another way that the province of Shandong has emerged as the potential epicenter for the next debt crisis: here, at least 20 private firms provide guarantees that account for at least 10% of their total net assets - a ratio surpassing all other regions, according to Lv Pin, an analyst from CITIC Securities Co.

"Private firms in Shandong have been exposed to more risks as they are caught up in the cross-guarantee trap, with bonds being dumped on the secondary market," said Chen Su, bond portfolio manager at Qingdao Rural Commercial Bank Co.

And, as noted above, local companies started suffering more financing difficulties as banks cut lending to this region earlier this year, Su said.

What makes this particular problem especially vexing is that, like a loose thread, once one company with cross-guarantees finds itself unable to fund its debt obligations, a cross-guarantee cascade is sprung, and dozens of other firms may end up unable to either satisfy their "guaranteed" commitments to the original debtor, until - ultimately - they are unable repay their own creditors.

Bloomberg notes that cross-guarantee troubles have been cropping up for a while:

When a disclosure last year showed that Shandong Yuhuang Chemical Co. had guaranteed 1.35 billion yuan of obligations tied to Hongye Chemical Group Holdings Co., yields on Yuhuang’s 2020 dollar note shot up more than 2.30 percentage points in a week.

For now, there hasn't been a default serious enough to drag down numerous firms at the same time, although that may soon change.

However, to make sure it doesn't, China is engaging in what it does best to avoid a credit crisis: government funded bailouts. Sure enough, the province of Shandong is making efforts to avert any credit collapse. Its state assets regulator said a government-backed 10 billion yuan fund will be set up to address liquidity risks at listed companies, the China Securities Journal reported on Friday. More broadly, as we reported two weeks ago, China’s central bank has launched initiatives to aid credit to small and medium enterprises, and support bond issuance.

And while the S&P analyst Kurz said that most companies surveyed by S&P are scaling back those cross-guarantees, for Beijing to make the unprecedented demand that banks allocate a third of new credit issuance to private companies, the problem must be far more dire than has been made public so far. And just as was the case with share loans, it is only a matter of time before cross-guarantees emerges as the focal point of China's next financial crisis.