China’s Biggest ‘Bad Bank’ Tests Beijing’s Resolve on Financial Reform

HONG KONG — BlackRock gave it money. So did Goldman Sachs.

Foreign investors had good reason to trust Huarong, the sprawling Chinese financial conglomerate. Even as its executives showed a perilous appetite for risky borrowing and lending, the investors believed they could depend on Beijing to bail out the state-owned company if things ever got too dicey. That’s what China had always done.

Now some of those same foreign investors may need to think twice. Huarong is more than $40 billion in debt to foreign and domestic investors and shows signs of stumbling. The Chinese government, which has stayed quiet about a rescue, is in the early stages of planning a reorganization that will require foreign and Chinese bondholders alike to accept significant losses on their investments, according to two people familiar with the government’s plans.

Beijing has spent decades bailing out Chinese companies that got in over their heads, but in recent years has vowed to turn off the tap. While regulators have promised to make an example out of financial institutions that gorged on loans and waited for the government to foot the bill, Huarong is testing the limits of that resolve.

Unlike the handful of small banks and state-owned companies that have been allowed to fall apart, Huarong is a central part of China’s financial system and, some say, “too big to fail.” Its vulnerable status has left China’s leaders with a difficult choice: let it default and pierce investor faith in the government as a lender of last resort, or bail it out and undermine efforts to tame the ballooning debt threatening the wider economy.

Analysts say Huarong’s future may be the strongest indication of China’s commitment to financial reform.

“The regulator and investors are kind of playing a game of chicken,” said Zhangkai Huang, an associate professor at Tsinghua University in Beijing. “The regulator is saying there is going to be some serious reform in the financial system. The investors are saying, ‘I bet you don’t have the courage to let this default happen because there will be a crisis.’”

Mr. Huang, who teaches finance, said the false sense of security created by government bailouts in China has led to an environment similar to the one in the United States before the 2008 financial crisis, when investors made bets assuming that they were safe.

If the government goes ahead with its plan to clean up Huarong, it will be the most dramatic statement yet that in its pursuit of reform, China is willing to sacrifice the investors who lend its companies money.

The timetable for a full overhaul of the company’s operations has not yet been set, but the people familiar with the government’s plans said China is strongly committed to making sure that both foreign and domestic bondholders do not receive full repayment of their principal. The goal is to dissuade people from investing in risky Chinese companies on the assumption that the government will bail them out.

Huarong was born two decades ago when China’s state-led economy was beginning to open up. Before state-owned banks turned to the global market to raise money, they needed to get rid of debt to make themselves more attractive. Huarong took some of the ugliest loans off these banks, and for this reason was given the title of “bad bank.”

Of the four “bad banks” in China, Huarong became the biggest, expanding its empire by financing companies in energy, insurance, property and beyond. It used its access to cheap loans from state-owned banks to invest in risky deals with higher returns. It used its international arm to raise money from foreign investors, to whom it now owes more than $20 billion.

Huarong’s appetite for risk was put in stark relief under the leadership of Lai Xiaomin. Mr. Lai, the former chairman of Huarong, was stripped of his Communist Party membership in 2018 and executed in January for corruption and abuse of power, a highly unusual punishment that…