The Strategist

The corporate debt problem in China

08/24/2016 - 15:12

Pace of China's economic growth slowed down, yet the performance is still growing, and the country accounts for about a third of global economic growth. In addition, the upturn is becoming more sustainable, since investment and exports are being replaced by domestic demand and services.

Despite the stabilization, the country still has serious internal risks. Primarily, rates of domestic lending are unreasonably high, while volume of corporate debt is close to dangerous levels.

According report of the International Monetary Fund on the state of the Chinese economy, lending volumes in the country are growing at about two times faster than the issue volume. Private non-financial, and financial sectors, which by the way are quite obscure, show are showing rapid growth. Although international standards consider the pace of credit growth pretty high (which is a key feature of a potential crisis), its positive effect on economic growth is declining.

Alarms are obvious, and, in general, the Chinese government admits there is a problem. Apparently, the state has to immediately take up a comprehensive reform that will eliminate underlying causes of the corporate debt problems. Among them are too soft budget constraints for state enterprises and regional authorities, direct and indirect debt commitments of the government, an excessive penchant for risk in the financial sector. All this exists thanks to inflated official targets of the economic growth.

In recent years, Chinese officials have taken few steps to increase flow of capital into the real economy. However, current level of prices has been steadily declining, and profit growth is slowing. This situation is obstructing repayment of local companies’ debts, which, in turn, can lead to a hard landing of the Chinese economy.

" In China, it is harder to control the debt market than the stock because amount of debt is more impressive " – argues analyst at Bank of America Merrill Lynch, David Cui.

Earlier, index of the Shanghai Stock Exchange Shanghai Composite fell down by more than 33% compared compared a peak of 5,178.19 points on June 12, due to investors' concerns about "bubbles" related to an excess of liquidity. Shenzhen Component Index fell by almost 40%.

Subsequently, Chinese financial regulators have resorted to a set of austerity measures that have contributed to the stabilization of the situation in the stock market. Currently, the Chinese watchdog continues investigation into market manipulations committed by bidders interested in falling share prices.

It is commendable that China has already started to work on the debt problem solution, in particular, reduction of the debt burden. The current five-year plan is meant to reduce overcapacity in the coal and steel industries, identification and restructuring of non-viable state-owned "zombie" enterprises, as well as support programs for affected workers. 

It's time for broader reforms in China. Balance sheets of banks still list relatively few non-performing loans, and reserves are high. Cost of potential losses on corporate debt (the IMF's latest report on global financial stability estimated them at 7% of GDP) can be managed. Moreover, the government has a significant airbag - size of public debt is relatively low and reserves, by contrast, are relatively high.

The question is whether China will be able to settle down the debt problem before these reserves are exhausted. Given past economic successes and the government's willingness to implement the ambitious reform program, China is able to take up this challenge, if only it begins now.