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Beijing is planning to recapitalise banks, overhaul local finances and remove implicit guarantees for corporate borrowing.Photo: Reuters

China's US$28tr debt burden results in policy split

Contradiction emerging between attempts to deleverage the economy and attempts to boost growth will see more small private companies fail

China debt

China has a US$28 trillion problem. That is the country's total government, corporate and household debt load as of the middle of last year, according to McKinsey & Co. It is equal to 282 per cent of the country's annual economic output.

Beijing aims to wind down that burden to more manageable levels by recapitalising banks, overhauling local finances and removing implicit guarantees for corporate borrowing that once helped struggling companies.

Those like Baoding Tianwei Group, a power equipment maker that on Tuesday became the country's first state-owned enterprise to default on domestic debt.

Now hold that thought, and consider this: China is also trying to prop up a US$10.4 trillion economy that is decelerating and probably will continue to do so until next year, or so says the International Monetary Fund.

The economy expanded 7 per cent - the leadership's growth target for this year - in the first quarter, the weakest since 2009 and a far cry from the 10 per cent average it managed from 1980 to 2012.

Against this backdrop, a barrage of policy moves in recent days comes into sharper focus. It also helps explain why various parts of the government do not always seem to be working from the same playbook.

"There's obviously a contradiction between attempts to deleverage the economy and attempts to boost growth," said Dariusz Kowalczyk, a senior economist at Credit Agricole who has covered emerging Asia for a decade and used to work at the Chicago Mercantile Exchange. "There's a trade-off. China will focus on deleveraging as long as growth meets its target but if growth slows excessively, then they will refocus."

On April 17, securities regulators clamped down on margin lending that has helped fuel epic stock market rallies in Shenzhen and Shanghai over the past year.

Three days later, officials unleashed about 1.2 trillion yuan (HK$1.5 trillion) into the economy - and stock markets - by cutting the level of deposits that banks need to hold in reserve with the central bank.

For large lenders, the reserve requirement was lowered a full percentage point, to 18.5 per cent, the People's Bank of China's most aggressive such step since 2008.

Also in recent weeks, Premier Li Keqiang has urged banks to support economic growth and roll over loans when needed to key borrowers.

That call, however, did not apply to Baoding Tianwei, which suffered losses last year amid a glut of investment in the solar energy industry.

Nor to Kaisa Group Holdings, which on Monday became the first Chinese property developer to default on dollar debt.

Ying Wang, a credit analyst with Fitch Ratings in Shanghai, sees more defaults ahead for "non-strategic, commercially unviable SOEs".

Such events might help "instil greater market discipline and reallocate capital more efficiently within the economy", she wrote.

For many observers, the defaults are the logical outcome of companies piling on excessive debt year after year.

The question is whether the calm remains as a weakening economy makes it harder for borrowers to service interest payments and the government becomes increasingly tolerant of some companies going under in crowded sectors such as real estate, steel and cement production.

"China is moving to a new model where the cheque is not blank anymore," said Chi Lo, a senior strategist on China at BNP Paribas Investment Partners. "It will be controlled and measured - large companies won't be allowed to fail. Small private and state companies in sectors with excess capacity will fail."

David Cui, the head of China equity strategy at Bank of America, said: "Without significant pain suffered by the local government and lenders, it is hard to instil discipline into local-government borrowing and lenders' risk assessments."

As policymakers in Beijing complete the strategy, regional governments are struggling to find cash to keep building roads, metro systems and water works. All this explains why cleaning up the debt mess matters. With US$3.73 trillion in foreign currency reserves, China has the financial resources to handle any future bank bailout or economic stimulus if need be.

Even so, if borrowing levels keep rising, at some point the country's ability to both roll over existing credit and fund new projects will get tapped out. That is not a good place to be for a one-party state with huge inequality and still-considerable development needs.

This article appeared in the South China Morning Post print edition as: US$28tr debt leads to mainland policy split
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