China’s debt predicament — State firms endangering banks
State-owned companies’ liabilities ran at 115 per cent of GDP last year.
Liabilities from China’s state-owned enterprise (SOE) sectors are the most worrying as their debt ratio with the economy is reaching alarming levels and restructuring them may hurt banks’ credit, analysts said.
China’s SOE liabilities were at 115 per cent of GDP last year – up from less than 100 per cent in 2012 – are higher than any other rated sovereign nation, Moody’s said in a research report on Tuesday.
By comparison, in Japan and Korea where SOEs also play a significant role in the economy, the liabilities amounted to 31 per cent and 28.9 per cent of GDP in 2014, the ratings agency said.
GDP — gross domestic product — is a measure of the size and growth of an economy.
China’s private-sector corporate debt is lower and more stable than the SOE’s debt. Household borrowing is moderate. Government debt stood at around 40 per cent of GDP in 2015, also moderate compared with similarly rated peers, according to Moody’s.
For listed SOEs, total liabilities of the 10 per cent most indebted companies stood at 3.7 trillion yuan (HK$4.11 trillion, or 5.5 per cent of GDP) as of the third quarter of last year. Factoring in non-listed SOEs, an equity injection of around 20 to 25 per cent of the GDP would be necessary to lower debt to the median level.
“It is a sizeable amount which would affect the sovereign’s balance sheet,” the report said.
To restructure the debts, Moody’s said Chinese authorities would have to merge SOEs, rollover debt, reduce capacity and take other measures involving banks. Cash injections and other forms of government support are also needed, Moody’s said.
Measures such as debt-to-equity swaps would reduce liabilities posed by SOEs because they would lower corporate debt.
However, debt-to-equity swaps alone would not address the issue of falling returns on assets.
The result will be a parallel increase in risk for the banks involved in these swaps and in turn raise
risks for the government stemming from banking-sector liabilities.
Moreover, under the current rules of the China Banking Regulatory Commission (CBRC), the sector’s watchdog, if a loan is converted into equity, banks will need to keep aside money to cover potential bad debts. These are called risk-weighted assets (RWA).
“Banks will face great pressure to maintain the capital adequacy ratio if there are no new policies, such as relaxing the regulations on RWA, along with the swap scheme. The scheme cannot be implemented on a large scale either,” said Jack Chan, EY’s managing partner of financial services, Greater China, yesterday.
The capital adequacy ratio is a measure of the amount of money banks keep on hold to cover potential bad debts.
China’s total debt, as held by the government, households, corporates and financial institutions, jumped to 280 per cent of GDP in the third quarter of 2015, compared with 215 per cent of GDP at the end of 2010, according to the Institute of International Finance.
More alarmingly, as the outstanding debt mounts, roughly two-fifths of new debt is swallowed up by interest on existing loans.
In 2014, 16 per cent of the 1,000 biggest Chinese firms — a lot of which are SOEs — owed more in interest than they earned before tax, news magazine The Economist said in story last week.
Facing pressure to ensure growth targets, the central bank injected fresh credit of US$1 trillion in the first quarter. The stimuli-based kick start seems to have been shorter than expected and manufacturing activity softened from April.
Francis Cheung, CLSA’s head of China and Hong Kong strategy, said new credit seems to be going to long-term corporate loans linked with infrastructure programmes and may ratchet up new bad debts.
“I worry it is not going to the right place,” he said. It is “providing liquidity, rather than end-user demand.”
It now takes nearly four yuan of new borrowing to generate one yuan of additional GDP, up from just over one yuan of credit before the financial crisis, The Economist said.
Despite increasing concerns about China’s rising recent onshore credit defaults, there could be a limited drag on Chinese equities, given the equity market did not keep pace with bonds on the upswing, said Andrew Swan, head of Asian fundamental equities, BlackRock.
Coming from an era where defaults were never heard of, the Chinese government will need to handle the credit defaults carefully — it is a balancing act to gradually let market forces decide an enterprise’s fate, while avoiding triggering financial instability and a more severe credit crunch scenario.
“In the short term, the uncertainties in the correction process can weigh on sentiment, but from a medium term perspective, earlier intervention is structurally positive to reduce the risk of a much bigger correction later on,” Swan said.