Curbing China’s corporate debt could hit economic growth, report warns

China’s annual economic growth rate could fall by one percentage point over the medium term if business investment is hit by a sharp slowdown in debt growth as the government cracks down on lending risks, Fitch Ratings said.

In a report published on Sunday, Fitch described the risks to growth that emerge from a scenario in which corporate debt growth slows significantly.

“It is hard to put a precise time frame on when China will start to see the deleveraging of the real economy, but at some point it looks inevitable,” said Brian Coulton, chief economist at Fitch. “The scenario analysis we have undertaken suggests that, when it does occur, it will be a process that will be a significant drag on growth.”

Beijing is in the third year of a regulatory crackdown on riskier lending practices, which has slowly pushed up borrowing costs and is pinching off alternative, murkier funding sources for companies such as shadow banking.

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Fitch’s scenario analysis suggests that to stabilise corporate debt to GDP ratio by 2022, business investment growth would have to fall by five percentage points per year – which would in turn reduce GDP growth by just over one percentage point over the next few years.

Once these adjustments are made, the corporate debt to GDP ratio would be set on a declining trend after 2022 without further falls in investment, Fitch said.

Chinese corporate debt to GDP ratio is already very high by international standards – at 168 per cent in 2017 – and is expected to start rising again as nominal GDP growth declines towards the 8 per cent from an unusually high rate of over 11 per cent in 2017, Fitch said.

Meanwhile, China’s banks, scrambling to adjust to the government’s deleveraging campaign, are likely to add to pressures on the corporate bond market as they shed more of their massive note holdings and reduce risk on their balance sheets.

Further payment problems are likely in a market that has already seen at least 14 corporate bond defaults this year, according to Logan Wright, Hong Kong-based director at research firm Rhodium Group. As well as cutting their own holdings, Chinese banks have pulled back from lending to other firms that use the funds to buy bonds, exacerbating the pressure on the market.

“You have seen banks redeeming funds placed with non-bank financial institutions that have reduced the pool of funds available for corporate bond investment overall,” Wright said.

He said the additional bond defaults were especially likely among those property developers and local government financing vehicles which have relied on shadow banking vehicles for their funding.

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Strains have already spread from high-yield trust products to corporate bonds this year as China’s campaign against its US$10 trillion shadow banking industry has choked off refinancing for the weaker borrowers. Banks’ lending to other financial firms, a common route for funds and securities brokers to add leverage for corporate bond investments, declined for three straight months, or a total of 1.7 trillion yuan (US$265 billion) since January.

The shadow banking campaign and tighter credit conditions are also forcing banks to buy fewer corporate bonds, said Jason Bedford, a Hong Kong-based analyst at UBS Group. That is eroding a key prop for the bond market.

“Unlike the US, where the majority of buyers of bonds are mutual funds, individuals and investment companies, in China, the key holders of bonds are bank on- and off-balance sheet positions,” said Bedford.

China’s four largest banks held about 4.1 trillion yuan worth of bonds issued by companies and other financial institutions at the end of 2017, nearly 20 per cent below the 5.1 trillion yuan from a year earlier, according to their annual reports.

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All Chinese banks held about 12 trillion yuan of corporate bonds on or off their balances sheets, some 70 per cent of outstanding issuance, according to Citic Securities.

Chinese companies must repay a total of 2.7 trillion yuan of bonds in the onshore and offshore market in the second half of this year and together with another 3.3 trillion yuan of trust products set to mature in the second half, the problems may get worse. More than eight high-yield trust products have delayed payments so far this year.