China’s private firms are succeeding where SOEs fail in race to reduce debt

Chinese private enterprises have been able to reduce their leverage in a way that their state-owned counterparts have not, according to research from Standard & Poor’s.

While the ratings agency believes levels of corporate debt in China are sustainable for now, should the current growth rate continue unabated for the next five years, banks may need to be recapitalised at a cost of up to 11.3 trillion yuan.

S&P’s survey of the top 200 corporates found that for the first time since 2009 private companies managed to reduce their debt in 2015, primarily thanks to robust revenue growth.

Leverage among state-owned enterprises (SOEs) continued to rise, however, and the median SOE had debt running at six times EBITDA (earnings before interest, tax, depreciation and amortisation). In such a scenario, the bulk of a company’s generated cash flow would be expected to go into debt servicing, leaving little for reinvestment and debt reduction and repayment.

In the report, S&P analysts led by Christopher Lee said: “State-owned companies are constrained by an inherent bias towards size and complexity (i.e. diversified businesses), and the weak equity market for fund raising. Unencumbered by these constraints, private companies have been able to meaningfully reduce their debt burden.”

Yesterday, China’s state council announced their latest set of initiatives to urge companies to reduce their levels of debts. However, despite a number of programmes and policies introduced in the past, S&P Global Ratings’ Terry Chan says the pace of SOE reform has been disappointing.

“The problem comes down to productivity, and for every dollar of debt, Chinese companies are now producing two fifths less than they did in 2010,” he said.

“Really it is to do with management behaviour. As they have gone up the ranks of SOEs, senior managers have been told that their company exists to help with national development. The problem is that production by itself does not equal national development.”

The fear is that companies that go on producing unsustainably will not be able to repay their debts, creating a knock-on effect for China’s financial system.

S&P believes, however, that China’s banks and financial system are able to withstand the current levels of debt. The ratings agency estimates that between 6 and 10 per cent of corporate debt is under stress, which would result in 5.6 per cent per cent of bank loans being “problematic”, a manageable figure given the banks’ current capital levels.

Looking to the future, S&P predicts that Chinese corporate credit growth will gradually slow

as the economy rebalances from heavy industry investment toward more productive consumer-oriented activities. In this scenario, the ratio of banks’ problem credit to their total credit could reach 8 to 10 per cent, a still manageable level.
However, if debt growth does not slow, S&P believes this ratio could rise to 11-17 per cent, at which level they estimate that deposit-taking institutions may need to raise between 6 trillion yuan to 11.3 trillion yuan of capital by 2020, which they note “could be more challenging to procure.”