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How Big A Threat Is China’s Debt?

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Chinese debt to GDP is growing at a rate rivaling that of the US, the UK, and Italy. But while we don’t need to fret about economic collapse – China’s central government is handling the situation – there is one kind of debt that the country needs to tackle in order to fix its debt dilemma.

Chinese debt was 256% of GDP in mid-2017, with the government (46.4% of GDP) and consumer (43.2% of GDP) debt representing relatively modest levels. But at 166.3% of GDP, corporate debt is the government’s main focus.

In early 2018, China’s Banking Regulatory Commission (CBRC) remarked that the amount of debt attributable to the nation’s corporations was a “grim and complicated” matter. Currently, China’s corporate debt is lower than Hong Kong (233.9%) but significantly higher than Japan (95.5%) and the USA (72.5%).

Between 2009 and 2015 China’s corporate Incremental Capital Output Ratio (ICOR) increased by more than 300%. In short, the constant access to and use of credit by Chinese corporations has resulted in them using higher levels of capital to produce each unit of pre-2008 production. Unfortunately, as Chinese corporations have increased the cost of per unit production, their companies have seen an increasing reduction in capacity to replay their banks’ loans.

When corporate debt goes bad

Mainland Chinese banks are the biggest lenders in mainland China. They primarily focus on industry, rather than individuals, making and make money available to different industries and companies based on the preferences and directives of the Chinese government. Unfortunately, their books are now beginning to bulge with bad debts:

  • Chinese companies, in particular, state-owned enterprises (SOEs), have received lots of stimulus money in the past. Unfortunately, the more stimulus money they received, the less productive and profitable they were.
  • Zombie companies – companies that have posted net losses for several consecutive years – are still receiving credit from the big banks, despite their diminishing ability to pay that credit back.
  • Local and provincial bank loans and shadow loans have increased over the years. Though the government doesn’t directly oversee these loans, they cannot be ignored. Shadow loans increased from US$80 billion in 2006 to US$3.8 trillion in 2016.
  • Further complicating the situation: The rise of wealth management products that make it more difficult to compare the debt between different companies, and how their debt obligations relate to one another.

How China’s cracking down on bad bank behavior

President Xi Jinping has demanded that the nation’s banks reduce their bad loans and stop overleveraging themselves. His government has pushed for more reforms and no bank bailouts. Part of those planned reforms include reductions in risky loans and bank leverage.

Currently, banks are subject to quarterly balance sheet reviews, which punish banks that fail to act in accord with the People’s Bank of China, the central bank of China,  directives for managing of assets and liabilities. Some of the directives are designed to reign in shadow loans.

Shadow loans increasingly consist of wealth management products (WMP) that are off-balance sheet assets. Some reforms made in regards to shadow loans are:

  • Trusts that manage WMPs that are off-balance-sheet items must maintain reserves in regards to those products, just like banks.
  • Make it clear through WMP regulation that the Chinese government will ‘insure’ WMPs if they collapse.
  • Increased reporting requirements for WMPs

The Chinese government has also used strong persuasion to convince banks with bad debt to swap their loan claims for corporate equity. It has also pushed smaller banks with large amounts of debt to merge with bigger banks. Moreover, as expected, the government has approved more bad loan write-offs, which have increased from 117 billion Yuan in 2013 to 576 billion Yuan in 2016.

The non-performing loan write-offs are a gift to investors, a compromise for the companies holding the bad debt, and a compromise for the creditor banks.

  • Write-offs may increase the value of the shares by removing the uncertainty of the bad debt from the corporate balance sheet.
  • The companies are forced to accept creditor banks’ oversight and control to varying degrees (depending on the amount of bad debt written off). However, they are able to reduce their debts and appear as healthier, more desirable investments after the bad debt write-offs.
  • The compromise for the banks has three parts:
    1. The bank gets the bad debt off its books, thereby reducing the uncertainty of the bank;
    2. Although the creditor banks have written off the loans, they are permitted by law to take equity in the debtor companies that is equivalent to the amount of debt written off by the debtor companies;
    3. Unfortunately, most banks are ill-equipped to manage companies or oversee their operations. So, the presence of creditor banks on bank boards and in bank operations is likely to be a hindrance to the operation of the debtor companies, and may ultimately result in continued poor performance of the company and possibly its bankruptcy.

As for cleaning up the local and regional banks’ balance sheets, the Chinese government has cracked down on debt-financed overseas investments. In 2016, the central government implemented overseas investment reforms that require oversight and approval of overseas debt-financed investments appraised at more than US$10 billion, and foreign real estate acquisitions valued at more than US$1 billion by SOEs.

While President Xi seeks to streamline the operations of China’s lending institutions, he also aims to improve their overall performance.

The dark and bright sides of banks’ debt difficulties

Chinese banks are big . . . incredibly big. They are also major sources of funds for SOEs, big companies, and other firms that can get loans from them. A collapse of the big banks in China would cause other banks to collapse and a number of businesses to fail – think global recession.

Hence, China has acted to guarantee its banks’ continued operation, decrease their liabilities, and steer them towards a better future.

The best thing about China’s debt problem, according to Eastspring Investments, is that

  • it is primarily internal debt that must be managed;
  • there are capital controls in place to limit the amount of money exiting the country;
  • the country has an above-average national savings rate of 46% of GDP; and
  • the Chinese government has and will continue to stabilize the banks and infuse money into them when necessary.

China has staked its claim to being a dominant force in the 21stcentury. It won’t sit back idly and let its banks fail.

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Disclosure: Alisa Hopkins does not own shares of any companies mentioned. Motley Fool Hong Kong is not licensed by the Hong Kong Securities and Futures Commission to carry out any regulated activities under the Securities and Futures Ordinance.