China’s Debt Problem – 4/26/16

As government policy pushes the Chinese economy towards growth targets, easy credit is leading state-owned companies to take on increasingly burdensome debt loads. In moves similar to those made during the 2009 crash by Chinese officials , the government has made borrowing costs low to encourage companies to grow in spite of lower profits and higher default risks in the long run.

Now those policies are losing their effectiveness and the threat of a financial reckoning seems closer than ever. In 2016, the operating profit of the average Chinese firm was only twice their interest expenses on debt versus 2010 when they could cover interest six times over. The debt expansion has been perpetuated by the People’s Bank of China, which has lowered benchmark interest rates six times since 2014 to help the economy reach the growth rates set down by the central government. Oil and gas, metals, and mining sector companies are especially strained by excess debt built up during prolonged commodity price declines.

Spending borrowed money may help China ease a transition to an economy driven less by investment and more by consumer spending and services, but it also risks slowing much needed reforms. Inefficient state-run companies tend to absorb most of the easy credit. It is tempting to point to areas like industrial output and real estate that rose faster than expected in March as successes, but they are the typical money sinks used to promote growth. If fueled by debt, that rise could mean more of the overcapacity deemed unsustainable by the central government. For example, the property market’s contribution to growth was 7% higher this past quarter heavily concentrated in a few big cities suggesting speculation and overbuilding.

China’s economy already showing signs of stress. Although, investment in fixed assets grew 10.7% over the quarter, the rate was only up 5.7% at private firms as opposed to 23.3% for less profitable state-owned firms. In 2015, their profits fell 21.9%, compared with a 3.7% increase for private companies. The overshadowing of private firms by state-owned ones is especially problematic since the government is counting on private sector jobs to make up for losses caused by reforms in what is likely to be a rough transition away from an investment driven economy.

Policy makers in Beijing are likely driven by largely arbitrary growth targets set at a range of 6.5% to 7%. Once targets are reached, officials are likely to be less generous with credit; however, the a new paper published by the International Monetary Fund suggests that it might be smarter to start curtailing early. In a recent paper about the systemic buildup of two decades of credit-fueled and state-directed growth, the IMF estimates bad corporate debt in China—obligations owed by firms whose profits can’t cover interest payments—amounts to $1.3 trillion, a problem that could trigger bank losses equal to 7% of the country’s GDP and cause a financial crisis damaging the world economy.

The paper questions Beijing’s proposal to allow banks to swap debt for equity in failing firms or bundling up those debts to be sold as securities as was done in the U.S. to help deleverage industries in the aftermath of the financial crisis. The authors expressed concern with the implementation of such plans as a means of dealing with the bad debt weighing on the economy.

“They are not a comprehensive solution by themselves,” said the authors of the paper, “Indeed, they could worsen the problem, for example, by allowing zombie firms (nonviable firms that are still operating) to keep going.”

They also mentioned that issues could arise as a result of China’s legal system and the complicated relationship many of the companies have with the government.

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