Over the past decade, because of the massive quantitative easing by developed economies, Western investors have been chasing yield wherever they could find it to escape low interest rates at home. As a result, disproportionate amount of liquidity found their way to emerging market and ended up as borrowings by risky emerging market firms. Today, corporate debt in emerging and developing economies significantly exceeds levels before the 2008 global financial crisis. The increase in corporate debt ratios has been “most pronounced in East Asia and the Pacific”. In China, its expansionary monetary policy in response to the GFC caused its non-financial corporate debt to quadruple to $17.4 trillion by 2015 and $21.6 trillion by 2018. This is equivalent to 165% of GDP compared to the 82% in South Korea, 51% in Malaysia, and 38% in India.[1]

 

Shift of China’s Corporate Debts from Bank Loans to Bond Financing

 

The composition of China’s corporate debt has been undergoing major shifts in recent years as a result of the growth of its bond market. The main factors driving the increasing popularity of bonds are its lower cost compared to bank loans and the government’s clampdown on shadow banking.[2]

 

According to Peoples’ Bank of China (PBOC), the Chinese central bank, the interest rate for bank loans in the first quarter of 2016 was 5.7% across all maturities while the yield on 10-year AAA-rated corporate bonds averaged only 3.8%. In addition, offshore interest rates are also considerably higher than the onshore market. With such a huge cost differential in borrowing, it is not surprising that Chinese corporates have rushed to the domestic bond market in recent years.

 

As a result, the share of bond financing has increased from almost negligible before 2004 to 12% of the total corporate financing in 2015.[3] Today, China’s onshore bond market is the world’s third largest with the current size of around $ 7.7 trillion, just behind the US and Japan.[4] Despite the increasing popularity of bonds, bank loans still account for over 56% of total corporate financing in 2016 while shadow credits the constitute the remaining 32%.

 

Low Currency Mismatch Risks but Rising Default Risk

 

Because of China’s restriction on foreign participation to minimize potential exchange rate risks and capital flow reversal in times of economic downturn, the onshore corporate bonds were predominantly owned by domestic investors, though restrictions have been reduced since 2016. In fact, 95% of the total corporate debt (i.e. bank loans and bonds) is financed domestically and in local currency. Offshore financing is only around 4% by end of 2015. As of 2018, about $1 trillion of China’s corporate debt is in foreign currencies – mainly dollars that have been appreciating sharply against the RMB. Relative to the size of GDP, China’s dollar-denominated debt to GDP ratio is relatively low at 6.3%.[5] Compared to other emerging economies whose corporate debt on average is only 62% in local currency, China’s corporate debt is thus very low in external financing. This makes Chinese corporates less vulnerable to currency mismatch risk that can be triggered by a shift in market sentiment. Moreover, China still enjoys a sizable current account surplus and there is more than enough foreign exchange reserves and resolve to defend the value of its RMB should it come under speculative attack.

 

The biggest risk factor for Chinese corporate debts is therefore their ability to repay due to a slowing economy caused not only by domestic structural issues but increasingly more so by Trump’s threat of an all-out Sino-US trade war. Though the size of the corporate debt is alarming, it should not be understood as the government being exposed to contingent liabilities as big as 162% of GDP. This is because a significant number of the SOEs are financially healthy and pose no risk of needing direct or indirect government support. According to Moody’s, debt owed by SOEs to the amount equivalent about 20-25% of GDP may require to be restructured.

 

The IMF estimated that the corporate debt could result in bank losses equal to 7% of GDP. The estimation does not include all categories of debt but already indicates clearly the significant pressure on the banking sector by SOE debt build-up. Signs of stress have also become apparent in China’s corporate bond market even before Trump’s announcements of tariffs for Chinese exports to the US. The value of bond defaults in the private sector has risen by more than a third in the first four months of 2018. According to a report from China Central Depository and Clearing, a state-run settlement service for financial products, more than 10 companies from a variety of industries have defaulted on 15 bonds worth more than 12.8 billion yuan (US$2 billion).[6] By early June, 20 corporate bond defaults totalling 14.2 billion yuan had occurred, many of them by private, listed firms. Rising default risks have not only worsened private firms’ bond ratings, pushed up the costs of issuing bonds, and forced some to shrink the scale of issuance.[7] They have also unsettled regulators eager to stave off systemic risks as they seek to reduce national debt levels.[8]

 

Factors Contributing to China’s Rapidly Growing Corporate Debt

 

Several factors are contributing to China’s rising corporate debt default.

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The first factor is the government’s efforts to deleverage. Since coming into office in 2013, the Xi-Li government has been working to reduce excess capacity and lower the country’s overall debt levels. To achieve that task, it adopted a neutral monetary policy with a tightening bias and, in 2015, launched its supply-side reforms with deleveraging as one of five key tasks. The irony of pre-empting a debt crisis is that while leveraging builds up a bubble, it is the sudden stop of leveraging that set in motion a vicious cycle that will eventually lead into crisis. As banks withdraw financing to comply with instructions to tighten credit, companies run out of cash which curtailed their ability to continue their operations and to service the debts. Eventually, it will lead to more defaults.

 

Next, China’s state banking system largely exists to serve local governments and state-owned enterprises (SOEs). Many small and medium marginalized private firms are thus forced to rely on non-bank financial institutions, including loan sharks, using short-term funds to finance their long-term investments paying interest rates as high as 10% a month or an annualised interest rate above 120% when the one-year benchmark lending rate is 4.35%. One entrepreneur, for example, borrowed 210 million yuan in principal but paid 590 million yuan in interest over two years. Many do so not only to finance their operations but also to service existing debts. Over time, they become highly leveraged and are usually the first victims when credit condition worsens, as it has with the deleveraging measures implemented in 2016 - 2017.

 

Finally, another factor contributing to the rising rate of defaults is policymakers’ determination to remove the “implicit guarantee” that bondholders would get their money back no matter what, hence negating any risk to the lenders. The guarantee had become entrenched in the country’s financial system and driven debt bubbles in the past. By allowing more corporate bonds to default, the Xi-Li government hopes to remove the implicit guarantee. The first bond default was reported as recently as 2014, one year after the change of the government. By 2016, the total value of bond defaults amounted to 39.8 billion yuan or three times that in 2015. In 2017, amid the leadership reshuffles, the top priority of the government was economic stabilisation which was achieved by ‘re-leveraging’. Even so, 44 corporate bonds worth 38.4 billion yuan defaulted.[9]

 

Divergent Trend in Leverage between the State and the Private Sector

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An added problem to this debt-fuelled growth model is the government’s tendency to support growth by lending more to the state sector, which is the least productive and efficient in terms of the use of capital. As a result, SOEs are incentivized to borrow the maximum amount at low interest rates from a state banking system that also prefers lending to the SOEs over the private firms because the implied bailout guarantees from the state render the loans to the SOEs risk free. Hence, there is a divergent trend in leverage between the state and the private sector. The debt to equity ratio is going down for private firms but moving up for the SOEs.

 

SOEs not only enjoy privileged access to credit. They also benefit from state’s bailout measures such as the swapping debts into equity. Almost all companies covered in the debt-to-equity swaps with banks are state-owned. To grease the debt-to-equity deals, PBOC has released 500 billion yuan to the country’s state banks.

 

According to Guo Shuqing, the head of the China Banking and Insurance Regulatory Commission, the focus of next phase of government’s structural deleveraging is on SOEs and local governments. Guo criticized SOEs for taking a wait-and-see attitude in disposing non-performing assets and “zombie” enterprises which are businesses that received cheap funding but generated losses or did not generate enough profit to cover their interest payments. According to a study from Renmin University, more than half of Chinese steel mills, mostly state-owned, qualify as zombie enterprises, with many of those emerging after 2008 following China’s 4 trillion yuan (US$635 billion) stimulus. They should have exit the market but the problem is that China lacks a market-driven bankruptcy mechanism in accordance with rule of law to allow them to do so properly.[10] Looking ahead, the real challenge for policymakers is to put in place a mechanism to eliminate SOEs’ incentive to increase their leverage so that they will not re-leverage at the expense of deserving private firms with growth potential.[11]

 

Policymakers are also keenly aware of the funding problems faced by small and medium private firms which account for 80% of jobs and 60% of China’s economic output. In particular, private businesses bear the brunt of the government’s aggressive deleveraging measures. Some entrepreneurs were so heavily in debt from their borrowings from underground banking system, which charged annualized interest rates as high as 120%, that they resorted to committing suicide as a way out of mounting debts when they failed to get new credit to roll over existing debts. Their suicides raised debate on Chinese social media about why Chinese private entrepreneurs are having harder times in an economy which officially still grew at a rate of nearly 7%. To address the situation, the central bank is working with several government bodies to boost loans to smaller firms. At the same time, the PBOC is discussing with the Ministry of Finance to give tax incentives to small businesses.[12] However, these efforts are unlikely to change the unsavoury reality that private businesses, especially those small and medium ones, will remain marginalized for a long time to come because of their weak political power.

 

2018: From Deleveraging towards More Monetary Easing Again Amid a Slowing Economy

 

By mid-2018, however, as incidents of bond defaults rose amid a slowing economy and Trump’s threats of an impending trade war, Beijing began to shift its stance, once again, from deleveraging towards more monetary easing.[13]

 

Measures adopted by the PBOC to inject liquidity into the financial system include a second cut of the year in the reserve requirement ratio for commercial banks in late June, unlocking over 700 billion yuan (US$101.8 billion) of liquidity, and the provision of 500 billion yuan of longer-term funding in late July through the so-called medium-term lending facility, the largest such operation since the scheme was launched in 2014. The spike in liquidity caused the Chinese interbank benchmark rate to fall making borrowing cheaper for firms. This easing of monetary policy is accompanied by fiscal measures involving tax cuts and infrastructure spending to support growth.[14]

 

PBOC insisted its steps to loosen policy do not amount to “flood irrigation”-style stimulus. Rather, the much tamer stimulus measures (in contrast to the more aggressive policy easing undertaken in 2011-12 and 2015-16) simply reverse some of the sharp tightening over the past year or so. Even if true, both the easing of liquidity and the increase in infrastructure spending are likely to result in an increase in debt levels for the corporate sector and local governments in the end.

 

Hence, despite its rhetoric that it wants to accelerate leverage reduction to tackle its debt mountain, the reality is that until China succeeds in moving away from investment-driven export-led growth towards a more balanced model in which consumption and the services sector can contribute more to generating GDP, the debt-fuelled growth model remains a convenient and indispensable quick-fix economic stabilization tool. Chinese policymakers are thus faced with a predicament of reconciling the imperative of deleveraging with the need to shore up a slowing economy made more pressing by the threats of trade war.[15]

 

Overall, despite having made some progress in lowering corporate leverage, the heavily indebted corporate sector remains an important challenge for the Chinese policymakers. By 2019, bonds worth about 20 trillion yuan are set to expire. Whether or not more firms will default depends not just on the domestic structural issues but also on how the Sino-US trade war will evolve, which China has little control over. In the event if Trumps decides to go all-out and imposes tariffs on all Chinese exports to the US, many Chinese firms are likely to face problems servicing their debts at least in the short term. Even if the Chinese government succeeds in staving off mass bankruptcy through more fiscal spending and monetary easing to prevent an economic hard landing, it merely kicks the can down the road while creating an even bigger debt bubble.

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REFERENCES

[1] See Anthony Rowley. (2018). “How Trump’s trade war combined with emerging market corporate debt could trigger a perfect storm.” SCMP. 22 August, 2018.

[2] See Atradius. (2016). “A closer look at corporate debt in EMEs.” 5 May 2016.

[3] See Li Yuefen. (2017). “China’s Debt Problem And Rising Systemic Risks: Impact Of The Global Financial Crisis And Structural Problems.” South Centre. Research Paper 83. November 2017.

[4] See Financial Times.(2016). “China securities houses on track for record bond fees.” 16 May 2016.

[5] See Anthony Rowley. (2018). “How Trump’s trade war combined with emerging market corporate debt could trigger a perfect storm.” SCMP. 22 August, 2018.

[6] See Sidney Leng. (2018). “China’s private firms default on US$2 billion bond repayments as Beijing’s deleveraging efforts bite.” SCMP. 14 May 2018.

[7] See Sidney Leng. (2018). “Caught in China’s cash crunch: why private companies are collapsing into a black hole of shadowy debt.” SCMP. 18 July 2018.

[8] See Sidney Leng. (2018). “China’s private firms default on US$2 billion bond repayments as Beijing’s deleveraging efforts bite.” SCMP. 14 May 2018.

[9] Ibid.

[10] See Maggie Zhang. (2018). “Debt defaults to rise as China focuses on tackling bloated state enterprises, local governments in deleveraging drive.” SCMP. 14 June, 2018.

[11] See Frank Tang. (2017). “Beijing ‘wants to deleverage, but not destabilise’”. SCMP. 25 March, 2017.

[12] See Nicholas Spiro. (2018). “China’s monetary easing supercharges its bond market but leaves harder questions about its economy unanswered.” SCMP. 14 August, 2018.

[13] See Enoch Yiu. (2018). “China picks its battles, to ease monetary policy amid trade war.” SCMP. 17 July, 2018.

[14] See Nicholas Spiro. (2018). “China’s monetary easing supercharges its bond market but leaves harder questions about its economy unanswered.” SCMP. 14 August, 2018.

[15] See Frank Tang. (2017). “Beijing ‘wants to deleverage, but not destabilise’”. SCMP. 25 March, 2017.

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