Investors have warmed towards China in 2017 amid a more stable outlook for the renminbi (after large outflows last year) and a likely focus on stability and policy continuity at the Communist Party’ 19th national congress next month.
China has posted a raft of robust economic data in recent months, including second-quarter GDP growth of 6.9 percent from a year earlier. Market sentiment has been cheered by MSCI’s decision to partially include China A-shares in its Emerging Market Index and by the launch of the Hong Kong-China Bond Connect scheme, which offers foreign investors easier access to China’s onshore bond market.
However, risks from rising debt levels and overcapacity in many manufacturing sectors remain – and that’s why China continues to perform a delicate balancing act between supporting growth when the economy needs it, and deflating bubbles in order to support long-term stability.
China’s recent decision at the National Financial Work Conference (NFWC) to create a super-regulator to oversee the financial system amid rising worries over systemic risks has been welcomed by many. The readout from the NFWC contained a recommitment to reform of state-owned enterprises (SOEs), to eliminate unproductive debt and improve economy-wide efficiency. But what will this mean for investors and will it really get to the root of the debt problem?
SOEs versus private companies
As a percentage of GDP, government and household debt in China is dwarfed by corporate sector debt (see chart 1 – China debt composition). According to the International Monetary Fund, in 2016 SOEs accounted for roughly 55 percent of total corporate debt while only producing 22 percent of overall economic output.
Reducing debt levels at SOEs then and directing resources into faster-growing, non-industrial sectors would seem to be a sensible first step in deleveraging the whole economy. It would also serve the related government goal of transitioning the economy to a more domestic consumption-led model and away from dependence on exports and government investment.
While overall financial leverage (measured by liability-to-asset ratios) for industrial firms has been declining since 2013, this has been driven mainly by improving balance sheets at non-SOEs. Meanwhile, the profitability of these heavy industrial firms in general is also much lower than that of non-SOEs.
Necessary but not sufficient
However, while SOEs account for just over half of China’s corporate debt, the real drivers behind the recent sharp increase in China’s debt load have been the real estate and financial sectors. Data on property firms is not as robust as for the industrial sectors, but statistics drawn from the statements of the listed companies—theoretically the most successful—show worrying borrowing patterns.
Net debt-to-equity ratios of listed property developers shot up from 39 percent in 2009 to 124 percent in the first quarter of 2017 . By comparison, the average net debt-to-equity ratio for all A-share companies was 51 percent during the period.
A cleanup of SOE debt alone is unlikely to touch these sectors. Moreover, the Chinese authorities have become increasingly conscious in recent times about real estate speculation, the complex structure of wealth management products and their links to the shadow banking system. That’s why investors should be prepared for wider debt reforms in future.
Read the runes
China SOEs are currently overrepresented in internationally accessible equity and bond markets and will continue to be the main targets of government-directed reforms. However, the recent rapid accumulation of debt has been driven by non-SOE entities, namely financial institutions engaged in creating wealth management products, real estate-linked companies financing China’s continued property boom and local governments (through linked corporate entities) spending on policy priorities.
While these activities may seem supportive of growth, the ever-mounting pile of debt they incur has reduced the effectiveness of the credit growth to GDP growth transmission mechanism.
As such, investors may want to avoid the immediate targets of SOE reform and those companies likely to be affected by wider efforts to clamp down on leverage, while increasing exposure to less-indebted sectors serving the “New China” economy, such as healthcare, consumption and information technology.
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