China's banks are struggling under debt's shadow

Lowy Interpreter

So China's economy will soon overtake the US in PPP terms.

Some commentators believe market-rate calculation is more meaningful than PPP, and forecast that on this basis China still is decades away from catching America. For here is a remarkable fact: the equity market capitalisation of the US is US$23 trillion compared to China's US$3 trillion. In other words, the market value of shares in listed American companies is roughly eight times that of China.

There are several possible explanations for this astonishing differential.

Perhaps the US stockmarket is overvalued while China's is undervalued. Not all Chinese companies are listed on an exchange, including some of the best ones (notably Huawei and Alibaba, although the latter soon will be). American companies are more seasoned and experienced. They are run solely for profit, while Chinese ones serve broader stakeholder objectives. And while China's PPP output may rival America's, it does so with different inputs: more labour and less capital. So China's capital stock should accordingly be valued less.

All are valid points. But there is a deeper explanation that reveals a stark contrast between American and Chinese capitalism: capital structure.

Capital essentially comes in two flavours: debt and equity. Debt is a real obligation, while equity is a residual, a leftover to reward shareholders. 

China's mix of capital is heavy on debt and light on equity; its corporations are among the world's most leveraged. The debt load they carry weighs down their equity. Why Chinese companies have taken on so much debt is easy to understand: financial repression (keeping interest rates low) has made debt cheap, especially for state-backed borrowers. Lenders assumed that such companies could never go bust. Chinese industry splurged on investment and now faces over-capacity, which has depressed profits and slowed the accumulation of equity. Now facing liberalised interest rates, weaker companies are in a gearing spiral.

Chinese banks are worried. They play a hugely important role in financing China, which doesn't yet have a well developed market for debt.

They also play an outsized role because of their own leverage: a dollar of bank equity can mobilise $10 of credit in the economy. Both banks and their customers have stretched their equity. But now that parts of China's economy are struggling, confidence in the banks' balance sheets has faded too. Some estimates suggest that total bank losses could go as high as US$3 trillion. Maybe we'll never know the true extent of damage, but Chinese banks are concerned enough about their eroding capital that they are raising more money. The deficiency of bank capital is like a hole in the heart of China's economy.

What China's banks really need is true equity, the residual capital that absorbs the ups-and-downs of the business cycle.

But because of waning investor confidence, bank stocks are now valued by the market below their book value. Under Chinese law, state property can't be sold at less than cost. So banks are unable to raise new equity at current prices. Regulators reluctantly allowed a new wheeze to circumvent this restriction. At least two large banks, ABC and BOC, are marketing 'preferred stock', which is a hybrid form of capital that lies between true debt and true equity. A whopping US$100bn worth of preferred stock reportedly is on its way. Preferred stock counts as bank capital under international rules, but it's seen as a controversial accounting fudge, discredited after the GFC experience.

The key technical question is 'loss absorption', which is exactly what it sounds like: do the holders of this weird hybrid capital (also known cynically as 'junk' capital) take the pain if the bad debts start rolling in?

Indeed, risk of loss is the root problem. Both Chinese industry and banks lack real equity. The economy is highly credit intensive, yet banks must continue underwriting loans to keep it running. But investors have lost confidence in the true state of the banks, which are in turn forced to issue junk capital. Investors are unwilling to buy it except at a high price, perhaps 7-8 per cent per annum for the best banks, which means 10 per cent or more for the weaker ones. No investor really expects a state-owned bank to go bust (if they did they'd demand a lot more than 7 per cent) but they are nonetheless scared of corporate losses piling up at the banks.

Under China's bold new economic reforms, it still isn't clear whether and how major financial losses will be permitted. Beijing needs somehow to untangle this knot and begin the recapitalisation of the banks and the entire economy: more equity, less debt.

Originally published by The Lowy Institute publication The Interpreter. Republished with permission.