China's next debt challenge

Despite Beijing's rates cut, Chinese corporate debt levels threaten to destabilise the country's growth. As business deleveraging sets in further action will be required.

FT.com

After nearly two decades of high tide for the Chinese economy, growth is slowing and the waters are receding. As Warren Buffett once warned, it may not be a pretty sight – a surprising number of companies have been swimming naked.

The Chinese government and Chinese households have been paragons of prudence in managing their finances, saving lots and borrowing little.

The same cannot be said of their corporate brethren. The indebtedness of Chinese companies is at an all-time high.

Private-sector borrowing as a percentage of GDP was 131 per cent in China at the end of last year, according to Standard & Poor’s. While that is much lower than the roughly 200 per cent levels in the US and Britain, it is unusually high for a developing country, where the norm is closer to 50 per cent.

More worrying is the pace at which debt has increased – an important predictor of financial trouble. The credit-to-GDP ratio in China’s private sector has increased about a quarter over three years, making for a "high credit risk” in S&P’s view.

The government has certainly not been blind to this risk. From newfangled central bank liquidity operations to old-fashioned communist central planning, officials have used every tool in their box over the past year to tighten China’s monetary screws.

They have, in one respect, succeeded. Formal bank lending to Chinese companies has slowed dramatically. Yet the past year has also exemplified a popular Chinese saying: shang you zhengce, xia you duice – policies come from above; countermeasures from below.

The countermeasures to official policy have provided short-term relief to Chinese companies – keeping the financing flowing – but at a clear cost.

Turned away by banks, many smaller businesses have gone to underground lenders. China International Capital Corp, a top domestic investment bank, estimates that private lending rose nearly 40 per cent in the first half of 2011 from a year earlier. Such banks are not saviours; they charge usurious rates, as much as 60 per cent on an annualised basis.

Bigger companies have escaped the scourge of the underground banks, but they too have devised a range of dangerous countermeasures to ease their credit strains. A recent warning from the Chinese banking regulator about the steel sector shed light on these techniques. Without naming names, it cautioned banks that some steel trading companies had pledged the same collateral multiple times or obtained fraudulent credit guarantees.

Another countermeasure has been selling to cash-strapped customers on credit. It is by going down this route that Zoomlion, a construction machinery company, has earned the dubious distinction of being the most shorted stock in Hong Kong. Vendor financing – the technical term for accepting IOUs from customers – accounted for 35 per cent of its sales last year.

These various ways of flouting the government’s controls on corporate borrowing help explain why Chinese economic growth had held up so well until recently. Credit had been much more generous than implied by official bank-lending figures. But this dynamic now appears to be changing. The government has, little by little, choked off informal and illicit credit flows, while bank lending has remained limited.

As loans have dried up, Chinese companies have started to meet their debt obligations not by refinancing, but by selling assets. In other words, deleveraging has finally come to China Inc.

Zhao Yang, an analyst with CICC, says there are plenty of signs that deleveraging is under way: a decline in corporate demand for debt financing; a rise in equity financing; a falling proportion of long-term loans among overall loans; and an active destocking of inventories. Given the high debt levels of Chinese companies, some deleveraging is a good thing. But it also poses its own dangers, to which European countries grinding through austerity measures can well attest.

Zhao warns that a negative feedback loop between corporate deleveraging and slowing growth could be taking hold in China. After growing at an annual pace of 9.1 per cent in the first quarter, the economy is on track to slow sharply this quarter, data suggests. Letting Chinese groups load on the debt again is not the answer.

Thankfully, Beijing has other options at hand. First and foremost, with total government debt equal to just 38 per cent of GDP, it has plenty of scope to spend more to prop up aggregate demand.

As Chinese corporations learn to pinch their pennies, it is time for the government to open its wallet.

Simon Rabinovitch is the Financial Times’ Beijing correspondent.

Copyright The Financial Times Limited 2012.