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To rein in its debt, China must be willing to let companies fail
Oct 18th 2014 | From the print edition
WEIGHED down by debt and running out of cash, Chaori Solar emerged this year as
an unlikely poster child for all that was going right with the Chinese economy
because it was allowed to go under. China s leaders had vowed to bring market
discipline to a financial system that had grown lazy in its dependence on ever
more credit. Chaori, the first company to default since China relaunched its
bond market a decade ago, was a symbol of the new tough-love approach. But
something unexpected happened this month: Chaori s creditors were bailed out.
It is a disturbing omen for the Chinese economy. For all the talk of reform,
many government officials still want to paper over bad loans. With credit going
to keep moribund companies alive, China s debt levels have soared even as
growth has slowed. Overall debt, including government, corporate and household,
has reached about 250% of GDP, up from 150% six years ago.
The precipitous rise began with China s gargantuan stimulus in response to the
global financial crisis in 2008. Its total debt-to-GDP ratio increased faster
than that of any other big country during that time, according to a new report
from the International Centre for Monetary and Banking Studies, a Swiss
research institute. Similar rises preceded banking crises in much of Asia in
1997 and in America more recently. Little wonder that financial fragility is
seen as the biggest macro risk to China, if not the global economy, according
to Standard and Poor s, a ratings agency.
Yet a sudden collapse is most unlikely. The same thing that got China so deep
into debt is what keeps it from blowing up: state control of the financial
system and the perception, often substantiated, of government backing for
debts. Instead the biggest danger is zombification , a hollowing-out of China
s financial system along the lines of Japan s slow decay over the past two
decades. In this scenario there would be no sudden crisis, but a relentless
corrosion of China s economic vitality as loans are used to patch up old holes
rather than to support new activity. The International Monetary Fund sounded a
recent warning: China s continued reliance on credit-fuelled investment
compounds the risk of an eventual sharp slowdown .
Can China avoid this fate? Much rests on whether the government can uproot
moral hazard from the financial system. By removing the perception of state
guarantees and allowing failing companies to fail, the authorities could force
banks and investors to allocate their capital much more carefully, slowing the
rise in debt.
There are reasons for concern. Officials tend to go weak at the knees when even
relatively inconsequential companies fall into distress. This year began with a
last-minute rescue of Credit Equals Gold #1, an investment product marketed by
Industrial and Commercial Bank of China, the country s biggest bank, that only
the wealthy were supposed to buy because it was risky. Huatong Road and Bridge
Group, a construction company in the northern province of Shanxi, was on the
verge of defaulting on a 400m yuan ($65m) loan in July, when the local
government stumped up the cash. And then there is this month s rescue of Chaori
s bondholders, led by Great Wall Asset Management, a state-run firm initially
set up to take bad loans off banks hands during a big bail-out a decade ago.
It strengthens investors expectations of an ironclad guarantee for bond
repayment, says Zhang Li of Guotai Jun an, a brokerage.
Half the buildings at Chaori s factory in Shanghai s far southern suburb of
Fengxian are abandoned, save for two security guards growing red beans on a
patch of soil in front. But thanks to the rescue, the other half is creaking
back to life. Workers load boxes of panels onto a flatbed truck, destined for a
Chinese solar market that still suffers from severe oversupply. The potential
price to the government for reviving Chaori is at least 788 million yuan the
size of the debt Great Wall has guaranteed. For solar companies that have
stayed in business on their own merit, the price is injurious,
government-subsidised competition.
Nevertheless, there have also been signs that China may yet manage to contain
its debt problem. The market, when left to its own devices, has actually done a
reasonably good job of cleaning up balance-sheets. Listed firms in industry and
transportation have stabilised their debts (see chart). A lot of companies
that saw a deterioration in revenues decided to cut back their leverage, says
Helen Qiao of Morgan Stanley. The continued rise in debt has instead been
driven by three groups: special-purpose vehicles controlled by local
governments, state-owned enterprises and property developers (see chart).
The dukes of moral hazard
This concentration should make it easier to defuse the risks. The government
may be willing to countenance defaults by property developers, not least
because foreign investors are some of their biggest creditors. Breaking the
implicit guarantees for local governments and state-owned companies is more of
a taboo. A budget law that goes into effect on January 1st will allow cities
and provinces to issue bonds directly instead of via opaque special-purpose
vehicles. As part of the deal, the central government will refuse to bail out
any localities that miss payments.
In theory this will create the hard budget constraint that is needed to stop
local officials from falling back on central government support. In practice,
bond traders point out that there is still no bankruptcy law for cities or
provinces, making it all but inevitable that the central government will pick
up their tabs if necessary.
State-owned enterprises, especially those controlled by the central government,
also enjoy a rock-solid backstop for their debts, and there is little chance of
that changing soon. One glimmer of hope is that Chinese banks are becoming more
discriminating. With their profits under pressure, the evergreening of loans to
state companies is too costly for them; just over half their corporate loans
went to private companies in 2012.
Most significant is the oft-repeated message from China s top leaders that the
quality of growth matters more than quantity. The implication for debt is
straightforward. If local officials are less obsessed with GDP, they will also
be less intent on pushing out the investments needed to rev it up. This is
where the demand for funding has come from, says Li Fuan, a senior Chinese
banking regulator. Of course there will be some pain in slowing down. It can t
be done without it . But for officials accustomed to plenty, pain is still a
hard sell.