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2014-10-21 11:30:42
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.