China: Corporates face toxic threat of debt

By:
Elliot Wilson
Published on:

Corporate debt at record high; NPLs at state lenders also on rise.

Levels of corporate debt in China have reached a worrying point, senior officials have warned, raising fears of a raft of fresh defaults as the wider economy slows. Speaking at the China Development Forum in Beijing on March 20, People’s Bank of China governor Zhou Xiaochuan warned that "corporate lending as a share of GDP is too high", adding that high leverage levels made the wider economy more prone to unintended and unforeseen risks. 

Debt levels have been on the rise for years, a problem that stems from Beijing’s decision at the height of the financial crisis to roll out a trillion-dollar stimulus programme to prop up the economy. Mainland banks at central and local level channeled record amounts of capital into infrastructure projects and favoured state enterprises. Bank lending has continued apace, hitting a record high in 2015, according to the China Banking Regulatory Commission (CBRC).

Despite concerted efforts to stave off or delay corporate defaults, either by forcibly restructuring or merging troubled state firms, failed and 'special-mention’ loans have surged, rising by Rmb1.22 trillion ($188 billion) in 2015, CBRC data show. The overall level of non-performing loans in the banking sector rose to 1.67% at end-2015, from 1.25% a year earlier, with the share of special-mention loans – those with a high likelihood of failing completely – rising to 3.79%. 

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Many others put the true level of NPLs far higher. In an October 2015 report, UBS analyst Lucy Feng said the "hidden" level of failed or failing loans at end-June 2015 was 11.7%, up from 10.8% six months earlier. An updated report by the Swiss lender on February 23 warned that rapid and excessive lending to corporates by the banking sector over many years had "set the foundation for significant potential losses, which would take years to clean up". 

UBS analyst Jason Bedford warned that the banking sector faced "serious challenges" ahead. Smaller, regional lenders, he said, had lent "excessively" to and through high-risk clients and investment vehicles. 

"We not only expect continued asset-quality deterioration as the credit cycle picks up speed, but also believe the potential for isolated NPL events is much greater," he added. 

Yet even China’s banks have struggled to keep pace with the demand for funds, forcing corporates – those in trouble, as well as those seeking to expand their operations at home and overseas – to turn to shadow-finance operators and, particularly, the formal debt markets, in search of fresh capital. A recent surge in unregulated lending by grey-market finance providers is helping to push property prices in Beijing, Shanghai and Guangzhou close to record highs.

According to data from Dealogic, total onshore bond issuance in the mainland hit a record $151.4 billion in the year to March 21, up from $82.4 billion in the same period a year ago. Corporate debt now stands at 160% of Chinese GDP, according to the Organization for Economic Cooperation and Development. In a briefing on March 16, premier Li Keqiang said high corporate debt levels were "not new in China", and could be solved through capital market reforms. But OECD secretary-general Angel Gurria warned that high leverage rates across a slew of sectors, including cement, steel, coal and flat glass, presented a short-term risk to the nation’s economy. 

Go global

A large slice of the new corporate borrowing is being used to fund bold acquisitions far from China’s shores. President Xi Jinping has for years urged domestic firms to spread their wings and "go global". In the first six weeks of the year, outbound spending on mergers and acquisitions by mainland firms totaled $86.1 billion, according to Dealogic, against $73.4 billion in the whole of 2015. Notable pending deals include Anbang Insurance’s $13.2 billion bid for Connecticut-based Starwood Hotels & Resorts. S&P Global Market Intelligence warned in a recent report that a majority of the 479 outbound M&A deals completed last year by mainland firms were "highly leveraged". 

High levels of corporate leverage constitute a problem across the emerging world, as economies slow or sink into recession. The Bank for International Settlements has warned that a steep rise in corporate debt, particularly in large developing nations, was "eerily reminiscent" of prevailing conditions in pre-financial crisis western markets. Chinese officials have spoken, both publicly and in private, about the threat to the domestic financial system and to economic growth, should a large number of mainland firms fail to meet their debts. 

Infection

Ratings agencies have begun to fret about high rates of leverage and the threat of wider infection, should a surge in corporate defaults undermine the global financial system. 

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Shang Fulin, CBRC
On March 2, Moody’s revised downward its outlook on China’s economy to negative from stable, and warned it may downgrade the sovereign rating, citing fears about rising debt and falling foreign-exchange reserves. Standard & Poor’s tips the number of bond defaults by Chinese corporates to double this year to 18, from nine in 2015, citing a rapid deterioration in credit quality. In the first week of the year, Fitch Rating said 12% of the mainland firms it rated were on watch for a downgrade, up from 7.4% a year ago.


Beijing is desperately casting around for ways to cut rising corporate debt levels and bank NPLs, without actually turning off the funding taps. In March, CBRC chief Shang Fulin said banks could use debt-for-equity swaps to wipe around $200 billion in bad loans off their balance sheets, exchanging the debt they hold in troubled firms for stock holdings. Chinese premier Li singled out the plan as a logical and necessary way to "progressively reduce corporate leverage".