China: Corporate debt not scary
A high-profile Washington think tank disagrees with the oft-touted view that China’s corporate debt is a key fault line in the Chinese economy and could spark a crisis if Beijing fails to tackle it now.
There is no question that China's corporate debt relative to GDP is the highest both historically and among the major economies, according to the Institute of International Finance.
“However, contrary to popular opinion, Chinese companies' leverage, measured relative to assets and cash, is neither high nor rising,” the IIF said in a report.
Using the financial data of listed companies, the IIF revealed that the liability-to-asset ratio of Chinese companies, at 56 per cent, is lower than in the US (66 per cent), Japan (58 per cent) Germany (71 per cent) and Brazil (66 per cent).
Further, Chinese companies’ interest-bearing financial debt relative to their assets is not high at 30 per cent, acording to the IIF which counts the world's biggest banks as members.
Moreover, Chinese companies are holding enormous amounts of cash, which is about 14 per cent of their total assets.
"This ratio is greater than in the US which has 12 per cent," the IIF noted.
“Another surprising truth is that the leverage of Chinese companies, especially the non-state-owned ones, has in fact been falling in the past decade.
According to the Institute, which tracks global capital flows, the problem is that the return on the corporate assets has been low and falling.
According to the IIF, the reasons for the diminishing return on assets are both benign (the growing share of capital-intensive industries) and worrisome (falling productivity).
"As China invests more in the capital intensive upstream sectors, it takes larger amount of investment for the same amount of GDP.
“However, the diminishing return is also a result of overcapacity and falling efficiency, as evidenced by the loss-making steel industry in the past few years.”
The IIF claimed a better understanding of the root cause of China’s high corporate debt is crucial for the correct policy response.
"As the problem is driven by diminishing returns, tighter monetary and credit policy, which would lower nominal GDP, is not the best approach.
"A better policy strategy would be to boost capital productivity by cutting excess capacity and reducing capital intensity."
Tough battles ahead
Further reform measures are needed to boost asset productivity and lower the debt burden relative to GDP.
Though much has been achieved in the past two years, the IIF argued more can be done to boost capital productivity by cutting excess capacity, shutting down zombie companies, and allowing more competition by the non-state sectors.
Allowing corporate default and reducing ‘implicit guarantee’ can help install stricter credit discipline.
A better developed equity market would allow more equity finance and reduce the reliance on new debt.
Debt-to-equity swaps can also help lower the existing debt stock.
"Although the “stock problem” of the corporate leverage is not too severe, China still needs to urgently deal with the “flow problem” of low capital productivity in order to lower debt relative to GDP."