Calling for prioritizing development quality over speed at the opening of the Chinese Communist Party’s 19th National Congress, Chinese President Xi Jinping signaled an increased tolerance for slower growth, the key to slower debt growth. Accepting slower growth by no means spells a fundamental change in the government position or China’s credit trajectory. It does, however, create room for the government to push through its deleveraging initiatives while imposing financial accountability on state firms.
After tackling local government debt, the central government turned to corporate leverage, the most severe problem among the government, the private sector, and non-financial enterprises. After stimulating housing sales with an unprecedented mortgage growth, a multi-year contraction has been reversed, bringing enterprises increased profits. Meanwhile, a controversial yet necessary debt-for-equity swap policy was released in order to deal with the financial legacy of the 2008 stimulus. In the long run, as the 13th Five Year Plan boosts the capital market, increased equity financing will reduce leveraged financing, further curtailing debt growth.
Reacting to the mounting debt loads and an unbalanced financial market, these initiatives miss the root cause of corporate indebtedness, which is soft budget constraints on state firms. Enjoying implicit government guarantees, state firms can raise funds regardless of their finances. Because they respond to government instead of market signals, financial institutions, especially state-owned banks, will keep financing state firms, betting that the government will bail out underperforming firms. As long as state firms are bounded by soft rather than hard budget lines, these implicit guarantees will prevail, leading to rounds of government bailouts.
Additionally, without substantial improvement on the part of state-owned firms, the fragile consensus on deleveraging is at risk of falling apart.
As a sharp deleveraging may trigger an economic crisis, a debt-shifting framework emerged, where the government and private sector would increase borrowing to make room for enterprises to deleverage. Under this approach, China’s central bank prioritized cutting housing inventories to help firms repair their balance sheets. With interest rates cut to a record low, households and investors alike flocked into the property market, leading to the current housing boom and an economic rebound from 2016-17.
However, the economic recovery has failed to deliver on its deleveraging promise. Although the profits of state firms supervised by the central government rose by 18.4 percent year-on-year in the first three quarters of 2017, their debt-to-assets ratio only decreased by 0.2 percent. To make it worse, as the short-lived rebound eases their debt-servicing difficulties, state firms feel less interested in making deals to reduce debt. As a result, a sense of debt deadlock has returned as the initial hope for meaningful debt-for-equity swaps diminishes.
After lobbying by enterprises, debt-for-equity swaps were first proposed publicly by Premier Li Keqiang in March 2016, to lower firms’ debt burden. After more than half a year of negotiation, the policy was unveiled in October 2016. By urging banks and other investors to accept stock stakes in underperforming firms in exchange for debt holdings, debt-for-equity swaps thus help cut firm leverage. The policy bent the Commercial Bank Law, which bans banks from holding firm equities, resulting in breathing space for indebted state firms, which had expanded their employment capacity after the 2008 global financial crisis.
However, arguing that the new policy would encourage moral hazard, banks pushed the government to harden budget constraints on state firms from the beginning. Pressed by the debt-for-equity policy and without alternatives, though, banks started to negotiate and make deals. One year since the policy took effect, banks’ concerns have only increased. Without effective participation in corporate governance and thus genuine improvements in firms’ performance, banks are worried their investments will be trapped in unprofitable firms.
For the same reason, the lack of financial and other accountability on state firms also discourages private investors from participating in debt-for-equity swaps. Sharing similar concerns with banks, interested private funds are waiting for a government signal on holding state firms accountable for investments. If market participants are limited to banks and their asset management units, debts will be simply moved off banks’ balance sheets, rather than fully disposed.
These difficulties have resulted in a very limited number of debt-for-equity deals being successfully negotiated, and those deals that have been signed are being very slowly executed. Despite government polishing, the scale of debts that have been addressed through negotiation pales before the remaining stockpile in the economy. Although deals worth 1.3 trillion yuan ($196.46 billion) had been signed as of September 22, banks and firms had identified bad loans worth 14.85 trillion yuan ($2.15 trillion) the end of 2016. The execution of signed swaps is even less impressive, with estimates varying from 10 percent to 13.7 percent of deals.
Budget discipline holds the key to state firm performance and China’s financial soundness in the long run. The 13th Five Year Plan states China will promote equity financing, meaning state firms will get increased direct financing access. However, without hard budget constraints, increased financial access may add to state firms’ relentless borrowing, creating still more ineffective investments.
While President Xi called for stronger, better, and bigger state firms at the Party Congress, he seemingly dropped his previous endorsement for national champions. The government thus should increase current efforts to improve the efficiency of state firms. First and foremost, hard budget constraints should be firmly in place. The government should also take advantage of the ongoing reforms in the state sector, especially with regards to corporate governance. All investors, private or public alike, should be granted equal say in state firms. All in all, the government should take advantage of the closing window of opportunity and commit to its deleveraging initiatives before debt spirals out of control.
Xinling Wang works for China Policy, a Beijing-based consultancy, and writes on Chinese politics and macroeconomic policy.