China debt: highly-leveraged state firms could threaten ‘efficient growth’, private investment post-pandemic

Karen Yeung
·4-min read

Surging debt among Chinese state-owned enterprises (SOEs) with close ties to local governments could become a major hurdle for private sector investment and broader economic growth, analysts say.

While China was the only major economy to post positive growth last year, it was partly because of a massive increase in corporate debt following aggressive monetary and fiscal policies aimed at fighting the coronavirus pandemic, according to economists.

China’s deleveraging campaign of recent years, which put particular focus on cleaning up inefficient SOEs and alleviating distortions in credit allocation, was halted last year.

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Company debt now stands at more than 160 per cent of gross domestic product (GDP), according to the Institute of International Finance (IIF), with most of it owned by state-owned firms.

“Corporate debt is probably [China’s] biggest risk,” said Martin Raiser, World Bank country director for China, Mongolia and South Korea. “One reason is because [SOEs] are not only highly leveraged, but tend to be less profitable than private firms.”

China’s key challenge comes from the imbalance between its high domestic savings rate and demand for productive private sector investments, he said. China had previously exported its surplus savings through overseas mergers and acquisitions, but there were questions over the quality of investments and it also created tensions with trading partners.

In recent years, the bulk of domestic savings have been used domestically, despite China’s weakening demand. This has seen a growing proportion of credit being funnelled into the real estate sector, fuelling expectations of continuously rising prices in some second and third-tier cities, Raiser said.

In 2020, SOE debt ratios as a per cent of assets increased for the first time since 2017 because of the pandemic, the IIF said.

The pandemic has slowed the deleveraging process

Emre Tiftik

Increasing SOE indebtedness has been even more striking as a percentage of GDP, surging from 130 per cent of GDP in 2019 to a record high of more than 142 per cent of GDP last year, said Emre Tiftik, director of sustainability research at the IIF.

Since China committed to reducing SOE debt and improving market-driven allocation of capital in 2015-16, there has been a notable increase in the number of onshore corporate bond defaults, although volumes remain modest relative to the size of the market, Tiftik said.

“The pandemic has slowed the deleveraging process,” he said. “Defaults slowed sharply in quarter two and three 2020 amid much-needed forbearance policies that gave corporates breathing room.”

Last month, China’s State-owned Asset Supervision and Administration Commission said debt risk in SOEs was largely under control, and there should be a move from deleveraging to stabilising leverage.

Debt at China’s state-owned firms in spotlight as credit tightening raises default pressure

Although a crisis is unlikely, China’s high debt ratio makes it challenging to shift away from an economic growth model driven by state investment and infrastructure towards one based on consumption, services and market-based equity finance, analysts said.

SOEs dominate China’s raw materials sector, which has been severely hit by the pandemic. Some debt among state-owned firms – especially at the local level – is related to infrastructure investment and might present contingent liabilities for government budgets.

As China tightens banking regulations and winds down its liquidity support, signs of distress could multiply because private company and household balance sheets have already been strained by the pandemic, analysts said.

China’s high debt ratio could become a hurdle for “efficient growth” as a result, dampening consumption in durable goods as well as the corporate business environment, said Alicia Garcia Herrero, chief economist for Asia-Pacific at Natixis Bank.

High debt will be a bigger concern for the Chinese economy than it was prior to the pandemic

Alicia Garcia Herrero

Any reduction in the debt to GDP ratio will require a more cautious attitude toward financing households and companies, she said.

Large fiscal debt can also restrict the government’s ability to take countercyclical measures when faced with an unexpected economic shock, Herrero said.

Many economists see China’s SOE debt, along with high local government liabilities, as vulnerabilities that could spill over into the central government’s budget.

“China will probably have to live with a higher debt ratio for a long time,” Herrero said. “In other words, high debt will be a bigger concern for the Chinese economy than it was prior to the pandemic.”

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