China’s Downturn Will Force SOE Reform
The standard analysis about China falls into three baskets. The first is the collapse or decline theory, with very negative views from investors like Jim Chanos and Kyle Bass against more benign economists who see China massaging the downturn. Others are hopeful that recent policy statements will lead to reform of the state sector and rejuvenate corporate activity, increase profits, reduce debt, and steer China toward growth. A third theory sees China rebalancing the economy toward consumption, as a result of lower fixed asset investment and a rising middle class.
I don’t think any of these capture the features that we are likely to see in the coming two to three years. Instead, I see China splitting into two camps – the wealthier cities, protecting their state firms, against the more impoverished smaller cities and remoter provinces, whose state firms will gradually run out of money. A collapsing property bubble will exacerbate this split.
The end result will see capital flowing to the powerful sectors and be withdrawn from the weaker ones – except on those occasions when social unrest forces the leadership to spread capital over a wider group of actors. The capital will drift to large SOEs who will generate lower returns. On the positive side, there is the potential for new sources of growth among small firms as local governments are forced to adapt.
Save the Big SOEs
There are several recent events that lend support for this “bifurcation” theory. First, the debt-for-equity swap which allows state-owned enterprises (SOEs) to exchange their debt for an equity stake. This policy clearly is designed to assist the large, centrally-owned SOEs. Three companies have allegedly jumped to the front of the queue. Two, China Erzhong and Sinosteel, are owned directly by the Beijing government. The third is in private hands with 43.6 percent floated on the Hong Kong exchange. But it owes 6 billion Rmb to the Bank of China, 2 billion Rmb to China Development Bank, and is clearly at the heart of China’s state system. Nicholas Lardy of the Peterson Institute has estimated that one-fifth of the benefits of financial repression – below market interest paid to savings accounts – go to state firms. The debt-to-equity swap merely extends this state subsidy.
Beijing has 103 state firms under its direct control, most of which are in oil, rail, telecom and national defense, and is likely to support these strategic industries. These industries with administrative monopolies account for the bulk of state firm revenue and profits. For example, in recent years the oil giants accounted for 43 percent of the revenue of A-share listed state firms and 46 percent of the profits. The telecom industry accounted for 10 percent of the profits.
However, there are an additional 120,000 locally owned state firms. They are concentrated in industries with over-capacity such as coal, steel and metallurgy. Why would Beijing support them given that they are squandering capital (due to overcapacity and lack of monopoly)? They are unlikely to receive bailout funds from the capital through the debt-for-equity program. Bloomberg tells the story of Tonghua Steel, first bought out by a private firm, and then by state giant Shougang, which promised no layoffs but is now requesting cutbacks
A second area of great weakness is China’s corporate debt. Although there is plenty of bank debt, from both State and Shadow Banks, the visible portion are corporate bonds. Defaults are accelerating. China has 3,900 corporate bond issuers. So far this year, 22 have defaulted, as many as in 2015.
What pattern is emerging here? Unlike the debt-for-equity program, bond defaults have occurred in both private and State firms. Shanghai Yunfeng Group Co., a subsidiary of the country’s third-largest property developer, Greenland Holdings Corp., is mostly private but has a minority stake by the Shanghai government. The bonds and commercial paper of several large state firms were allowed to default including Sinosteel, China Railway Materials, and Baoding Tianwei Group Co., a subsidiary of central government-owned China South Industries Group Corp. These defaults of central government firms are designed to wave a red flag to the debt-ridden corporate sector to slow their misuse of capital.
But these state giants are quietly being given a helping hand. China Railway is reportedly “negotiating a restructuring” and Sinosteel has avoided an outright default by delaying payment eight times. This suggests the the big state firms are being treated less harshly.
By sector, eight firms that have so far have run into payment problems for their bonds are all in the ailing mining, metals or equipment industries. The only exception is Tianwei New Energy, which is facing overcapacity in the solar industry. This suggests that state firms will be protected – but primarily the ones in stronger sectors. Firms in weaker industries will be allowed to die or will be merged into larger groups to avoid embarrassing senior officials and bury the debt.
Saving the Local Governments?
In 2015, Beijing forced the banks to buy low interest bonds in exchange for their higher interest loans. This was designed to be a low-cost way to give a boost to local governments struggling with 24 trillion Rmb in debt and declining cashflow from land sales. However, what happened next was unexpected. Instead of writing off the bank loans as per instructions, the banks were quietly asked by the local governments to leave them on the books. Thus, the 3 trillion Rmb swap turned into a 3 trillion Rmb stimulus – without anyone saying so explicitly. The program is supposed to go to 5 trillion Rmb this year. This flies in the face of the theory that Beijing will allocate capital to itself and the big State firms and leave the outer provinces twisting in the wind. However, this stimulus was not a formal Beijing policy. Instead, the banks sat down with the local government officials and the local PBOC and hammered out a compromise position, Province-by-Province, each with its own amendment on how the existing loans would be handled. It was what I think of as a stealth stimulus with no formal backing.
Contracting Circle of Capital
What we will see over time is a gradual narrowing of the circles of capital. Weaker provinces, smaller state firms, and SMEs will be squeezed out of the circle, leaving only the larger SOEs and cities including Beijing, Shanghai and Guangzhou with priority access to capital. One-third of 122.8 trillion Rmb of aggregate financing in 2014 (including most Shadow Loans) went to just three places: Beijing and the provinces containing Guangzhou and Shanghai. This concentration of wealth will accelerate, resulting in several outcome
First, regional credit institutions will be allowed to fail. In Japan in 1994, the Tokyo Government closed the Tokyo Kyowa Credit Cooperative and Anzen Credit Cooperative, followed in 1995, by the Cosmo Credit Cooperative (Tokyo) and the Kizu Credit Cooperative (Osaka). Larger financial institutions fell later. China has done this in the past in 1999 with the closure of 18,000 Rural Credit Foundation.
Second, weak local SOEs will be shuttered or absorbed larger SOEs. The lucky ones will be absorbed depending on their political clout and size of employment.
Third, SOE banks will find their margins shrinking. This will occur in several ways: through programs like the local bond swap that lowered returns, the debt for equity that eliminates debt payments, and other bail out programs.
Fourth, debt will be centralized – but not in obvious ways. Expanding central government bonds is anathema to the leadership as they like their low 40 percent official debt to GDP ratio. Instead, the various forms of corporate and local debt will be monetized through stealth programs like the local bond swap.
Fifth, SMEs in many areas of the country will resort to high interest Shadow Loans that will be increasingly difficult to obtain.
Conclusion. Investors looking for a new round of effective stimulus, significant SOE reform, or sharp reduction in leverage will be disappointed. Instead, China’s economy will grind slower and slower. Much of the restructuring and sharp downturn in economic activity will occur out of sight in the hinterlands. But it will be significant.