How to best solve SOEs’ debt prob­lem

China Daily (Canada) - - VIEW -

China’s eco­nomic slow­down has been the sub­ject of count­less de­bates, dis­cus­sions, ar­ti­cles and analy­ses. While the pro­posed reme­dies vary con­sid­er­ably, there seems to be a broad con­sen­sus that the ill­ness is struc­tural. But another fac­tor has gone largely un­no­ticed: the busi­ness cy­cle.

For decades, China’s econ­omy sus­tained dou­ble-digit GDP growth, but it wasn’t im­mune to the busi­ness cy­cle: in fact, the six-year slow­down China ex­pe­ri­enced af­ter the 1997 Asian fi­nan­cial cri­sis was a symp­tom of pre­cisely such a cy­cle.

To­day, China’s busi­ness cy­cle has led to the ac­cu­mu­la­tion of non-per­form­ing loans (NPLs) in the cor­po­rate sec­tor, just as it did at the turn of the cen­tury. While of­fi­cial data show the rate of NPLs is lower than 2 per­cent, many econ­o­mists es­ti­mate it is more like 3-5 per­cent. If they are right, NPLs could amount to 6-7 per­cent of China’s GDP.

Most of this debt is held by State-owned en­ter­prises, which ac­count for just one-third of in­dus­trial out­put, yet re­ceive more than half of the credit dis­pensed by China’s banks. Though the debt-eq­uity ra­tio of the in­dus­trial sec­tor as a whole has de­clined over the past 15 years, the SOEs’ has in­creased since the global fi­nan­cial cri­sis, to an av­er­age of 66 per­cent, 15 per­cent­age points higher than that of other types of en­ter­prises.

That may not have been a prob­lem when China’s econ­omy was grow­ing rapidly, but it rep­re­sents a se­ri­ous eco­nomic risk to­day, which is why the gov­ern­ment has set delever­ag­ing as one of its ma­jor tasks for this year. But ex­e­cu­tion has been slow, owing partly to China’s fail­ure to fully en­force its bank­ruptcy law.

That com­mer­cial banks are not al­lowed to hold shares in com­pa­nies has also im­peded delever­ag­ing, as it pro­hibits the use of di­rect debt-eq­uity swaps to re­duce SOE debt. This should change.

China has used debt-eq­uity swaps to re­duce NPLs in the State sec­tor be­fore. In 1999, it es­tab­lished four as­set-man­age­ment com­pa­nies (AMCs) to take on the weak­est loans of the four-largest State-owned banks, thereby improving those banks’ fi­nan­cial sta­bil­ity. And the AMCs made hand­some prof­its from those shares.

To­day, too, debt-eq­uity swaps may be the only vi­able so­lu­tion to the NPL prob­lem. But in­stead of re­ly­ing only on govern­men­towned en­ti­ties to as­sume the debt, China should al­low pri­vate eq­uity funds to act as AMCs, bid­ding for the NPLs at a dis­count.

Such an ap­proach would not just ad­dress the NPL prob­lem, by giv­ing the pri­vate sec­tor a stake in the SOEs, but also help spur per­for­mance-en­hanc­ing re­forms. Af­ter all, de­spite their grim fi­nan­cial per­for­mance, many SOEs have a lot go­ing for them, in­clud­ing state-of-the-art equip­ment, firstrate tech­ni­cal staff and com­pet­i­tive prod­ucts.

Their prob­lem is bad gov­er­nance and poor man­age­ment— a prob­lem that, as China’s top lead­ers rec­og­nized in 2013, pri­vate­sec­tor in­volve­ment can help re­solve. Of course, there are some ob­sta­cles to introducing debt-eq­uity swaps be­tween the pub­lic and pri­vate sec­tors, be­gin­ning with con­cern about the loss of State as­sets. Given the sever­ity of SOEs’ debt prob­lem— the China Rail­way Cor­po­ra­tion alone holds 3 tril­lion yuan ($449 billion) in debt— dis­counts are in­evitable when SOE debts are trans­ferred to pri­vate AMCs. This could cause some to as­sert that the pri­vate com­pa­nies are re­al­iz­ing un­just gains.

To over­come this ob­sta­cle, China should en­gage in lo­cal ex­per­i­men­ta­tion— a tried-and-tested ap­proach that has long guided the coun­try’s re­form— be­gin­ning in the re­gions where the SOE debt prob­lem is the most acute. The re­sult­ing re­vi­tal­iza­tion of SOEs would also help quell any doubts about debt-eq­uity swaps with the pri­vate sec­tor.

Another ob­sta­cle is the fear that, by al­low­ing SOEs, yet again, to es­cape mar­ket dis­ci­pline, debte­quity swaps would set a dan­ger­ous prece­dent. But the im­prove­ments to cor­po­rate gov­er­nance that would fol­low from the in­tro­duc­tion of pri­vate share­hold­ers would re­duce sub­stan­tially the like­li­hood of SOEs con­tin­u­ing to abuse the fi­nan­cial system.

By al­low­ing pri­vate-sec­tor par­tic­i­pa­tion in debt-eq­uity swaps, China could kill three birds with one stone: ad­vance SOE delever­ag­ing, strengthen cor­po­rate gov­er­nance in the state sec­tor and en­hance eco­nomic ef­fi­ciency. With lo­cal ex­per­i­men­ta­tion, Chi­nese au­thor­i­ties can map out that stone’s most ef­fec­tive tra­jec­tory.

The author is the di­rec­tor of the China Cen­ter for Eco­nomic Research and dean of the Na­tional School of De­vel­op­ment at Pek­ing Univer­sity. Pro­ject Syn­di­cate

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