China’s corporate-debt challenge
The Chinese economy has slowed in recent years, but it is still a strong performer, contributing about one-third of total economic growth worldwide. It is also becoming more sustainable, in line with the shift in its growth model away from investment and exports and toward domestic demand and services.
In the run-up to the G20 summit in Hangzhou on Sept 4-5, China has been calling loudly for new commitments to structural reforms to stimulate growth in advanced and emerging-market economies. But China faces serious risks at home. Above all, domestic credit continues to expand at an unsustainable pace, with corporate debt accumulating to dangerous levels.
According to the International Monetary Fund’s recently published annual report on the Chinese economy, credit is growing about twice as fast as output. It is rising rapidly in both the non-financial private sector and in an expanding, interconnected financial sector that remains opaque. Moreover, while credit growth is high by international standards — a key indicator of a potential crisis — its ability to spur further growth is diminishing.
Warning signs are flashing, and the Chinese government has acknowledged the overall problem. But, to avoid a crisis, it should immediately implement comprehensive reforms to address the root causes of the corporate debt problem. These include soft budget constraints for state-owned enterprises (SOEs) and local governments, implicit and explicit government guarantees of debt, and excessive risk taking in the financial sector — all of which have been perpetuated by unsustainable official growth targets.
To tackle the problem, the Chinese government must, in the words of Premier Li Keqiang, “ruthlessly bring down the knife [on] zombie enterprises”. This culling should be combined with a concrete strategy to restructure salvageable firms; recognise and allocate creditor losses; account for displaced workers and other social costs; and further open private-sector markets. More fundamentally, the government must accept the inevitability of lower near-term growth.
It is especially important to restructure SOEs. Many are essentially on life support, contributing only one-fifth of total industrial output but accounting for about half of all corporate debt. A serious restructuring effort — including stricter budget constraints and an end to lending to non-viable firms and government guarantees on debt, along with other supply-side reforms already under way — will create space for more dynamic companies to emerge and contribute to growth.
China is unique in many respects, but it is not the first country to experience corporate-debt difficulties. Its leaders should heed three broad lessons from other countries’ experience.
First, the authorities should act quickly and effectively, lest today’s corporate-debt problem become tomorrow’s systemic debt problem. Second, they should deal with both creditors and debtors — some countries’ solutions address only one or the other, sowing the seeds for future problems.
Finally, the governance structures that permitted the problem to arise must be identified and reformed. At a minimum, China needs an effective system to deal with insolvency; strict regulation of risk pricing and assessment; and robust accounting, loan-loss provisioning, and financial disclosure rules.
Influential voices in China are quick to draw the lesson from international experience that tackling corporate debt can limit short-term growth and impose social costs, such as unemployment. These are valid concerns, but the alternatives — half measures or no reform at all — would only make a bad situation worse.
China should begin by restructuring unviable companies in its fastest-growing regions, where workers will find new jobs more quickly and reforms are not likely to hurt growth. Policymakers can then be more selective when it comes to restructuring in slower-growing regions and cities where a single company dominates the local economy.
Moreover, structural unemployment and worker resettlement costs can be mitigated with a strong social safety net that includes funds for targeted labour redeployment so that workers can get back on their feet. This approach would show the government’s commitment to those at risk of displacement.
To its credit, China has already made some efforts to solve its debt problem and begin deleveraging. The current Five-Year Plan aims to reduce excess capacity in the coal and steel sectors, identify and restructure nonviable “zombie” SOEs, and fund programmes to support affected workers.
Now is the time for China to push for far-reaching reforms. Banks’ balance sheets still have a relatively low volume of non-performing loans (and high provisioning). The costs of potential losses on corporate loans — estimated at 7% of GDP in the IMF’s latest Global Financial Stability Report — are manageable. Furthermore, the government maintains high buffers: debt is relatively low, and foreign-exchange reserves are relatively high.
The question is whether China will manage to deleverage enough before these buffers are exhausted. Given its record of economic success and the government’s strong commitment to an ambitious reform agenda, China can rise to the challenge. But it must start now.
Many Chinese state enterprises are essentially on life support, contributing only one-fifth of total industrial output but accounting for about half of all corporate debt