As children, my sister and I loved our family road trips. Stopping for a meal was usually confined to a strip-mall buffet restaurant offering the kind of “Americana” cuisine of French fries, mac and cheese, steamed broccoli and cheddar where the portions were big, the price tag small and the nutritional value next to nothing.
China's debt situation has a lot in common with an all-you-can eat buffet. Cheap financing and low interest rates have made it easy for many of China’s companies to pile their plates high with debt. This has been a growing concern for many investors, particularly when it comes to corporate sector debt.
Over the summer, China created a super-regulator to oversee the financial system amid rising worries over financial risks, underlining its efforts to refocus financial activity on economic growth. So what could these continued reforms mean for China’s economy and for investor portfolios?
The government has cited state-owned enterprise (SOE) reform as a priority in tackling high debt levels and poor profitability in the industrial sector. My colleagues in Asia have done extensive research on the topic and according to the International Monetary Fund, in 2016, SOEs accounted for roughly 55 per cent of China’s total corporate debt, despite only producing 22 per cent of economic output. As a result, deleveraging SOEs would seem an easy first step in deleveraging the whole economy.
SOE reform also helps the government’s goal of transition to a more consumption-led economy. Corporate leverage and SOEs are concentrated in heavy industries. Maintenance of these companies has taken its economic toll, as funding their activities diverts resources from companies that are focused on faster-growing, less-industrial sectors.
Overall financial leverage, measured by liability-to-asset ratios, for industrial firms has been declining since 2013. However, this was primarily driven by improving non-SOE balance sheets, while SOE liability-to-asset ratios remain elevated. Meanwhile, the overall return on assets of these same firms has deteriorated, dragged down by the poor profitability of SOEs.
High leverage is concentrated in a few sectors: heavy industries and utilities suppliers, which are dominated by SOEs, and property developers. In contrast, the healthcare, consumption and information technology sectors are among the least leveraged.
The overarching aim of the SOE reforms is to relink credit and GDP growth. For much of China’s recent history, ratcheting up credit growth has been a reliable way for the country to boost flagging economic growth: between 2001/2008, an average of 1.9 additional units of credit resulted in one additional unit of GDP.
But since the financial crisis, it takes four units of credit to generate an additional unit of GDP. In other words, one of the government’s most reliable tools for reaching its economic goals no longer works as well as it once did.
SOEs are over-represented in internationally accessible equity and bond markets and will remain targets for government-led reform. This means that individual names, especially in the most-leveraged industrial sectors, may face lean times.
As such, active investors may want to identify firms that are less likely to suffer from a greater regulatory crackdown on SOEs, and which boast stable and strong balance sheets. Non-SOEs in sectors serving China’s more consumption-driven economy, such as healthcare, consumer discretionary and IT, will feel less of a pinch from reform and have already been posting higher returns for investors.