Chapter

11 The Finances of China’s Enterprise Sector

Author(s):
Wanda Tseng, and Markus Rodlauer
Published Date:
February 2003
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Author(s)
Paul Heytens and Cem Karacadag 

Solving the closely related problems of the state enterprise and financial sectors and of China’s medium-term fiscal sustainability represents the central economic challenge facing China. The weak performance of the state-owned enterprises (SOEs) has burdened the state commercial banks (SCBs) with a large amount of nonperforming loans, creating contingent liabilities that could threaten medium-term fiscal sustainability. Although the authorities have made progress in improving the governance and performance of the SOEs and the SCBs, the remaining agenda is formidable, and the financial costs of reforms are high but difficult to quantify. The difficulty of quantifying the costs of reform is exemplified by the substantial and still-continuing revisions made to measures of asset quality in the financial system.1

This chapter examines the systemic risks arising from China’s state banks and state enterprises and their policy implications from the perspective of enterprise balance sheets. It examines the leverage, efficiency, and debt repayment capacity of China’s enterprise sector. The risk profile of enterprises, in turn, holds a mirror to the financial system’s soundness, given that until recently most credit has been lent to enterprises.

The analysis uses aggregate financial data published by the National Bureau of Statistics and two firm-level data sets on China’s listed companies (see Appendix I). The aggregate data describe China’s enterprise sector (both state and nonstate enterprises), whereas the firm-level data allow an examination of the finances of listed enterprises (most of which remain under majority state ownership and control).2 The cash coverage of interest expense forms the bridge between the enterprise sector analysis and the assessment of financial sector asset quality. This measure has provided useful insights into financial sector vulnerabilities elsewhere in the region (Ramos and others, 1998, 2000) but has not been applied to China before now.

Overview of SOE and Financial Sector Reform

The restructuring of SOEs and of the financial sector has been the most difficult of China’s structural reforms. The financial performance of the SOEs has historically been weak, reflecting both macroeconomic and industry-specific factors, including poor management, overstaffing, heavy indebtedness, outdated products and technologies, an excessive social welfare burden, and high tax rates. SOE losses have required heavy subsidization by the state; before the start of reform in the late 1970s this was provided by direct budgetary allocations, but thereafter it took the form of loans from the SCBs. By the mid-1990s reform of the SOEs and the SCBs could no longer be delayed. Even so, the pace of reform remained conditioned by concerns about social stability, as layoffs from the SOEs added to regional income disparities and strained an inadequate social safety net.

The focus of recent SOE reform has been to privatize small enterprises and to commercialize large ones under the principle of “seize the large and release the small.” Some progress has been made on hardening budget constraints, and enterprise profitability has improved following the authorities’ initiative in 1998 to revitalize medium-size and large SOEs. Better earnings mainly reflect outside factors such as higher oil prices and interest savings from debt-equity swaps, but durable efficiency gains have been secured through layoffs, a reduced social welfare burden, and reductions in excess capacity.3

Financial sector reforms have focused on commercializing SCBs’ lending operations. The reforms were initiated by establishing policy banks to relieve the four large SCBs of their policy lending, while taking steps to commercialize the SCBs and hold them accountable for their own operations and financial results. After the onset of the Asian crisis a range of new reforms were introduced, which included limiting local government interference in bank lending decisions, abolishing the credit plan, recapitalizing the SCBs through a Y 270 billion bond issue in 1998, and transferring Y 1.4 trillion in nonperforming loans to four asset management companies (AMCs) during 1999–2000. Internal SCB reforms have included the revamping of loan approval and analysis procedures, the introduction of more incentive-based compensation systems, branch rationalization, and staff reductions.

These efforts, however, have so far not succeeded in ending noncommercial lending to SOEs or in overcoming their operational inefficiencies. Enterprise management is still weak, outside governance minimal, excess labor high, and exit channels for poorly performing SOEs limited. Bank loans satisfy the working capital and investment needs of SOEs, many of which accumulate inventories unlikely to be sold and receivables with little prospect of payment. Cash-short enterprises then accumulate tax liabilities and are kept afloat by debt rollovers and new loans from banks, whose capacity to assess and price credit risk remains limited. Even if lenders intended to distinguish good risks from bad ones, corporate accounting practices distort financial statements to a degree that makes it difficult to screen and monitor borrowers.4

Enterprise Sector Analysis

This section examines two types of data on Chinese enterprises: an aggregate data set for all industrial enterprises, including SOEs, published in the annual China Statistical Yearbook, and data on individual listed enterprises, most of which are state owned. The available data confirm the weak financial condition of the enterprise sector. They also suggest that enterprise finances are vulnerable to considerable downside risk from even a moderate weakening of their business environment. Deficiencies in the quality of corporate financial data, however, warrant some caution in interpreting these conclusions.

The financial condition of enterprises, particularly SOEs, has important implications for the soundness of the banking system, given that SOEs are the predominant users of bank credit. SOEs accounted for over half of outstanding credit in 2000; two-thirds of these loans were of less than one year’s maturity.5 Although loans to consumers (currently around 3–4 percent of total loans) have been growing rapidly in recent years, credit to enterprises will continue to represent a large share of bank assets. The financial system’s risk exposure to the enterprise sector should decline over time, however, as a growing share of new credits are granted to private enterprises, and as banks lend on an increasingly commercial basis.

Aggregate-Level Analysis

Although the share of SOEs in China’s industrial sector has been declining, it is still sizable. The share of state enterprise output and employment has been on a declining trend since 1994 (Table 11.1).6 Nevertheless, SOEs continue to generate over 50 percent of industrial value added and employ more than half the industrial workforce. Also noteworthy is the steady rise in the value added of foreign-funded enterprises, which doubled between 1994 and 2000, in contrast to that of collective-owned firms, which fell by more than half.7

Table 11.1.Output, Employment, and Value Added of Industrial Enterprises by Ownership Type(In percent of total)
Type of Ownership1994199519961997199819992000
Output
State owned137.834.634.030.226.526.3
Collective owned38.237.336.936.436.132.9
Individual owned10.213.114.517.116.116.9
Shareholding4.33.13.14.27.39.1
Foreign funded29.611.911.412.114.014.8
Employment
State owned166.466.566.365.057.254.551.1
Collective owned24.422.722.221.416.915.213.7
Other9.210.711.513.625.930.335.2
Value added
State owned154.554.549.447.358.355.751.9
Collective owned28.425.429.227.117.414.611.6
Shareholding5.85.15.47.43.07.413.5
Foreign funded211.315.016.118.221.322.323.0
Source: China Statistical Yearbook, various issues.

For 1998–2000, includes enterprises in which the state held a controlling share.

Includes enterprises owned by investors in Hong Kong SAR, Macao SAR, and Taiwan Province of China.

Source: China Statistical Yearbook, various issues.

For 1998–2000, includes enterprises in which the state held a controlling share.

Includes enterprises owned by investors in Hong Kong SAR, Macao SAR, and Taiwan Province of China.

SOEs control the bulk of productive assets in the industrial sector. They held two-thirds of the net fixed assets of all industrial enterprises in 2000 (Table 11.2).8 By contrast, collective enterprises’ share of fixed assets fell by two-thirds between 1994 and 2000, with shareholding and foreign companies increasing their shares modestly. The decline in the share of collectives is attributable to falling growth in and investment by township and village enterprises (which are classified as collectives), and because many collectives were actually private and were reclassified as such in 1998. A noteworthy trend is the rising share of fixed assets in the total assets of all enterprises, particularly SOEs. The share of net fixed assets in SOEs’ total assets stood at 44 percent in 2000, up from less than 36 percent in 1994.

Table 11.2.Net Fixed Assets of Industrial Enterprises by Ownership Type(In percent)
Type of Ownership1994199519961997199819992000
As a share of total fixed assets of industrial enterprises
State owned165.764.464.962.471.368.165.4
Collective owned16.915.814.913.98.67.25.8
Shareholding5.24.74.96.71.56.611.4
Foreign funded7.26.67.89.29.39.49.3
Hong Kong and Macao SARs, and Taiwan Province of China5.18.47.67.89.38.88.1
As a share of total assets of indicated ownership type
State owned135.536.842.041.542.642.243.9
Collective owned29.529.932.333.033.933.933.9
Shareholding26.028.830.332.234.335.743.2
Foreign funded36.631.133.035.337.938.637.9
Hong Kong and Macao SARs, and Taiwan Province of China32.336.637.739.040.240.138.4
All enterprises33.634.738.438.540.840.542.0
Source: China Statistical Yearbook, various issues.

For 1998–2000, includes enterprises in which the state held a controlling share.

Source: China Statistical Yearbook, various issues.

For 1998–2000, includes enterprises in which the state held a controlling share.

However, the efficiency of investment in the SOE sector is relatively low (Figure 11.1). The ratio of value added to fixed assets for SOEs was 37 percent in 2000, compared with 56 percent for shareholding companies, 61 percent for foreign companies, and 94 percent for collectively owned firms. Although the efficiency of all groups fell during 1994-2000, the relative drop in this ratio was sharpest for SOEs, at 35 percent.

Figure 11.1.Ratio of Value Added to Fixed Assets of Industrial Enterprises

(In percent)

Source: China Statistical Yearbook, various issues.

1For 1998–2000, includes enterprises with a controlling share by the state.

Leverage among industrial enterprises remains high, despite the downward trend in recent years (Table 11.3). The liabilities-to-equity ratio for all enterprises stood at 144 percent in 2000—down from 200 percent in 1994. Enterprise leverage is on a par with levels prevailing in Brazil, Indonesia, and Thailand in the run-up to their financial crises and much higher than in the Czech Republic, Hungary, and Poland, where the median debt-equity ratios of listed companies stood at 43, 14, and 45 percent, respectively, in 1998–99.9

Table 11.3.Ratio of Total Liabilities to Equity of Industrial Enterprises by Ownership Type(In percent)
Type of Ownership1994199519961997199819992000
State owned1211192186184176160155
Collective owned234243249234209192188
Shareholding11712213013119110997
Foreign funded167120131129129125127
Hong Kong and Macao SARs, and Taiwan Province of China161164174164148140136
All enterprises200186184177171152144
Source: China Statistical Yearbook, various issues.

For 1998–2000, includes enterprises in which the state held a controlling share.

Source: China Statistical Yearbook, various issues.

For 1998–2000, includes enterprises in which the state held a controlling share.

Interest coverage has strengthened, mirroring the decline in leverage, but remains low.10 Chinese enterprises’ interest coverage averaged 3.6 times in 2000 (that is, operating profits were 3.6 times interest expense), which is low by international standards (Table 11.4).11 SOEs had the lowest coverage at 2.9 times, and shareholding companies the highest at 5.7 times. By contrast, interest coverage ranged between 10 and 20 times for listed companies in Hong Kong SAR and Singapore, and between 5 and 10 for listed companies in Germany, Japan, and the United States (Pomerleano, 1998). Listed companies in the Czech Republic, Hungary, and Poland also had strong interest coverage of 6–11 times in 1999.

Table 11.4.Ratio of Operating Profits to Interest Expense of Industrial Enterprises by Ownership Type(In percent)
Type of Ownership1994199519961997199819992000
State owned11.71.61.51.61.92.42.9
Collective owned2.32.12.32.73.45.54.3
Shareholding2.42.22.02.33.93.65.7
Foreign funded2.32.32.32.73.34.65.1
Hong Kong and Macao SARs, and Taiwan Province of China1.91.71.72.02.73.43.9
All enterprises1.91.81.82.02.33.03.6
Source: China Statistical Yearbook, various issues; and IMF staff estimates.

For 1998–2000, includes enterprises in which the state held a controlling share.

Source: China Statistical Yearbook, various issues; and IMF staff estimates.

For 1998–2000, includes enterprises in which the state held a controlling share.

Profitability was weakest among industrial enterprises during 1994–2000 (Table 11.5). Foreign-funded enterprises were the most profitable, with an operating profits-to-assets ratio of 17 percent, almost double that of SOEs.

Table 11.5.Operating Margins of Industrial Enterprises by Ownership Type

(In percent of assets)1

Type of Ownership1994199519961997199819992000
State owned212.711.410.59.48.68.710.4
Collective owned17.316.817.016.716.121.716.7
Shareholding14.513.511.911.617.811.416.8
Foreign funded15.514.113.513.613.015.217.2
Hong Kong and Macao SARs, and Taiwan Province of China13.011.411.311.211.211.913.4
All enterprises13.912.712.111.310.311.012.5
Sources: China Statistical Yearbook, various issues; and IMF staff estimates.

Operating margin equals sales minus cost of goods sold.

For 1998–2000, includes enterprises in which the state held a controlling share.

Sources: China Statistical Yearbook, various issues; and IMF staff estimates.

Operating margin equals sales minus cost of goods sold.

For 1998–2000, includes enterprises in which the state held a controlling share.

Firm-Level Analysis

Firm-level data allow a more in-depth analysis of China’s enterprise sector than has been available in the literature until now. Two sets of firm-level data are analyzed: data for a subset of listed enterprises (from the Worldscope database), and a data set of virtually all listed enterprises, pursuant to the disclosure requirements of the China Securities Regulatory Commission (CSRC). Indicators of enterprise financial risk are generated for each company.

To summarize what follows, firm-level analysis suggests that Chinese enterprises are financially weak and exposed to adverse macroeconomic developments. In particular:

  • China’s corporate sector is largely unprofitable and illiquid. Several enterprises in the firm-level data sets—accounting for 20–30 percent of the total debt of all firms in the sample—are unable to generate enough cash flow to pay interest on their debts.

  • The corporate sector is susceptible to even modest interest rate and demand shocks. Sensitivity analysis suggests that a moderate rise in interest rates or drop in sales could cause 40–60 percent of the debts of all firms to become unserviceable, underscoring the financial fragility of the sector.

  • The interest coverage analysis corroborates the high level of nonperforming loans in the banking system. With implied nonperforming loans in the 20–30 percent range, the analysis suggests that the figure reported by the four large SCBs of nearly 30 percent is a lower bound (since the interest coverage analysis does not include amortization).

The results of the firm-level analysis are broadly consistent with those for the aggregate enterprise sector. The financial parameters and results derived from the two samples of listed enterprises are compatible with and, where directly comparable (that is, with respect to leverage, profitability, and interest coverage), similar to the aggregate-level figures discussed earlier.12

Asset Structure and Leverage

The large share of receivables and inventories in total assets indicates that SOEs have been producing goods that few want to buy or can pay for, and that their assets are overvalued. Fixed assets account for the largest share of total assets (32–36 percent), followed by receivables (16–27 percent) and inventories (12–15 percent; Table 11.6). Fixed assets’ share in total assets is broadly comparable to equivalent figures reported in the aggregate data (42 percent; Table 11.2). Receivables are higher for all listed companies, at 22–27 percent, than for the Worldscope subset, at 16–18 percent, whereas inventories represent near-equal shares for both groups. The difference in receivables may be attributable to the relative strength of companies represented in the Worldscope data set, which appear to have higher rates of cash collection per unit of sales.

Table 11.6.Inventories, Receivables, and Fixed Assets of Listed Companies(In percent of total assets)
Sample and Item1995199619971998199920001
Worldscope database
Inventories15.213.111.911.7
Net receivables15.517.718.316.5
Fixed assets32.935.534.033.2
CSRC financial disclosures
Inventories12.312.111.6
Net receivables21.826.826.0
Fixed assets33.232.931.5
Sources: Worldscope, company disclosures, and IMF staff estimates.Note: CSRC, China Securities Regulatory Commission.

Data are for the first half of the year.

Sources: Worldscope, company disclosures, and IMF staff estimates.Note: CSRC, China Securities Regulatory Commission.

Data are for the first half of the year.

The leverage of listed companies appears to be relatively low, but this may be misleading because of the overvaluation of inventories, receivables, and fixed assets. For both data sets the leverage of listed companies is under 100 percent (Table 11.7), well below the 144 percent reported in the aggregate figures (Table 11.3). This may reflect the fact that listed companies in the sample have access to more-diverse sources of financing (including equity) than the enterprise population as a whole. In addition, several studies have shown that SOEs overvalue their assets (Lardy 1998; Steinfeld, 1998). Various adjustments have been made to assets and equity to illustrate the potential impact of asset overvaluation on measures of leverage and solvency.13

Table 11.7.Leverage of Listed Companies Under Illustrative Scenarios(In percent)
Sample and Indicator199519961997199819992000
Worldscope database1
Liabilities-to-equity287.687.080.584.7
Liabilities-to-equity I78.978.469.776.8
Liabilities-to-equity II83.483.878.185.0
Liabilities-to-equity III93.490.384.693.0
Liabilities-to-equity IV109.096.494.8100.7
Liabilities-to-equity V101.796.686.2104.0
Liabilities-to-equity VI126.4123.9116.8140.7
Liabilities-to-equity VII193.1174.0175.3261.9
Insolvent companies in Worldscape database
Negative equity I30.61.01.03.0
Negative equity II5.51.01.84.4
Negative equity III6.63.54.25.4
Negative equity IV11.98.86.29.2
Negative equity V0.67.87.210.0
Negative equity VI2.412.613.816.6
Negative equity VII12.015.022.025.0
CSRC financial disclosures1
Liabilities-to-equity72.074.976.0
Liabilities-to-equity I94.0114.9115.9
Liabilities-to-equity II102.7129.5132.9
Liabilities-to-equity III114.3146.8147.2
Liabilities-to-equity IV127.2170.7166.0
Liabilities-to-equity V117.0152.6154.4
Liabilities-to-equity VI156.7232.4227.0
Liabilities-to-equity VII226.0463.5406.9
Insolvent companies among CSRC financial disclosures
Negative equity I33.07.16.9
Negative equity II3.38.510.9
Negative equity III5.711.414.0
Negative equity IV10.115.118.1
Negative equity V10.224.023.8
Negative equity VI13.732.130.2
Negative equity VII33.845.843.2
Sources: Worldscope database, company disclosures, and IMF staff estimates.

Data for liabilities-to-equity ratios are medians of the firms in the sample.

No adjustment made to reported numbers in this line. For the remaining leverage indicators I-VII, the balance of receivables minus payables is deducted from reported equity. In addition, except for I, equity is adjusted by a reduction in the value of inventories (II, 25 percent; III, 50 percent; IV, 75 percent) or of fixed assets (V, 25 percent; VI, 50 percent; VII, 75 percent).

As a share of sample total assets.

Sources: Worldscope database, company disclosures, and IMF staff estimates.

Data for liabilities-to-equity ratios are medians of the firms in the sample.

No adjustment made to reported numbers in this line. For the remaining leverage indicators I-VII, the balance of receivables minus payables is deducted from reported equity. In addition, except for I, equity is adjusted by a reduction in the value of inventories (II, 25 percent; III, 50 percent; IV, 75 percent) or of fixed assets (V, 25 percent; VI, 50 percent; VII, 75 percent).

As a share of sample total assets.

The leverage indicators increase significantly, and several companies become insolvent, when equity is adjusted for the possible overvaluation of assets (Table 11.7). The deduction from equity of 75 percent of the value of inventories results in nearly one-fifth of all domestically listed companies becoming insolvent and in a more than doubling of liabilities-to-equity ratios. A 75 percent reduction in the value of fixed assets pushes more than a third of all domestically listed companies into insolvency and results in a three-to fivefold increase in their liabilities-to-equity ratios.

Leverage indicators for the Worldscope subset deteriorate under these scenarios to a similar degree, although the number of companies that become insolvent is considerably smaller (mirroring the smaller number of insolvent enterprises in the baseline scenario). The implication for locally listed companies as a whole is that overvaluation of assets may account for a substantial portion of reported enterprise equity.

Profitability and Liquidity

The profitability of listed companies fell during the periods examined and is now weak. The median return on equity was 7 percent in the first half of 2000 (on an annualized basis) for all domestically listed companies and ranged from 4 to 7 percent during 1997–98 for the subset of listed companies covered by Worldscope. Further, although the operating margin relative to the total cost of sales (operating margin II in Table 11.8) is high, margins based on a broader measure of net operating income that incorporates total operating costs (operating margin I) are considerably lower, reflecting the still-high social welfare burden borne by Chinese enterprises.

Table 11.8.Profitability of Listed Companies

(In percent)1

Sample and

Profitability Measure
1995199619971998199920002
Worldscope database
Return on assets5.44.83.51.6
Return on equity10.310.07.24.0
Operating margin I311.89.38.86.5
Operating margin II428.828.328.726.9
CSRC financial disclosures
Return on assets5.65.04.0
Return on equity10.19.17.0
Operating margin I3.76.24.7
Operating margin II33.935.435.3
Sources: Worldscope database, company disclosures, and IMF staff estimates.

Data are medians of the firms in the sample.

Data are for the first half of the year.

Sales minus total operating costs.

Sales minus cost of goods sold.

Sources: Worldscope database, company disclosures, and IMF staff estimates.

Data are medians of the firms in the sample.

Data are for the first half of the year.

Sales minus total operating costs.

Sales minus cost of goods sold.

The liquidity position of listed companies is also weak. Long-term debt accounts for only 6–8 percent of the total debt of domestically listed companies (Table 11.9). For the set of firms covered by World-scope, the share is higher (15–19 percent) but still relatively small. The dominant share of short-term debt puts current liabilities well above liquid assets. Current assets, which include illiquid and overvalued inventories and receivables, cover less than a third of current liabilities. The degree of mismatch would widen further if current assets were adjusted downward for the overvaluation of inventories and receivables or for their illiquid portion.

Table 11.9.Liquidity of Listed Companies

(In percent)1

Sample and Liquidity Measure1995199619971998199920002
Worldscope database
Long-term debt to total debt19.018.417.014.6
Current assets to current liabilities32.731.733.029.6
CSRC financial disclosures
Long-term debt to total debt7.46.07.9
Current assets to current liabilities24.228.527.9
Sources: Worldscope database, company disclosures, and IMF staff estimates.

Data are medians of the firms in the sample.

Data are for the first half of the year.

Sources: Worldscope database, company disclosures, and IMF staff estimates.

Data are medians of the firms in the sample.

Data are for the first half of the year.

Interest Coverage and Implied Nonperforming Loans

The cash coverage of interest expense is an indicator of the quality of bank loan portfolios. It measures the capacity of enterprises to service their debt, thus linking enterprise financial performance to the quality of assets in the financial system. Experience in other countries has shown that this indicator often provides greater insights into the asset quality of financial institutions than do conventional banking indicators, because of weak accounting and classification standards, which can result in the understatement of problem loans.14 Of course, the information content of the cash coverage indicator itself hinges on the accuracy of enterprise financial statements.

In the case of China, the reported cash flow data likely overstate profits. In particular, reported earnings include accrued income from receivables. As explained in Appendix I, several adjustments are made to earnings before interest, taxes, depreciation, and amortization (EBITDA) and to interest expenses in order to provide a better measure of the interest coverage ratio. With these adjustments, the EBITDA-to-interest expense ratio is calculated for each firm. Those enterprises whose interest coverage ratio is below 100 percent are assumed to be in default on their debts, and the entire balance of their outstanding debt is treated as a “nonperforming loan.” The nonperforming loans of all companies are then tallied to yield an “implied nonperforming loan ratio” for the sample of enterprises as a whole.

The nonperforming loans of companies with negative EBITDA are considered to be “structural.” The intuition behind segregating this subset from total implied nonperforming loans is that “structural” nonperforming loans belong to firms whose debt servicing capacity will not be improved by interest rate cuts or debt restructuring. As money losers they presumably have serious operational deficiencies that cannot be rectified by financial restructuring alone (Ramos and others, 2000).

Based on interest coverage, the implied nonperforming loan ratios broadly range between 20 and 30 percent (Table 11.10). This result corroborates the problem of large nonperforming loans in the banking system. With interest coverage of 2–3 times for the Worldscope sample, and 2–4 times for all domestically listed companies, average enterprise interest coverage is weak. The interest coverage measure, however, provides only a upper bound on debt servicing capacity, since it does not include amortization. The short-term duration of claims on enterprises probably means that actual levels of nonperforming loans are much higher.

Table 11.10.Interest Coverage and Implied Nonperforming Loans of Listed Companies(In percent)
Sample and Item1995199619971998199920001
Worldscope database
Implied interest rate6.05.68.57.9
Adjusted interest rate11.010.59.07.9
Interest rate plus 2% shock13.012.511.09.9
EBITDA to interest expense306.9215.9235.4220.2
Implied NPL ratio11.038.119.017.0
Structural NPL ratio0.08.510.613.2
EBITDA to interest expense I2259.7181.4195.5185.9
Implied NPL ratio14.344.919.321.5
Structural NPL ratio0.08.510.613.2
EBITDA to interest expense II3–4.678.038.7–66.0
Implied NPL ratio43.744.249.056.5
Structural NPL ratio36.920.940.452.6
EBITDA to interest expense III4–3.965.631.8–51.4
Implied NPL ratio44.449.049.056.5
Structural NPL ratio36.920.940.452.6
CSRC financial disclosures
Implied interest rate7.35.95.4
Adjusted interest rate7.36.05.4
Interest rate plus 2% shock9.38.07.4
EBITDA to interest expense260.4409.7418.6
Implied NPL ratio30.321.232.0
Structural NPL ratio16.112.122.9
EBITDA to interest expense I2211.8323.7253.2
Implied NPL ratio32.624.437.1
Structural NPL ratio16.112.122.9
EBITDA to interest expense II3179.6313.9303.5
Implied NPL ratio36.328.138.6
Structural NPL ratio21.515.928.0
EBITDA to interest expense III4147.2243.1188.6
Implied NPL ratio42.331.244.5
Structural NPL ratio21.515.928.0
EBITDA to interest expense IV5244.1221.1
Implied NPL ratio40.739.8
Structural NPL ratio35.233.7
Sources: Worldscope database, company disclosures, and IMF staff estimates.Note: NPL, nonperforming loans.

Data are for the first half of the year.

Interest expense incorporates a 2-percentage-point interest rate shock.

Earnings incorporate a 10 percent negative shock to sales.

Ratio incorporates both a 2-percentage-point interest rate shock and a 10 percent negative shock to sales.

Earnings incorporate full repayment of annual buildup in short-term nonbank liabilities.

Sources: Worldscope database, company disclosures, and IMF staff estimates.Note: NPL, nonperforming loans.

Data are for the first half of the year.

Interest expense incorporates a 2-percentage-point interest rate shock.

Earnings incorporate a 10 percent negative shock to sales.

Ratio incorporates both a 2-percentage-point interest rate shock and a 10 percent negative shock to sales.

Earnings incorporate full repayment of annual buildup in short-term nonbank liabilities.

Enterprise interest coverage is quite sensitive to adverse changes in interest rates and demand. Two scenario analyses are carried out on the interest coverage ratios to assess the extent to which implied nonperforming loans rise in the face of adverse financial and economic developments. The first scenario is a 2-percentage-point rise in interest rates for all firms. The second is a 10 percent fall in sales revenue, which translates into a 3 percent decline in earnings, given operating margins of around 30 percent of sales in the two samples. The combined impact of the two stress scenarios is also reported. Under the higher-interestrate scenario, implied nonperforming loan ratios rise by 3–7 percentage points. Lower sales have a greater impact: implied nonperforming loans for the Worldscope sample more than double in three out of the four years analyzed; they rise by 6–7 percentage points in the larger sample of domestically listed companies. The combined effect of the two shocks raises implied nonperforming loan ratios to 44–57 percent and 31–45 percent, respectively, for the two samples (Table 11.10).

A substantial proportion of implied nonperforming loans are structural. For the Worldscope sample, in 1996–98, about a quarter to half of implied nonperforming loans are structural; for all listed companies, some half to two-thirds are structural during 1998–2000 (Table 11.10). The share of structural nonperforming loans in the total approaches 80 percent in both samples under the severest scenarios applied to them (EBITDA-to-interest expense III for Worldscope and EBITDA-to-interest expense IV for CSRC financial disclosures).

Conclusions

The empirical results indicate that the financial condition of China’s enterprise and financial sectors is weak:

  • Across a range of indicators, SOEs are less efficient and display poorer financial profiles than do enterprises under other forms of ownership. They are more leveraged, less profitable, and less liquid, and they possess a disproportionate share of fixed assets relative to their output and value added.

  • The enterprise sector has seen a buildup of leverage to finance the acquisition of fixed assets.

  • The study points to a large problem of nonperforming loans in the banking system, underscoring the urgency of stemming the flow of new bad loans. To the extent that banks continue to finance unworthy borrowers, they run the risk of amassing a growing stock of liabilities that are unmatched by performing assets, presenting a potentially large future fiscal liability and drag on growth.

  • The analysis also suggests that the financial position of the enterprise and financial sectors could deteriorate further under modest economic and financial stress.

These conclusions highlight the need for decisive action to strengthen SOEs and financial institutions and have the following policy implications:

  • The weak performance of SOEs and the contingent fiscal costs underscore the importance of accelerating planned SOE and financial sector reforms. In striking a balance between the pace of reforms and social stability, it is vital to avoid escalating quasi-fiscal losses that threaten medium-term fiscal sustainability.

  • The persistence of money-losing enterprises points to the need to harden enterprise budget constraints, improve enterprise governance, and accelerate the exit of nonviable SOEs.

  • Enterprise accounting and reporting practices need to be strengthened so that lenders can accurately assess the true financial condition and risk profile of borrowers.

  • The large stock of problem loans highlights the importance of strengthening bank governance, the prudential regulation and supervision of banks, and the capacity to resolve distressed debts.

  • Particular focus is needed on improving and monitoring the quality of new bank lending. Ongoing efforts to improve the risk management and operations of banks are yielding results, with recent reports suggesting that SCBs are reducing their stock of nonperforming loans.15

Table 11.11.Sources of Financial Data on Chinese Firms
Data SetCoverage

(No. of Companies)
YearsSelection Criteria
Aggregate data465,239 in 1994

162,885 in 2000
1994–2000Industrial enterprises with annual sales of over Y 5 million
Worldscope database118 in 19981995–98Companies with higher market capitalization and investor interest given priority
CSRC disclosures883 in 1998

1,055 in 2000
1998–2000All companies listed on the Shan and Shenzhen stock exchanges
Sources: China Statistical Yearbook, various issues; Worldscope; company disclosures.
Sources: China Statistical Yearbook, various issues; Worldscope; company disclosures.
Appendix I: Data Sources

As noted in the text, this study draws upon one aggregate and two firm-level data sets in the analysis of China’s enterprise sector. The aggregate data set comes from annual editions of the China Statistical Yearbook and covers all state and nonstate industrial enterprises with annual sales of over Y 5 million ($0.6 million; Table 11.11). The data are disaggregated in various ways—by ownership, provincial location, type of industry (heavy or light), and sector—and covered 162,885 enterprises in 2000.

The first firm-level data set comes from the Worldscope database, which covers 22,000 listed companies in 53 countries (Primark Corporation, 2000).16

Financial data are gathered from company reports and adjusted to conform with the evolving principles of the International Accounting Standards Committee. The overwhelming majority of these companies are industrial companies, with a few in the transportation and utilities sectors. The selection criteria for inclusion in the database give priority to firms with higher market capitalization, which command greater investor interest and whose financial statements are relatively more reliable. The companies chosen are therefore likely to represent top-tier firms with above-average management and financial performance among listed Chinese companies. For example, the 1998 sample of Chinese companies includes 118 listed companies, 29 of which are listed on the Hong Kong Stock Exchange, and the remainder on the Shanghai and Shenzhen bourses.

The second firm-level sample is a much larger data set of virtually all companies listed on the Shanghai and Shenzhen stock exchanges—there are 1,055 such companies in the sample for the first half of 2000. The database includes detailed balance sheet and income statement items made public pursuant to the disclosure requirements of the CSRC and spans the period from 1998 through the first half of 2000. The average firm in this data set underperforms its counterpart in the Worldscope database but is likely to enjoy better management and stronger finances than unlisted SOEs because of the disclosure and enterprise governance standards imposed by the CSRC.

A number of adjustments have been made to the firm-level data in order to correct for deficiencies in Chinese enterprise accounting and reporting practices, which distort the true financial condition and risk profile of enterprises. These distortions and the adjustments made to the firm-level data are summarized below:

  • Overvalued inventories. Reductions are made to inventory stock values in order to obtain more accurate measures of assets, equity, and leverage. Where possible, adjustments are also made in earnings figures that are known to include revenue from the buildup of inventories.

  • Overvalued receivables. Most firms have accumulated sizable amounts of both receivables and payables on their balance sheets. Given that most receivables are unlikely to be collected and most payables unlikely to be paid, payables are subtracted from receivables to yield net receivables. The stock of net receivables is then deducted from assets and capital, resulting in higher leverage ratios. Earnings (EBITDA) are also adjusted by the annual change in net receivables when calculating the interest coverage ratio.

  • Overvalued fixed assets. As with inventories, reductions are applied to reported fixed assets, which are not sufficiently depreciated over time, in order to obtain more realistic measures of assets, equity, and leverage.

  • Understated interest expenses. The extent of understatement is estimated by deriving the implied interest rates from reported total debt and interest expenses: reported interest expense is divided by reported debt. If the implied interest rate is lower than the prevailing fixed interest rate on short-term loans, interest expenses are adjusted upward by an amount reflecting the difference between them. This results in lower interest coverage ratios and higher implied nonperforming loans.

References

As noted in Chapter 10, in 1998 the PBC estimated the SCBs’ nonperforming loans to be 25 percent of their total loans. After the transfer of many nonperforming loans to AMCs in 1999–2000, the PBC once again released an estimate of 25 percent for the SCBs, based on the old classification system, implying a substantial increase in the estimated ratio from 1998. Following the introduction of a new loan classification system effective January 2002, the four SCBs revised their nonperforming loan ratios upward, to a combined average of 30 percent of total loans at the end of 2001. Until the end of 2001, loans were classified only after principal (not interest) payments were past due, and only the portion of principal past due (according to the original payment schedule) was classified as nonperforming, not the entire loan, and not any unpaid interest. Similarly, provisions were capped at 1 percent of total loans, and most Chinese banks maintained loan-loss reserves of only 1–2 percent of total loans. The authorities recently adopted a new loan classification and provisioning standard, (see Chapter 10).

The aggregate data span 1994–2000, and the two firm-level data sets span from 1998 to mid-2000, and 1995–98, respectively. Although the rise in SOE profitability, particularly in 2000, is reflected in the aggregate data and analysis, the firm-level statistics do not fully capture the recent improvement in enterprise sector performance.

According to official statistics, the aggregate profits of large and medium-size SOEs surged by 135 percent in 2000, to Y 240 billion. Available data through September 2001 suggest that the upward trend in SOE profitability had leveled off.

Firms overstate profits and assets. All goods produced are valued at market prices, regardless of whether they are sold or paid for. Unsold goods accumulate as inventories, while sales of goods that are not paid for accumulate as receivables. Both are then valued at market prices and classified as current assets. Furthermore, both inventories and receivables are credited as revenues in the income statement and included in profits, even though neither generates cash. Appendix I details the statistical adjustments made to correct for the data anomalies.

The credit stock, at 125 percent of GDP at the end of 2000, is high by emerging market standards, reflecting China’s high saving rate.

The jump in SOEs’ share of industrial value added in 1998 (as well as in their share of industrial fixed assets; see Table 11.2) resulted in part from a broadening of the classification to include enterprises in which the state has a controlling share. In addition, it may reflect the impact of increased fiscal spending—which was largely channeled through SOEs—to support growth following the Asian financial crisis.

Shareholding companies doubled their share of industrial value added in both 1999 and 2000, but the increase stems in part from the reclassification of collectives and SOEs as shareholding companies.

The increase in SOEs’ share of fixed assets may also reflect (in addition to the broadening of classification just noted) a pickup in “technological renovation” investment following the authorities’ plan, adopted in 1998, to rehabilitate large SOEs.

Cross-country leverage indicators are obtained from a database constructed from corporate financial indicators in the Worldscope database.

Interest coverage (the ratio of operating profits to interest expense) is computed by estimating interest expenses, which in turn are calculated by multiplying reported total liabilities by the prevailing interest rate on short-term loans.

In the run-up to the Asian crisis, median interest coverage ratios for the domestically listed companies of the crisis countries ranged between 2 and 3 in 1996 (Claessens, Djankov, and Lang, 1998).

The sample of listed companies accounts for 16 percent of total assets of all medium-size and large industrial enterprises. Assets of companies in the sample totaled Y 1,915 billion at the end of 1999, compared with Y 8,047 billion for all medium-size and large SOEs reported in the China Statistical Yearbook. However, the two figures are not directly comparable because listed companies include firms in the utilities and transportation sectors, which are excluded from the aggregate industrial enterprise data.

Several illustrative scenarios have been calculated. First, the balance of receivables and payables is deducted from equity in all adjusted leverage ratios (liabilities-to-equity ratios I-VII in Table 11.7). Second, three progressively larger reductions in value—25, 50, and 75 percent—are applied to inventories and fixed assets, which are then deducted from equity. The reductions are applied to inventories (liabilities-to-equity ratios II-IV) and fixed assets (liabilities-to-equity ratios V-VII) separately, not simultaneously.

See Ramos and others (1998, 2000) for an analysis of the Republic of Korea, Malaysia, Thailand, and Taiwan Province of China, among others.

The government has targeted a 4 percent annual reduction in SCBs’ stock of nonperforming loans over the next five years. Official data suggest that the SCBs are on track to meet this goal in 2002.

Worldscope has data for only 37 companies in 1999, most of which are listed in Hong Kong SAR. Figures for 1999 are thus biased. The analysis, therefore, is based on the 1995–98 period results for the Worldscope sample.

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