Abstract
The People's Republic of China: Selected Issues
Resolving China's Corporate Debt Problem1
Corporate credit growth in China has been excessive in recent years. This paper looks at the causes and consequences of this credit boom and outlines a strategy to address the problem of excessive corporate debt.
The credit boom is largely related to the large rise in investment after the global financial crisis. Investment efficiency has fallen and the financial performance of corporates has deteriorated steadily, affecting asset quality in financial institutions.
The corporate debt problem should be addressed urgently with a comprehensive strategy. Key elements: identifying companies in financial difficulties; proactively recognizing losses in the financial system; burden sharing; corporate restructuring and governance reform; removing debt overhang through workouts; and hardening budget constraints.
A proactive strategy would trade off short-term economic pain for larger longer-term gain.
1. China's high credit growth points to elevated economic and financial risks. In response to the Global Financial Crisis (GFC) and collapse in external trade, China deployed policies to boost domestic demand supported by high credit growth, which averaged around 20 percent per year between 2009 and 2015—much higher than nominal GDP growth and the previous trend. The (broadly defined) nonfinancial private credit-to-GDP ratio rose from around 150 percent to over 200 percent over the same period as a result, and 15–25 percentage points above the level consistent with the historical trend at end-2015—a potentially dangerous, high 'credit gap.' The gap is comparable to countries that experienced painful deleveraging (Borio and Drehmann, 2009).
Credit Booms Tend to End Badly
(In percentage points)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Source: IMF staff estimates.1/ Average growth differential between 5-year post-boom and 5-year pre-boom periods.2/ No growth change as China's boom has not ended.3/ Banking crisis is identified following Laeven and Valencia (2012).Credit Booms Tend to End Badly
(In percentage points)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Source: IMF staff estimates.1/ Average growth differential between 5-year post-boom and 5-year pre-boom periods.2/ No growth change as China's boom has not ended.3/ Banking crisis is identified following Laeven and Valencia (2012).Credit Booms Tend to End Badly
(In percentage points)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Source: IMF staff estimates.1/ Average growth differential between 5-year post-boom and 5-year pre-boom periods.2/ No growth change as China's boom has not ended.3/ Banking crisis is identified following Laeven and Valencia (2012).2. Credit growth in China is concentrated in the corporate sector. The rapid increase in credit could reflect financial deepening in a fast-growing economy. But the credit-to-GDP ratio for the corporate sector is significantly higher in China than in countries at a similar level of development and exceeded the level typical for developed economies. This indicates that credit growth has been faster than a normal path of financial deepening.
Corporate Credit: High vs. Peers
(Selected economies, 2014)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: Bank for International Settlments (BIS); and IMF staff estimates.1/ Calculated as total social financing minus equity and household loans.2/ Calculated as total social financing minus equity, LGFV borrowing and household loans.Corporate Credit: High vs. Peers
(Selected economies, 2014)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: Bank for International Settlments (BIS); and IMF staff estimates.1/ Calculated as total social financing minus equity and household loans.2/ Calculated as total social financing minus equity, LGFV borrowing and household loans.Corporate Credit: High vs. Peers
(Selected economies, 2014)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: Bank for International Settlments (BIS); and IMF staff estimates.1/ Calculated as total social financing minus equity and household loans.2/ Calculated as total social financing minus equity, LGFV borrowing and household loans.3. High corporate investment after the GFC has been the main factor behind rapid credit growth. Credit has financed broad-based scaling-up of infrastructure spending and real estate investment, which has then supported rapid development in upstream industries such as steel, cement and coal. In addition, corporate sector borrowing has increased in response to growing payments arrears.
4. The use of capital has become less efficient, affecting corporate financial performance. The 'efficiency of credit' (incremental GDP growth relative to incremental increase in credit) has been declining. Growth payoffs from additional capital spending have been falling despite the additional borrowing to finance balance sheet expansion. As a result, the corporate leverage ratio has been rising while return on assets has been steadily falling, suggesting deteriorating debt servicing capacity. This is most pronounced in real estate, construction and related upstream activities.
While Credit Intensity Has Increased
(In percent, new credit per unit of additional GDP)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: Bank for International Settlements (BIS); World Economic Outlook (WEO); and IMF staff estimates.While Credit Intensity Has Increased
(In percent, new credit per unit of additional GDP)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: Bank for International Settlements (BIS); World Economic Outlook (WEO); and IMF staff estimates.While Credit Intensity Has Increased
(In percent, new credit per unit of additional GDP)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: Bank for International Settlements (BIS); World Economic Outlook (WEO); and IMF staff estimates.
Increasing Leverage and Falling Profits 1/
(In percent)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: S&P Capital IQ; and IMF staff estimates.1/ Listed non-financial companies.Increasing Leverage and Falling Profits 1/
(In percent)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: S&P Capital IQ; and IMF staff estimates.1/ Listed non-financial companies.Increasing Leverage and Falling Profits 1/
(In percent)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: S&P Capital IQ; and IMF staff estimates.1/ Listed non-financial companies.5. SOEs have been more leveraged and less profitable than the private sector. They have acted partly as a conduit for policy-driven investment. Soft budget constraints (access to cheap financing by state-owned banks underpinned by implicit government guarantees) have also contributed to the large buildup of leverage in SOEs. Staff estimates suggest that implicit guarantees translate to a 4–5 notches upgrade in credit ratings, and appear to lower borrowing costs by about 1–2 percentage points. As borrowing costs are not commensurate with returns and risks, they distort the allocation of resources and promote inefficiency.
Debt-at-Risk by Sector
(In percent of total debt at risk) 1/
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: Standard & Poor's Capital IQ; and IMF staff estimates.1/ ICR<1.Debt-at-Risk by Sector
(In percent of total debt at risk) 1/
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: Standard & Poor's Capital IQ; and IMF staff estimates.1/ ICR<1.Debt-at-Risk by Sector
(In percent of total debt at risk) 1/
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: Standard & Poor's Capital IQ; and IMF staff estimates.1/ ICR<1.6. Credit quality of bank loans has been deteriorating accordingly. Reported NPLs and special mention loans have been on the rise, although they still remain relatively low (at about 5½ percent of total loans). However, staff estimates based on corporate data suggest that potential "debt-at-risk" amounts to 15½ percent of the total corporate loan portfolio, which could yield estimated potential losses of about 7 percent of GDP when applying a 60 percent loss ratio on these loans (IMF, 2016a).
7. The authorities recognize the problem and are developing plans to tackle it. They have announced reductions of 10–15 percent of existing capacity in coal and steel over the next 3–5 years, together with a RMB 100 billion restructuring fund to absorb the re-employment and resettlement costs for an expected 1.8 million laid-off workers, signaling firm intent to reduce excess capacity and restructure the economy. But the current plan on operational restructuring is still narrowly focused on coal and steel industries and the full extent of associated losses in the financial system yet to be addressed. In addition, overall progress in state-owned enterprise (SOE) reforms has been slow and the current approach does not address decisively the issue of tightening budget constraints as implicit guarantees are still in place and promoting mergers and acquisitions among stronger and weaker SOEs does not help impose financial discipline (see Selected Issues chapter on SOEs). Cases of "mini" or "near" defaults among Chinese corporates have been rising, but corporate debt workouts are currently handled on a case-by-case basis and do not seem to promote corporate restructuring as ad-hoc state intervention in SOEs without clear guidance on the state's role does not provide an effective mechanism to harden budget constraints.
8. China needs a comprehensive proactive, strategy to address the debt problem. Key elements should include:
Identifying companies in financial difficulties (triage). This could be done through a market-based approach (driven by creditors) or by setting up a separate entity vested with sufficient legal and political powers (driven by government). A transparent and standardized process, including external experts in valuation, would provide an independent basis for decision making.
Loss recognition. Proactively recognizing losses in the financial system through an enhanced supervisory and regulatory framework. Positive and negative incentives ("carrots and sticks") need to be introduced to support the debt restructuring process.
Burden sharing. Once the losses have been recognized, they should be allocated among the indebted firm, its creditors and local/central government. This should consider moral hazard (imposing costs on those whose decisions led to them), capacity to repay, and social consequences. Mechanisms should be developed to facilitate debt workouts (e.g., debt-equity conversions, IMF, 2016b).
Corporate restructuring. Corporate restructuring and governance reform—particularly in SOEs—should also be a part of the process. Otherwise losses will resume.
Hardening budget constraints. Additional measures (e.g., regulatory reforms, particularly in the bond market) are needed to harden budget constraints of corporates, including to remove implicit guarantees.
9. Supporting policies are also needed for successful corporate restructuring, including:
Enhancing the legal framework. A long-term goal is to improve the legal system and the institutional framework to handle insolvencies. But large-scale and expedited restructuring requires out-of-court mechanisms to complement the existing framework.
Minimizing the hit to near-term growth and employment (and helping those that are affected). Corporate restructuring will have short-term economic costs. They will ultimately be offset by activity and employment created in new sectors, but supportive mechanisms to facilitate this transition—such as strengthening the social safety net, retraining, and easing restrictions on migration—are needed.
Improving local government fiscal discipline. Boundaries between public and private debt are blurred. Local governments have been borrowing off-budget through local government financing vehicles, which are nominally part of the corporate sector, but in reality they are part of the public sector. Although the recent (2014) Budget Law regularized local government financing, they still face incentives to engage in such off-budget activity.
10. The enhanced debt restructuring strategy could be deployed on a pilot basis involving a small number of SOEs in a sector with clear overcapacity, and experiencing diverse degrees of distress. The pilot could be based on a predominantly out-of-court approach, conducted under the oversight of a SOE Restructuring Task Force consisting of the relevant institutions for corporate debt restructuring and using independent expert valuations. Once the target enterprises are selected, the pilot could proceed according to the following steps:
Determining fair value of claims held by major creditors of the target enterprises by the China Banking Regulatory Commission.
Debt workouts. Two alternative approaches could be considered: a) sale of the loans, at fair value, to a newly established asset management company (AMC); or b) establishment of a creditor committee by the relevant banks.
Restructuring or liquidation of the target enterprises. The decision to restructure or to liquidate target enterprises must be taken by creditors, and should be based on market valuations, viability assessment, and restructuring plans prepared by independent experts.
Transfer of claims/ownership. Equity acquired by banks in debt workouts could be sold to private investors or to SOEs with the appropriate governance mechanisms.
Assistance to laid-off workers, utilizing the restructuring fund.
11. The proactive strategy would have short-term costs, but these would be more than offset by longer-term gains. Staff's illustrative scenarios suggest that the short-term growth slowdown is mainly driven by output and employment cuts in over-leveraged and overcapacity industries. This, however, gradually gives way to higher production and employment as labor is reallocated elsewhere, partly to services. The reallocation produces higher and more sustainable growth in the future, with less investment and credit, but higher total factor productivity growth. The simulation shows that growth in the proactive scenario will temporarily dip to 6 percent by 2017 (which would be 5½ percent excluding some assumed high-quality fiscal stimulus), but pick up afterwards and maintain a growth rate of 6½ percent in the medium term. The credit/GDP ratio would stabilize in the short term, while gradually declining to more sustainable levels in the medium term.
GDP Growth: Illustrative Scenarios
(In percent, year-on-year growth)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: CEIC Data Company Ltd.; and IMF staff estimates.Note: For the no-reform scenario, the upper bound refers to growth absent a crisis, while the lower bound refers to growth in the hard landing scenario adjusted by the probability of such a scenario.GDP Growth: Illustrative Scenarios
(In percent, year-on-year growth)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: CEIC Data Company Ltd.; and IMF staff estimates.Note: For the no-reform scenario, the upper bound refers to growth absent a crisis, while the lower bound refers to growth in the hard landing scenario adjusted by the probability of such a scenario.GDP Growth: Illustrative Scenarios
(In percent, year-on-year growth)
Citation: IMF Staff Country Reports 2016, 271; 10.5089/9781475524383.002.A006
Sources: CEIC Data Company Ltd.; and IMF staff estimates.Note: For the no-reform scenario, the upper bound refers to growth absent a crisis, while the lower bound refers to growth in the hard landing scenario adjusted by the probability of such a scenario.References
Borio, C and M Drehmann, 2009, “Assessing the Risk of Banking Crises—Revisited,” BIS Quarterly Review, March, pp 29–46.
International Monetary Fund, 2016a, Global Financial Stability Report (Washington, April).
International Monetary Fund, 2016b, “Debt-Equity Conversions and NPL Securitization in China—Some Initial Considerations,” Technical Notes and Manuals 16/05 (Washington).
Prepared by Joong Shik Kang (APD), drawing on a forthcoming paper by W. Maliszewski, S. Arslanalp, J. Caparusso, J. Garrido, S. Guo, J. S. Kang, W. Lam, D. Law, W. Liao, N. Rendak, P. Wingender, J. Yu, and L. Zhang.
