Selected Issues

Abstract

Selected Issues

Tackling Corporate Debt and Achieving Productivity Gains—the Central Role of State-Owned Enterprises1

  • State-owned enterprises (SOEs) are at the center of China’s high and rising corporate debt. Many of them are nonviable “zombie” firms and in overcapacity sectors. These companies account for an outsized share of corporate debt and have contributed to much of its rise.

  • Reforms will not only be critical to reducing debt vulnerabilities and containing financial risks, but also to raising productivity and growth. Staff estimates that SOE reforms could raise China’s long-term growth potential by about 1 percentage point a year.

  • Various reforms have been introduced to facilitate deleveraging and resolve weak companies but progress has been slow. Progress is complicated by limited SOE reforms, the reopening of shutdown capacity, and piecemeal exit of zombies.

  • Accelerating progress requires a more holistic and coordinated strategy, which should include: time-bound actions that “triages” weak firms; recognition of losses; fostering operational restructuring and reducing implicit support; liquidating zombies; and relying on market forces in resolving overcapacity.

A. Introduction and Key Facts

1. Faced with high and rising corporate debt, the government has put forward a broad agenda to address the risks of excessive leverage. The strategy aims to restructure debt, reduce overcapacity, and eliminate nonviable “zombie” firms.2 At the same time, the government is pursuing gradual deleveraging and reforming SOEs to reduce credit misallocation.

uA03fig01

Sharp Increase of Corporate Credit

(Percent of GDP)

Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A003

Sources: CEIC; IMF staff estimates.1/ Includes part of local government financing vehicles (LGFV) debt that is recognized as official local government debt.2/ LGFV debt not classified as official general government debt.

2. The most pressing corporate debt vulnerabilities are concentrated among SOEs, zombies, and overcapacity firms (Table 1). As a group, these companies account for an outsized share of total corporate debt and have contributed to much of the its increase in recent years (Appendix Table 1). Empirical analysis of firm-level data suggests that weak firms have substantial overlaps and are more likely to be state-owned, in overcapacity sectors, and in north and northeast regions.

Table 1.

Scorecard of Corporate Debt Vulnerabilities1/

article image

The degree of vulnerabilities ranks from dark red, red, yellow, green. Dark red indicates the most severe vulnerabilities.

Corporate fundamentals measured by profitability, leverage ratios, and interest coverage.

Zombie Firms

3. The government defines zombies as firms that incur three years of losses, cannot meet environmental and technological standards, do not align with national industrial policies, and rely heavily on government or bank support to survive.3 The share of zombies in total corporate debt has risen in recent years. Zombies contribute to corporate debt vulnerabilities, not just because of their debt level, but also their persistent weak performance and potential crowding out of non-zombie firms’ investment (Tan and others 2017). They have higher leverage, lower returns, and lower productivity than non-zombie firms. The zombie firms remain so after 3–5 years and their performance continues to deteriorate.

Overcapacity Firms

4. Overcapacity sectors are those that suffer from low capacity utilization rates and persistent losses.4 Although overcapacity firms contributed moderately to the rise in corporate debt during 2008–16, they are estimated to account for 10–15 percent of total corporate debt (Appendix Table 1). While profitability has improved since late 2016, their share of total corporate debt has remained high.

SOEs

5. SOEs often undertake noncommercial functions such as pursuing national development strategies and performing social service functions. Central state-owned conglomerates are about 102 in number, each with layers of subsidiaries, that add up to some 167,000 nonfinancial SOEs nationwide. They tend to enjoy implicit support on factor inputs, such as land endowment, credit, and protected markets (estimated at about 3 percent of GDP) while also incurring additional costs in fulfilling social functions (Lam and Schipke 2017).

6. While SOEs account for declining shares of industrial output (from over 40 percent to about 15–20 percent over the last 15 years), they have an outsized share of corporate debt (57 percent of total corporate debt or 72 percent of GDP in 2016) and contributed to almost 60 percent of the rise in total corporate debt during 2008–16. SOEs underperform private firms on average, with lower returns and productivity (IMF 2016). Productivity was also 25 percent lower than that in private firms on average, controlling for industries.

uA03fig02

Nonviable Zombie Firms are Rising Again, particularly in Debt Share

(in percent of total industrial firms, weighted by number of firms and total liabiltiies)

Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A003

Sources: NBS Industrial Firm Survey and staff estimates.1/ Data for 2010 are missing and based on average of 2009 and 2011. Estimates are average between two definitions of zombies (State Council and Fukurama and Nakamura (2001).
uA03fig03

Implicit Support to SOEs Increasingly Related to Credit Allocation

(Percent of GDP)

Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A003

Sources: Unirule Institute of Economics (2015); CEIC; authors’ estimates.1/ Numbers in the bar chart refer to the share of total implicit support.

Productivity Gains from Resolving Weak Firms

7. Reforms to resolve weak firms and harden budget constraints for SOEs will improve resource allocation and raise efficiency. Based on the productivity distribution of Chinese firms, converging to countries that have a more efficient productivity distribution (measured by the top 75–90 percentile across countries) would generate productivity gains and raise long-term growth potential 0.7–1.2 percentage points per year (IMF 2017; Lam and others 2017; Hsieh and Klenow 2009).

B. Recent Developments and Policy Measures

Deleveraging and Restructuring Debt

  • Government strategy and recent developments. The overarching strategy envisages a market and legal framework for debt restructuring—rather than state direction or bailouts—and aims to guard against systemic or regional risks. Incremental progress has been made on debt restructuring. An inter-ministerial group, led by the NDRC, was tasked to facilitate deleveraging and regulators have renewed focus to resolve excessive leverage. Guidelines for debt-equity swaps and creditor committees for claims of multiple creditors were issued.

  • Assessment. The guidelines are positive initial steps toward a comprehensive framework to resolve excessive corporate debt. However, the guidelines lack important details on loss recognition and on operational restructuring of weak firms. While some SOE restructuring cases contain elements of operational restructuring, details and time frames are not specified (at least not publicly). A few debt-equity swaps appear to be equity in name but debt in essence. And without concerted efforts to slow credit growth, there is an increasing risk of superficial financial restructuring to meet a deleveraging “target” (such as reducing firm-level liability-to-asset ratios) without tackling underlying structural problems, essentially “kicking the can down the road”.

Cleaning up Zombies

  • Government strategy and recent developments. The government’s strategy is to allow zombies—mainly focused on SOEs—to exit through a menu of options, including asset transfers, consolidation, and liquidation. The government has identified as zombies over 2,000 central SOE (with total assets of about 4 percent of GDP) and over 7,000 local SOEs. Reportedly, 20 percent of the identified central SOE zombies were resolved in 2016, although without details. Amendments were made to the regulation of nonperforming loans to expedite the liquidation of zombies.

  • Assessment. Renewed focus to allow the exit of zombies is appropriate. Lack of resolution details, however, makes it difficult to assess progress. Although zombie debt is estimated to be moderating due to improving profitability, resolving them may still prove difficult as zombies are about 30 percent more likely to remain so if they are state-owned.

Reducing Overcapacity

  • Government strategy and recent developments. The government intends to phase out low-technology and high-polluting capacity through a combination of market forces, legal, and administrative measures. The coal and steel sectors have set a medium-term target to cut capacity by 10–15 percent of 2015 output and to reduce employment by 1.8 million workers over 3–5 years. Capacity reduction exceeded the target in 2016 and is on-track in 2017, while the workforce was down by 30 percent over the last 2–3 years without creating major unemployment (Appendix Table 2). The government also broadened cuts to other sectors such as coal-fueled power and building materials and strengthened the social safety net by a RMB 100 billion restructuring fund.

  • Assessment. The reduction targets are appropriately frontloaded but could be more ambitious. Under the current cut targets, crude steel capacity would still be close to 2013 levels and account for nearly half of global capacity by 2018–20 due to previously-planned investment (Sekiguchi and others 2016; European Union Chamber of Commerce 2016). By some accounts, some closures have resumed production. The debt in overcapacity sectors has not fallen, suggesting problem loans have not been fully recognized (banks do not classify those problem loans as nonperforming loans). The government has also relied on administrative measures, such as mergers, work day reductions, and window guidance on prices, while banks reportedly refinanced firms with payment difficulties (e.g., seven major coal firms in Shanxi). The impact on production has also been muted, with coal and crude steel output up by 3–8 percent since 2015.

Reforming SOEs

  • Government strategy and recent developments. SOE reforms were highlighted as key priorities with the strategy to “integrate naturally” modern corporate governance and leadership of the Communist Party so that they can raise efficiency while meeting national development goals (IMF 2016, Naughton 2016 and Leutert 2016). Recent measures include (1) consolidating some central SOEs; (2) phasing out SOEs’ social functions to workers; (3) transferring about ½ percent of state-owned equity to social security funds; (4) cutting central SOE losses (5) individually incorporating the subsidiaries of central SOEs by 2017; (5) implementing pilot employee stock ownership programs to align incentives; and (6) bringing in other investors under the mixed-ownership pilot reforms and committing to open up sectors (such as travel, medical care, electricity, and power and utilities) to private and foreign investment.

  • Assessment. SOE reform implementation has lagged other reforms and has not yet raised growth potential. For example, the transfer of SOE profits to the budget has been well below the target 30 percent level. Preliminary classification suggested that only less than 60 percent of SOEs were considered commercially competitive—the category in which SOEs will face direct market competition—which raise concerns whether SOE reforms can achieve significant productivity gains.

C. Policy Implications

8. Corporate debt vulnerabilities cut across zombie companies, overcapacity firms, and SOEs. Progress is complicated by the reactivation of closed capacity, piecemeal exit of zombies, and limited progress in SOE reforms. Resolving the excessive debt in these weak firms requires a holistic, coordinated approach with time-bound actions. The focus should therefore be a government-led process that allows market forces to operate, while complementary actions should follow with operational restructuring to raise efficiency (Maliszewski and others 2016). Specifically:

9. Restructuring Corporate Debt. Building on recent efforts, steadfast implementation is critical. Particularly:

  • Assessing firm viability. A targeted asset quality review would be useful to assess firm viability. Supportive policies will also include reinforcing accounting and audit rules to provide timely and accurate financial information, raising the standards of appraisers for asset valuation, and developing efficient credit registers.

  • Recognizing and allocating losses. Regulators should strengthen reviews of regulatory policies such as loan classification, bank capital, collateral valuation, and prudential reporting to foster banks’ proactive NPL resolution.

  • Operational restructuring plans should be quickly developed for weak SOEs. Creditors and new equity holders need to have reasonable assurance that the restructured firms will be viable on a going-concern basis. Empirical results strongly support that corporate governance reforms (possibly divestment and a change of management), deleveraging, and tighter budget constraints will help distressed firms return to viability.

  • Refining the restructuring mechanism:

    • Creditor committees should also align with international best practices (for example, the insolvency principles for multi-creditor workouts, INSOLs), which allow a sufficient standstill period, information sharing between debtors and creditors, and restraints on debtors from weakening the firm value.

    • Debt-equity swaps should be preceded by an asset quality review of troubled firms and supported by operational restructuring. Bank loans should be transferred at economic/market value (rather than face value) with independent assessment.

  • Ensuring sufficient resources for bankruptcy courts and professionals on valuation and overcoming remaining hurdles in the insolvency framework will be critical.

  • Clarifying the role of the public sector. First, the joint-ministerial council should be given an explicit mandate to help guide expectations, particularly for identification of zombies and SOE reform. Second, the government should lead the assessment of SOE viability, which should exclude state support. Third, public creditors such as the tax authorities will need to acknowledge a loss in the debt restructuring (under strict conditions).

10. Removing zombies.

  • Suspending implicit support. The government should suspend implicit support and allow banks to manage their claims on zombie SOEs so as to reallocate assets to productive uses. Essential social functions provided by zombies should be transferred to fiscal budget.

  • Liquidating identified zombies. Nonviable zombies should be publicly identified and subject to greater use of liquidation. This should be complemented with a clear timetable to resolve all identified zombies within 1–2 years.

11. Reducing overcapacity.

  • Raising the net reduction target. The government should shift the reliance from administrative measures—which inevitably leads to further distortions—to strict enforcement of a larger, more ambitious net reduction of capacity. Indicative targets can be set for other overcapacity sectors and more ambitiously in net reduction terms.

  • Phasing out energy subsidies and imposing resources tax. Greater use of (coal) resource and environmental taxes, reducing energy subsidies, and stricter enforcement of regulatory standards (such as safety and environmental) will help phase out substandard capacity.

  • Providing social safety net. Capacity closures and debt restructuring will involve social welfare costs, such as layoffs (estimated at 2.8 million workers). Targeted social policies can complement local social security to mitigate the social cost of layoffs.

12. Reforming SOEs. Without decisive progress on SOE reforms, measures to tackle corporate debt could risk being a purely financial restructuring exercise and not improve the allocation of new credit.

  • Operational restructuring. Greater emphasis should be placed on operational restructuring of weak SOEs and recognizing (and stopping) losses. The state should neither “window-dress” by merging them with sound SOEs nor encourage creditors to refinance, even if that means immediate loss recognition and a mild growth slowdown.

  • Hardening budget constraints. Reducing credit access and implicit support to SOEs will not only address existing debt overhang but also improve the efficiency of new credit. This requires hardening budget constraints by greater tolerance of defaults and by enforcing the transfer of individual SOE profits to the fiscal budget to reach 30 percent by 2020.

  • Facilitating market entry. Reducing entry barriers and phasing out restrictions that give SOEs a privileged role will level the playing field and make markets more contestable. Implementing the commitment to open up protected markets in the state-dominated services sector, such as logistics, finance, and telecommunications, and breaking up administrative monopolies would foster competition and promote growth.

References

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Appendix I. Debt Vulnerabilities of Zombie Companies, Overcapacity Firms, and SOEs

article image
Sources: PBC, CEIC, NBS, IMF staff estimates.

Regional concentration is measured by the average share of industrial liabilities relative to the provincial total among the North and Northeast regions (Heilongjiang, Jilin, Liaoning, Shanxi, Shaanxi, and Hebei provinces, and Inner Mongolia autonomous region). For example, coal firms account for an average of 17 percent of industrial liabilities in the selected provinces (highest in Shanxi at 51 percent) and steel firms account for an average of 18 percent (highest in Hebei province at 37 percent). Overall, overcapacity firms account for 21–65 percent of industrial liabilities in North and Northeast regions.

Leverage ratio is measured by total liabilities to total owners’ equity (in percent).

Overcapacity sector includes coal, steel, plated glass, cement, aluminum, nonferrous metals.

The debt share of zombie firm is based on industrial liabilities in National Bureau of Statistics industrial survey from 1998–2013, which is then scaled to total corporate debt based on the aggregate ratio. Data after 2013 are estimated based on overall increase in credit and aggregate corporate performance.

Appendix II. Reduction of Capacity in Coal and Steel Sectors

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Sources: WIND, CEIC, and IMF staff estimates.

The authorities intend to reduce 0.5 million employment in 2017 (or a total of 1.8 million workers over the medium term) for coal and steel sectors. Here assumes the reduction target for 2016 is one-fifth of the total target based on 2015 employment levels.

1

Prepared by W. Raphael Lam based on the forthcoming working paper by W.R. Lam, Y.Y. Tan, Z.B. Tan, and A. Schipke (2017). QI Zhe, TAN Yuyan, WU Yuchen provided excellent research. We are grateful for comments from the People’s Bank of China, National Development and Reform Commission, Ministry of Finance, State-owned Assets Supervision and Administration Commission (SASAC), and China Banking Regulatory Commission (CBRC).

2

Nonviable zombie firms are those whose liquidation value is greater than their value as a going concern, taking into account potential restructuring.

3

This paper also uses an alternative definition proposed by Fukuda and Nakamura (2011), with adjustment applied on short-term debt due less than a year. This defines “zombies” as firms incurring persistent losses and with interest payment costs below market lending rates—a proxy for support from creditors or the government.

4

This paper includes coal, steel, cement, plated glass, and aluminum industries as overcapacity sectors. Paper, solar power, chemicals, ship building, coal-fueled power are sometimes included in other studies (such as the European Chamber of Commerce 2016). Data for these industries are grouped into the broader manufacturing sector.

People's Republic of China: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept
  • View in gallery

    Sharp Increase of Corporate Credit

    (Percent of GDP)

  • View in gallery

    Nonviable Zombie Firms are Rising Again, particularly in Debt Share

    (in percent of total industrial firms, weighted by number of firms and total liabiltiies)

  • View in gallery

    Implicit Support to SOEs Increasingly Related to Credit Allocation

    (Percent of GDP)