Abstract
Selected Issues
Improving the Allocation of Corporate Credit in China1
China has succeeded in reducing the corporate debt-to-GDP ratio, but leverage remains high as credit allocation is skewed towards less efficient state-owned enterprises (SOEs) as a result of their implicit government guarantee. The needed financial regulatory tightening has reduced leverage but with the unintended consequence of constraining credit to the private sector, especially small and medium sized enterprises (SMEs). The authorities’ initiative to establish competitive neutrality will help support the development of the private sector.
Concerted efforts to promote debt and regulatory neutrality to create a level domestic playing field will improve the allocation of corporate credit. Implementation of the reforms will need to be sequenced appropriately. Equally important will be to ensure that policies are market-oriented so that they are durable and not circumvented, leading to a more efficient allocation of resources. Policies would include removing implicit guarantees given to SOEs, increasing banks’ risk weights on corporate loans with implicit guarantees, adjusting cost advantages provided to SOEs, and hardening SOE budget constraints.
Improving allocation of credit can also be achieved by enhancing support to private-owned enterprises (POEs) and SMEs under an expanded coverage of competitive neutrality, such as by lowering credit rating thresholds to allow small firms to issue bonds, encouraging equity financing, and revising or applying laws uniformly to improve credit allocation.
Strengthening the overall credit culture will also improve lending decisions and enhance financial resilience. Reforms include improving credit ratings, strengthening credit registries, ensuring adequate capitalization of banks and promoting more risk-based vs. collateral-based lending.
A. Impact of China’s Deleveraging on Credit Allocation
The Positives…
1. China’s corporate leverage, measured as the debt-to-GDP ratio, has declined, reflecting de-risking measures since 2016. Peaking at 142 percent of GDP in 2016, China’s corporate debt (for all types on enterprises excluding local government financing vehicles (LGFVs) declined to 129 percent of GDP in 2018. To reach this goal, the authorities implemented several measures, which include applying SOEs’ debt ceiling and restricting the leverage ratios over the medium-term (IMF, 2018; see Annex I for details).
Corporate Sector: Debt to GDP Ratio
(In percent of GDP)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Haver analytics; and IMF staff calculations.1/ Excluding credit to LGFVs.Corporate Sector: Debt to GDP Ratio
(In percent of GDP)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Haver analytics; and IMF staff calculations.1/ Excluding credit to LGFVs.Corporate Sector: Debt to GDP Ratio
(In percent of GDP)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Haver analytics; and IMF staff calculations.1/ Excluding credit to LGFVs.2. SOE leverage ratios have also fallen. Measures of SOE leverage such as the ratio of debt-to-assets or debt-to-equity have steadily declined since 2016. The decrease in the leverage ratio of industrial SOEs in 2018 was driven more by the increase in assets than by the reduction in debt (the assets and liabilities of the industrial SOEs increased by about 7 and 6 percent (y-o-y) respectively).
Leverage Ratios: Industrial SOEs vs. POEs
(In percent)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: China Ministry of Finance; and IMF staff calculations.Leverage Ratios: Industrial SOEs vs. POEs
(In percent)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: China Ministry of Finance; and IMF staff calculations.Leverage Ratios: Industrial SOEs vs. POEs
(In percent)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: China Ministry of Finance; and IMF staff calculations.…and the Unintended Consequences
3. Financial regulatory tightening, while needed to support China’s de-risking, has had the unintended consequence of constraining credit to private corporates. SMEs were particularly hit hard from the contraction in shadow banking, an important source of financing for the private sector. The intended outcome of channeling credit to private corporates through the banking sector did not happen, as banks opted to continue lending to less risky SOEs. As a result, financing conditions tightened for POEs, and their default numbers increased.
Small and Micro Enterprise Lending Growth
(In percent, year-on-year)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: CESRC, PBOC, and IMF staff estimates.Small and Micro Enterprise Lending Growth
(In percent, year-on-year)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: CESRC, PBOC, and IMF staff estimates.Small and Micro Enterprise Lending Growth
(In percent, year-on-year)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: CESRC, PBOC, and IMF staff estimates.
Bond Defaults by Corporates
(Number of defaults)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Wind; China bond; and IMF staff calculations.Bond Defaults by Corporates
(Number of defaults)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Wind; China bond; and IMF staff calculations.Bond Defaults by Corporates
(Number of defaults)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Wind; China bond; and IMF staff calculations.Remaining Challenges and Vulnerabilities
4. Deleveraging has not significantly changed the overall allocation of credit in China.
SOE performance has gradually improved but remains below that of the POEs. For example, the number of loss-making firms has declined since 2015 as many central zombie firms have exited, but there are still twice as many loss-making SOEs than POEs. Yet, despite SOEs’ lower profitability and weaker balance sheets, a majority of bank loans still flows to SOEs (Lardy, 2019), indicating scope for improving bank credit allocation.
Deleveraging has led to some increase in market financing. Deleveraging has induced corporates to find alternate sources of funding, such as equity or retained earnings. However, the amounts so far are small, with banks still providing over 70 percent of corporate financing. In addition, while corporate bond and equity issuance has increased, it still constitutes a small portion of the total liabilities.
Although China’s corporate debt-to-GDP ratio has fallen since 2016, it remains one of the highest in the world, reflecting partly stimulus after the global financial crisis (GFC). Corporate debt ratios still remain above the average of advanced economies and emerging markets as well as China’s pre-GFC levels of 2008. And there is the risk that the decline since 2016 may still unwind in coming years as credit growth picks up and if nominal GDP growth slows and industrial profitability weakens.
Corporate Performance: SOEs vs POEs
(In percent)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: CEIC and IMF staff calculations.Corporate Performance: SOEs vs POEs
(In percent)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: CEIC and IMF staff calculations.Corporate Performance: SOEs vs POEs
(In percent)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: CEIC and IMF staff calculations.
Corporate Financing: Bonds vs. Equity
(In trillions of Renmimbi)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Haver Analytics; and IMF staff calculations.Corporate Financing: Bonds vs. Equity
(In trillions of Renmimbi)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Haver Analytics; and IMF staff calculations.Corporate Financing: Bonds vs. Equity
(In trillions of Renmimbi)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Haver Analytics; and IMF staff calculations.
Corporate Debt-to-GDP
(In percent)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: BIS; and IMF staff calculations.Corporate Debt-to-GDP
(In percent)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: BIS; and IMF staff calculations.Corporate Debt-to-GDP
(In percent)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: BIS; and IMF staff calculations.B. Applying Principles of Competitive Neutrality to Credit Allocation
The Status of Competitive Neutrality in Financing
5. SOEs continue to receive a large share of credit allocation due to their prevalent and persistent implicit guarantees. SOEs enjoy implicit support on several factor inputs such as land, credit, and natural resources. Overall the implicit support to SOEs in recent years has declined to below 3 percent of GDP, but a considerable part of the implicit support is related to credit allocation (left graph, Lam and Moreno-Badia, 2019). Banks are more inclined to lend to SOEs as they are perceived to be less risky and shielded from defaults. Implicit guarantees also boost the profitability of SOEs; adjusting for the estimated implicit support, SOE return on equity falls from an average of 8 percent to about -1.3 percent during 2011–15 (Lam and Schipke, 2017).
Implicit Support to SOEs
(In percent of GDP)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: CEIC, WEO, Lam and Moreno-Badia (2019), and Lam and Schipke (2017).Note: Numbers in the bar chart refer to the share of total implicit support.Implicit Support to SOEs
(In percent of GDP)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: CEIC, WEO, Lam and Moreno-Badia (2019), and Lam and Schipke (2017).Note: Numbers in the bar chart refer to the share of total implicit support.Implicit Support to SOEs
(In percent of GDP)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: CEIC, WEO, Lam and Moreno-Badia (2019), and Lam and Schipke (2017).Note: Numbers in the bar chart refer to the share of total implicit support.
Adjusting Return on Equity based on Implicit Support to SOEs
(Net return on total owners’ equity; Percent)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: Lam and Schipke, 2017.Note: Based on nominal profits of industrial SOEs net of fiscal subsidies, implicit support through the use of land and natural resources, and lower implicit financing cost.Adjusting Return on Equity based on Implicit Support to SOEs
(Net return on total owners’ equity; Percent)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: Lam and Schipke, 2017.Note: Based on nominal profits of industrial SOEs net of fiscal subsidies, implicit support through the use of land and natural resources, and lower implicit financing cost.Adjusting Return on Equity based on Implicit Support to SOEs
(Net return on total owners’ equity; Percent)
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: Lam and Schipke, 2017.Note: Based on nominal profits of industrial SOEs net of fiscal subsidies, implicit support through the use of land and natural resources, and lower implicit financing cost.6. SOEs also benefit from lower cost of capital from higher credit ratings due to implicit guarantees. The credit ratings of SOEs in China often overstates the firms’ underlying financial health because of the perceived implicit guarantees. Comparing the two credit ratings of each corporate (with and without factoring in implicit guarantees), SOEs are estimated to have credit ratings about two to three notches higher than comparable POEs (graph). As a result, SOEs benefit from interest rates that are estimated to be 150- 200 bp lower than those paid by their private sector peers for bonds with similar maturities (GavekalDragonomics, August 2018). Even after controlling for additional factors (such as the type of credit bond, industry, and trading year), SOEs typically pay over 100 basis points less in borrowing costs than private firms with the same financial conditions such as leverage, profitability, and size (Zhang and Wu, 2019)2.
Corporate Credit Rating
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Standard & Poors; Bloomberg L.P.; and IMF staff calculations.Note: Size of the bubble denotes the entity’s total debt. Shaded area shows corporates that have a higher credit rating than their stand-alone credit profile.Corporate Credit Rating
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Standard & Poors; Bloomberg L.P.; and IMF staff calculations.Note: Size of the bubble denotes the entity’s total debt. Shaded area shows corporates that have a higher credit rating than their stand-alone credit profile.Corporate Credit Rating
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Standard & Poors; Bloomberg L.P.; and IMF staff calculations.Note: Size of the bubble denotes the entity’s total debt. Shaded area shows corporates that have a higher credit rating than their stand-alone credit profile.How Can the Principles of Competitive Neutrality be Applied to Financing?
7. To boost the prospects for the private sector, the authorities have adopted competitive neutrality as a mandate. In the 2019 Plan for National Economic and Social Development, the authorities committed to “follow the principle of competitive neutrality … enterprises under all forms of ownership will be treated in equal footing”. For the upcoming year, they have also announced several specific measures for credit allocation towards the private sector.
8. The first step in establishing competitive neutrality would be to separate SOEs that should compete with POEs. The authorities launched an initiative to divide non-financial SOEs into three categories – social, strategic, and competitive firms. Although SASAC completed the identification process in 2017, no information has been released on the firms in each category. The first step to level the playing field should be to release a publicly available list of the SOEs with their assigned category. This classification will ensure that identified SOEs will not be exempt from the rules that apply to POEs.
Classification of Corporates
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: Lardy (2019) and IMF staff.Classification of Corporates
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: Lardy (2019) and IMF staff.Classification of Corporates
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: Lardy (2019) and IMF staff.9. As China transitions to a market-based economy, it will benefit from recognizing the distinctive roles of the government and the market. Historically, SOEs in China have fulfilled multiple roles including social responsibilities such as addressing poverty. Going forward, it will be important to evaluate areas where the central government can fulfill social functions instead of SOEs. Equally important would be to control the growth of state-owned capital invested in SOEs, including SOEs operating in non-strategic sectors as this could release public funds for other causes. At the very least, SOEs will need to make a commercial rate of return, otherwise this would imply a loss in the value for the state as an owner.
10. Among the eight main principles of competitive neutrality formulated by the OECD, two directly impact allocation of credit: debt neutrality and regulatory neutrality. All eight principles aim to eliminate market distortions or unfair regulations that give advantages to SOEs, and thereby could indirectly affect the allocation of credit. For example, the principle of procurement neutrality could help with equalizing input costs of firms and affect their profitability. This in turn would influence banks’ and investors’ decision about where to allocate credit. This paper focuses on debt and regulatory neutrality principles that directly impact credit allocation.
Components of Competitive Neutrality
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: OECD, 2012b.Components of Competitive Neutrality
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: OECD, 2012b.Components of Competitive Neutrality
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: OECD, 2012b.Policies to Establish Debt Neutrality in Financing
11. OECD Guidance recommends that public enterprises access credit on the same terms as the private sector. This guidance is generally applicable to state-owned enterprises as receivers of credit, but also to state-owned banks as providers of credit. In the case of China, three main guiding principles under the debt neutrality umbrella apply (Box 1).
OECD Guiding Principles on Debt Neutrality
SOEs should access finance according to “competitive conditions” and on “purely commercial grounds”. Good practices to avoid preferential treatment include:
Guarantees: The state should not give an automatic guarantee to SOE liabilities.
Equity Financing: SOEs should be encouraged to seek other sources of financing such as equity.
Credit Terms and Transparency: Grant credit on the same terms as the private sector. If better terms are given, adjust the cost advantages. There should be fair practices with regard to the disclosure and remuneration of state guarantees.
Debt Neutrality through Eliminating Guarantees
12. Dismantling implicit guarantees would require careful sequencing of reforms. Implicit guarantees have biased credit to SOEs by lowering the cost of capital and shielding SOEs from defaults. Unwinding these guarantees, however, should only occur after appropriate conditions are in place including: accepting more defaults through hardened SOEs budget constraints, rationalizing and phasing out implicit subsidies; and implementing a comprehensive system-wide plan with legal and institutional insolvency frameworks for exiting zombie firms and restructuring viable firms (Daniel et. al., 2016). Equally important would be to internalize that nonviable firms should not be in operation only to reach employment and growth targets.
13. Removing implicit guarantees to SOEs would have spillovers on the fiscal sector. Exit of local SOEs zombies will have fiscal implications for local governments that rely on local SOEs for economic and social spending, raising the need to address the gap between local government revenue and expenditures. Comprehensive reform of the social safety net will help soften the impact of exiting zombies on local employment. Reforming the “hukou” for greater labor mobility can also help. Opening more sectors to POEs can also support employment.
14. The removal of implicit guarantees can also adversely affect the financial sector in the near term. Any change to the perception on guarantees could lead to a sudden repricing of risk and disruptive withdrawals—such as by retail investors from investment products exposed to SOEs. Even a gradual reevaluation of expected returns, including the possibility of retail investors taking principal losses, may create uncertainty and trigger capital flight. To address these risks, the financial sector will need to be reinforced to remain resilient (IMF, 2017). To prepare banks for the removal of implicit guarantees, risk weights could be increased on loans to corporates that currently receive implicit guarantees, to mitigate the underpriced risk to the banks. Additional options include building liquidity buffers, strengthening oversight, reducing reliance on short-term funding to reduce risks from creditor runs.
Sequencing of Reforms for Dismantling Implicit Guarantees
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: IMF staff.Sequencing of Reforms for Dismantling Implicit Guarantees
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: IMF staff.Sequencing of Reforms for Dismantling Implicit Guarantees
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: IMF staff.15. The authorities have already embarked on policies that can support an orderly removal of implicit guarantees. For example, the authorities have taken steps for the exit of zombie firms and are planning to review the Enterprise Bankruptcy Law. The results so far are uneven and concerted efforts are needed to put all the components together, including:
System-wide Plan for Restructuring and Exit of Local Zombies. While the authorities have been successful in supporting the exit of central SOE zombies, they have not addressed the issue of local SOE zombies where few firms have been restructured on a market basis. To make further progress, a comprehensive system-wide plan is necessary (Daniel et.al, 2016; Wojciech et.al, 2016; Lam et.al, 2017), which includes:
Assessing the viability of distressed local firms; restructuring the viable and liquidating the nonviable.
Requiring banks to proactively recognize and workout NPLs;
Burden sharing among banks, corporates, institutional investors, and the government; and
Developing distressed debt markets.
Market-based Debt-Equity Swap. This has been used for SOE reform since 2016 but with limited application3 despite the authorities’ supportive policies including RRR cuts to provide funding for swaps and lowering banks’ risk weights. Improving the effectiveness of debt-equity swap would need:
Greater emphasis on strict solvency and viability eligibility criteria;
A more proactive approach of banks in their role as new equity holders to support restructuring;
Limits in scope and time to bank ownership of equity to reduce conflict of interest and improve incentives; and Conversion at fair value, with recognition of losses.
“TEMASEK-style” Reforms. Restructurings of firms have not been entirely market-based in China with restructurings done through mixed ownership between public and private, or mergers with stronger SOEs. Alternate methods could be a Singapore style “Temasek” where a governing body holds shares in state firms, giving the body autonomy while requiring they operate as efficiently as the private sector.
Legal Reform for Corporate Restructuring. The Enterprise Bankruptcy Law (2007) generally follows best international practices but is very concise with many gaps, leaving it subject to uneven interpretation and implementation. As a result, the law does not provide adequate guidelines for many complex problems in insolvency, a growing problem given China’s deadline to resolve “zombies” by 2020. The authorities’ initiative to form a committee in June 2019 to draft the amendments to the existing law is a welcome step. The amendments to law should focus on providing greater clarity and details on:
the scope of the law’s application,
the conditions for bankruptcy, and
bankruptcy procedures;
Furthermore, a tax neutral treatment for insolvency and debt restructuring in the law would contribute to a more efficient restructuring process. Along with reforming the law, enhancing the capacity of the judiciary to handle insolvency cases is needed. An effective application of the amended law will also help prevent unwarranted interventions in bankruptcy proceedings that could prevent the start of eligible cases.
Tolerance of Default Events. Despite the recent increase in the number of SOEs defaults in the last quarter of 2018, the total default rate compared to POEs remains small. To strengthen market discipline, defaults, if they occur, should be tolerated. Only through market-based defaults and resolution would investors start to properly price credit risks without the influence of implicit guarantees and the government would be able to establish a reputation for allowing market forces to work.
Dividend Payout Policy: The authorities have directed central SOEs to increase their dividend transfer to the fiscal budget to 30 percent of profits by 2020. Dividends as a share of profits have declined from their peak in 2015 to around 7 percent in 2018, highlighting that more effort is needed to harden the budget constraints. These funds should also be channeled to the general budget rather than transferred to weaker SOEs to enhance corporate discipline (Lardy, 2012).
Rationalization of Subsidies: The authorities have been successful in gradually reducing subsidies since 2015 for both SOEs and POEs. However, more needs to be done as SOEs receive relatively more subsidies than POEs who are typically smaller is size which can lead to market distortions competitive neutrality principles. Moreover, even with subsidies, a quarter of SOEs in 2015 remained loss making, possibly because they received subsidies to continue their support of government policies (Lardy, 2019).
Number of Zombies: Legal Entities of Central SOEs
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Wind database; CEIC Ltd; and IMF staff calculations.Number of Zombies: Legal Entities of Central SOEs
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Wind database; CEIC Ltd; and IMF staff calculations.Number of Zombies: Legal Entities of Central SOEs
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: Wind database; CEIC Ltd; and IMF staff calculations.
Dividend Paid to Government by Central SOEs
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: CEIC, MoF, and IMF staff calculations.Dividend Paid to Government by Central SOEs
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: CEIC, MoF, and IMF staff calculations.Dividend Paid to Government by Central SOEs
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Sources: CEIC, MoF, and IMF staff calculations.
Government Subsidies to Listed Companies
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: WIND.Government Subsidies to Listed Companies
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: WIND.Government Subsidies to Listed Companies
Citation: IMF Staff Country Reports 2019, 274; 10.5089/9781513511252.002.A003
Source: WIND.Removing the Debt Bias to Promote Equity Financing
16. With SOEs receiving preferential treatment in credit/debt markets, other sources of financing such as equity could help level the playing field. While both SOEs and POEs can benefit from access to alternate sources of financing, improving the conditions for equity financing can help POEs who rely more on equity financing. A possible step could be an Allowance for Corporate Equity (ACE) which provides an income tax deduction for a “normal” rate of return on equity, a measure which has been used by other countries such as Belgium (2006), Italy (2012), Cyprus (2015), Portugal (2010–13), and Turkey (2015) to minimize the debt bias. The implementation of ACE should be accompanied by measures to mitigate the impact on tax collection for the government.
Paying the Cost of Implicit Guarantees
17. Debt neutrality requires that all corporates be given credit on the same terms, and cost advantages be adjusted if any corporate receives benefits. Ensuring that corporates adjust cost advantages requires transparency on practices with regard to the disclosure and remuneration of state guarantees. Several countries have successfully implemented this principle (box 2). In China, one way would be to require corporates that receive such implicit advantages to explicitly pay the cost to the budget; this would be in addition to the standard targeted transfer of SOE profits to the fiscal budget. However, it can be difficult to accurately estimate these advantages, especially when the guarantees are implicit and pervasive as in China.
18. In the absence of the first best option where the corporates pay the implicit guarantees, increasing banks’ risk weights on corporate loans that receive implicit guarantees can correct the underpricing risks to the banks. Alternatively, SOEs that fail to meet the dividend payout target of 30 percent of profits could be penalized, such as by reducing their access to loans or increasing their credit spreads.
International Experience: SOEs Pay Cost of Guarantees to Budget
Australia: Any cost advantages associated with public ownership can be adjusted through a debt neutrality payment to the Office of Public Accounts.
New Zealand: Loan documentation from SOEs are required to have an explicit disclaimer making clear that the government does not guarantee repayment of debt.
Spain: Payments are made to the Treasury taking into account the costs associated with advantages from public ownership (e.g., debt, guarantees, safeguards).
Switzerland: SOEs (for example the postal service) pays dividend to the government as reimbursement for lower interest rate.
Turkey: The government levies a guarantee fee for government guaranteed loans. Source: OECD, 2012, Competitive Neutrality: National Practices
Regulatory Neutrality in Financing
19. Applying the same financial regulations between SOEs and POEs can help level the financial playing field (box 3).
Prudential Tools. Prudential tools can be used to level the playing field by applying the same regulatory policies to all corporates. In this context, bank exposure limits can be equally applied to SOEs and POEs, but this may take time as bank have large exposures to SOEs. A possible way forward in the near-term would be to put caps on bank lending to SOEs with large exposure and gradually increase the cap over time to the same limits that apply to POEs (large and related party limits). Increasing sectoral risk weights can also address credit misallocation by making it costlier to lend to overleveraged sectors, often dominated by SOEs. To improve SME’s access to financing several policy options are available (see section D) which are preferable to lowering risk weights for SMEs or expanding public credit guarantees.
Transparency in Application of Regulations. Large state-owned banks can also disclose their policies and practices in providing financial and other services to enterprises of different ownership types.
OECD Guiding Principles on Regulatory Neutrality in Financing
To maintain competitive neutrality, government business should operate, to the extent feasible, in the same regulatory environment as private enterprises
Government-controlled financial sector activities are often identified as an area where state-owned business may sometimes be subject to a lighter regulatory approach.
Financial Regulation should be applied in a consistent, “functionally equivalent” manner (i.e., neutral from a product, institutional, sectoral, and market perspectives) so that similar risks are treated equivalently by regulation.
C. Measures to Enhance Access to Finance by Private Enterprises
20. Structural measures can help level the playing field and improve the allocation of credit.
Reduce Barriers to Entry: Giving all corporates free entry into all sectors can help level the playing field. The authorities have recently announced opening up the financial sector, elderly care, education and health care to the private sector. This is a welcome step and could be extended to state-dominated services sector such as logistics, and telecommunications. Breaking up administrative monopolies can also enhance private sector entry, for example by ensuring under the Company Law no government entity may use industrial policies or regulations to restrict the access by POEs.
Elimination of Targeted Lending: The authorities have announced several quantitative targets to allocate credit towards the private sector at lower cost. These include increasing loans to SMEs by large state-owned banks by 30 percent and using multiple policy tools to lower the financing cost of SMEs by 1 percentage point. In addition, the authorities announced the “1–2-5” policy goal to improve credit allocation to the private sector (at least 1/3 of new corporate loans from large banks to be extended to private firms; at least 2/3 of new loans to be extended from small and medium size banks; and at least 50 percent of all new corporate credit across the banking system to be extended to the private sector over the next three years). To improve credit allocation, credit should be channeled in a market-oriented manner towards highly productive industries, while avoiding moral suasion to reach allocated targets. In particular for SMEs, some policies include:
Using state-owned/development banks to expand credit to SMEs based on clear mandates, sound governance, clear performance criteria, risk-based loan pricing, and qualified staff, etc.
Developing specific capital markets targeted at SMEs (e.g., Korea has KONEX securities exchange platform for SME’s direct financing).
Lowering Ratings Threshold for Bond Issuance. In terms of issuance procedures, all credit bonds (excluding private placement) require minimum ratings, such as AA or A–, or in some cases AAA. Regulators can strike a better balance in risk sharing between investors and bond issuers by lowering the regulatory threshold for bond issuance which would encourage more issuance by smaller private firms, while allowing bonds to default and investors to bear the risks.
Harmonizing regulations of credit bond schemes. Although there is no prohibition on issuing bonds, for historical reasons SOEs and POEs have mostly issued specific types of bonds. China’s credit bond market is segmented, with different regulators, issuance procedures, trading platforms, and depositories (Schipke et. al., 2019). Harmonizing the regulation of the different bond schemes would be an important step forward to reduce segmentation and regulatory arbitrage, increase liquidity, and foster price discovery.
Uniform Application of Laws. The Commercial Bank Law does not differentiate corporates based on ownership. Although the same law applies, bank officers are often more reluctant to lend to private enterprises because of the higher probability of defaults as opposed to SOEs which are perceived to be less risky. To address this bias, the Commercial Bank Law can protect bank staff who have exercised proper due diligence when extending a loan, by dropping the “lifelong accountability” to bank staff for a loan default by a private enterprise if a proper due diligence has been followed.
D. Creating a Conducive Environment for Lending
21. In general, strengthening the credit culture in China can benefit all corporates, especially SMEs. Measures here include:
Credit Culture beyond Collateral. As in many countries, SMEs in China usually do not have sufficient fixed asset collateral for bank loans. Policies to expand access to credit include:
Fostering the use of movable collateral (such as machinery and accounts receivables) as well as leasing and factoring through NBFIs for SME financing. This may require amending or formulating a new law on security interest.
Expanding risk-based lending to SMEs based on potential profitability rather than collateral.
Improving credit reporting mechanisms such as credit bureaus (CB) and public credit registries – for example, a specialized CB could be introduced to run credit ratings for “small enterprises.” The specialized CBs can leverage different source of credit information (e.g., credit card sales slip, telephone/electricity bills, online shopping, various commercial transactions, information from fintech lenders) for SMEs without collateral or guarantee.
More Accurate Credit Ratings. Better allocation of credit by ownership can be achieved through more accurate credit ratings. In China, over 90 percent of onshore bonds are rated AA to AAA by local rating agencies. This partly reflects the stringent regulatory threshold for issuance requirements, but also the nascent rating industry, which needs further improvement to provide more informative ratings. The recent approval of S&P Global Inc. to provide credit-rating services is a welcome development. Improving domestic ratings agencies and encouraging operations of more foreign ratings agencies will strengthen the credit ratings sector in China.
Credit Bureau/Registry. A properly designed credit bureau/ registry can strengthen bank supervision and improve the quality of credit analysis by financial institutions. China has one public credit registry, which covers credit history from the banking sector. Licenses have been granted to eight institutions to establish credit bureaus focusing on new types of financing (P2P, etc.), but progress is limited. An agreement to share key data by the public and the private credit bureaus/registry can ensure consistency of information as well as provide information on wider credit instruments. China can also strengthen supervision and regulation on credit registry agency (CRAs) by:
Enhancing disclosure to improve the comparability of ratings among CRAs;
Strengthening assessment of CRAs focusing on adequacy/consistency of rating methodologies and timeliness of rating adjustment;
Requiring more enhanced internal control to avoid conflicts of interests between issuers and agencies; strengthening enforcement actions of supervisors, etc.
Data Quality and Availability. Accurate, high-quality data is needed to guide proper credit allocation and policies. For example, a breakdown on credit by corporate ownership and information on subsidies and guarantees are limited.
E. Concluding Remarks
22. Measures to reduce corporate leverage should continue and focus on improving the allocation credit to POEs, especially the SMEs. The way forward would be to push ahead with high-quality reforms but in a sequential manner, under the mandate of competitive neutrality. Principles of debt and regulatory neutrality can be established to eliminate market distortions and promote a more efficient allocation of credit. Proactive, market-friendly measures can be also be taken to support SMEs to level the playing field. All policies should be market-oriented, to ensure a more efficient allocation of resources.
References
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Annex I. Authorities’ Major Initiatives to Channel Credit to the Private Sector in 2018 to 2019 Q2
| Policies | Measures Adopted or Announced |
|---|---|
| Monetary Policy (PBC) |
|
| Effective May 15, 2019 RRR cut for small and medium-sized banks up to 3.5 ppt to 8 percent. | |
| Other Measures taken by PBC |
|
| Fiscal Policy (MoF) |
|
| Regulatory Policy (PBC, CBIRC, MoF, SASAC) |
|
| Competitive Neutrality |
|
| Policies | Measures Adopted or Announced |
|---|---|
| Monetary Policy (PBC) |
|
| Effective May 15, 2019 RRR cut for small and medium-sized banks up to 3.5 ppt to 8 percent. | |
| Other Measures taken by PBC |
|
| Fiscal Policy (MoF) |
|
| Regulatory Policy (PBC, CBIRC, MoF, SASAC) |
|
| Competitive Neutrality |
|
Prepared by Sarwat Jahan (lead), Mario Catalan, Emilia Jurzyk, Simon Paroutzoglou, and Longmei Zhang. This note covers the reforms that directly impact corporate credit allocation, which are complementary to broader SOEs reforms.
The sample covers bonds traded on the exchange market. The regression may not capture other characteristics of SOEs for example age of firms, risk aversion, or social responsibilities.
By Nov 2018, 226 agreements amounting to RMB 1.8 trillion had been signed. However, only 25 percent was delivered.
