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Shadow Banking Clampdown, SOE Reforms to Help China Fight Corporate Debt Risk

China's crackdown on shadow banking and move to reduce borrowings of state-owned enterprises will help tackle corporate debt concerns, analysts said.

The country has the highest corporate leverage risk among the world's largest economies, noted a February S&P Global Ratings report.

Its corporate debt has grown by 104% since end-2011 when authorities directed bank lending towards nonfinancial companies, including state-owned enterprises, or SOEs, to "achieve pre-determined macroeconomic growth targets." China aimed to grow 8% economically in 2011; it ultimately grew 9.2%, according to its National Bureau of Statistics.

By comparison, the report set out, corporate debt since end-2011 grew 36%, 8% and 14% in the U.S., U.K. and the eurozone, respectively.

China's corporate debt of US$18.9 trillion as of June 2017, S&P added, comprised 28% of the 2017 global total. The still-high leverage — that is, borrowed capital aimed at raising return on investment or finance an asset — of global corporates marks a “significant credit risk,” and a “material repricing in bond markets or faster-than-expected normalization in money market rates” could hit credit profiles and trigger the next default cycle.

Fighting Risks

To combat this, the country's government reiterated in January that it would continue to crack down on risks such as irregular lending practices and shadow banking, which exist outside of the formal banking sector and are hence less regulated. In March, China announced plans to merge its banking and insurance regulators and give the central bank a bigger role in prudential supervision, in a shake-up that aims to plug gaps in the system that have fueled financial risk.

Shadow banking has been a source of finance for companies that do not qualify for direct loans from banks, due to factors such as insufficient collateral or inadequate business performance. It includes trust lending, where companies obtain financing from banks via third party trust companies, and sales of short-term, high-yield wealth management products by banks that are then channeled as funding to companies.

According to calculations by Bloomberg Economics in January, based on data released by the central People's Bank of China, the combined outstanding volume of trust lending, entrusted loans and undiscounted banks’ acceptances — three common components of shadow banking — surged by 3.57 trillion yuan year over year to 27.8 trillion yuan in 2017. Entrusted lending occurs when companies finance one another through intermediary banks while undiscounted banks’ acceptances, or drafts, are short-term debt products.

China also released in February new measures to further reduce leverage levels at SOEs, including debt-to-equity swaps and mixed-ownership reforms, where state-approved private investment funds are allowed to invest in these companies, and improve their governance and efficiency structures. In 2017, more than 90 billion yuan of private capital was injected into SOEs, Shanghai Securities News reported in January.

SOEs were responsible for about 60% of China's corporate debt, reported the state-owned China Daily in August 2017.

According to China’s Ministry of Finance, the total liabilities of these enterprises, many of which operate in traditionally sensitive industries such as finance, utilities and energy, and telecommunications, grew 9.5% year-over-year to 99.716 trillion yuan in 2017. The data did not specify liability by type.

'In the right direction'

Analysts believe these measures are working, with China's central bank governor Zhou Xiaochuan noting as well in a March 9 press briefing that the country's leverage levels are "stabilizing and gradually falling," reported China Daily. The growth in broad money supply, for example, he noted, has fallen below nominal GDP growth.

Grace Wu, head of China banks ratings at Fitch Ratings, noted tighter regulation, such as introducing in January rules on entrusted loans for the first time, is so far helping to improve overall transparency in the banking sector. Among other things, banks have been told to separate their trust operations from their other lending businesses and to accept funds only from companies with compliant and legal funding sources.

Fitch expects the pace of credit growth to slow from prior years, she said, though the absolute decline in debt leverage is unlikely in the near future. This is because "deleveraging in shadow activities is in part substituted by migration of such credit back on to banks’ balance sheets," the Hong Kong-based Wu said in an interview.

Moreover, genuine deleveraging would hurt near-term economic growth, she added.

Meanwhile, the S&P report noted China’s efforts to curb the leverage of SOEs “should start to bear fruit.”

“As the economy rebalances more toward consumption from heavy-industry investment, household debt will likely rise faster than corporate and government sector debt,” it said.

Nathan Chow, a Hong Kong-based senior economist at DBS Bank, noted China is trying to make SOEs more efficient through the gradual use of market practices.

"The government had tried to control the default rate previously which meant [many SOEs were] under its guarantee," he said in an interview. "Now they are likely to let it rise slowly, because the absolute amount [of debt] is still very high, but things are going in the right direction."

George Xu, a credit strategy and standard analyst at Moody's, added the regulatory crackdown has hit the ability of shadow banks to supply credit to the real economy, particularly marginal corporate borrowers. Consequently, refinancing risks are rising for sectors "such as smaller property developers, local government financing vehicles, and companies from overcapacity and polluting industries."

"There is an increased likelihood that we will see rising defaults in these sectors," said the analyst, who is also based in Hong Kong.

As of March 22, US$1 was equivalent to 6.33 yuan.