China liberalises but fails on disciplines: IMF

CHINA’s reforms have done more to liberalise economic activity —
creating markets and freedom to compete -— than to impose disciplines and hard budget constraints on borrowers, warns the IMF’s David
Lipton . . .

AS DAVID LIPTON sees it, China’s corporate indebtedness is a key fault line in the Chinese economy. Lipton, First Deputy Managing Director of the International Monetary Fund, says it is surely within China’s power to address this problem, but the question is how best to do this.
Overall, China’s total debt is equal to about 225 per cent of GDP. Of that, Government debt represents about 40 per cent of GDP while households also account for about 40 per cent. Both figures are not particularly high by international standards. “But China’s corporate debt is a different matter,” Lipton says. “About 145 per cent of GDP is very high, by any measure,” he told a Chinese Economist Society conference at Peking University Shenzhen Graduate School in Shenzhen.
IMF calculations show that State-owned enterprises (SOEs) account for about 55 per cent of corporate debt — far greater than their 22 per cent share of economic output,” he said.
“These corporates are also far less profitable than private enterprises. In a setting of slower economic growth, the combination of declining earnings and rising indebtedness is undermining the ability of companies to pay suppliers, or to service their debts.”
Banks are holding an increasing volume of nonperforming loans (NPLs). The past year’s credit boom is just extending the problem, and already, many SOEs are
essentially on life support, according to Lipton.
The IMF’s most recent Global Financial Stability Report estimates that potential losses for Chinese banks’ corporate loan portfolios could be equal to about 7.0 per cent of GDP.
Lipton says this estimate is conservative
because it excludes potential problem exposures in the “shadow banking” sector.
The Government is rolling out a reform plan for State-owned enterprises calling for capacity reduction targets in the coal and steel sectors.
Lipton spoke of international experience in dealing with corporate indebtedness. He said Beijing’s first lesson is to act quickly. “The Government clearly recognises the need to address the issue,” he said, referring to recent comments made by unnamed Chinese officials.
China, he said, would require a regulatory framework backed by technical expertise for assessment and mediation to deal with the problem. “In other words, the process has to be led by business judgment, not political favour.”
He stressed that only viable firms should be saved, saying insolvent ones should be cut loose immediately and allowed to die.
“Corporate restructuring requires an enforcement regime that enables creditors to enforce their claims in a predictable, equitable and transparent manner,” he said.
“This likely will call for both carrots and sticks to enforce payment discipline. Also, banks must always be prudent in recognising losses, and ensure that they have adequate loss-absorbing capacity.”
Lipton cited the workout of firms across the region following the 1997-98 crisis.
The Governments of Indonesia, Korea,
Malaysia, and Thailand supported the restructuring process, but that process essentially took place out of court. In some countries, he said, debt-to-equity conversion played a role. By converting debt to equity, a firm’s financial structure was deleveraged and banks’ claims were realigned accordingly. China is encouraging conversion of debt to equity in sectors such as the all-important real estate industry.
Lipton warned that this approach only works if two conditions are fulfilled.
First, he said, banks need to be able to assert creditor rights and to conduct a triage, distinguishing non-viable firms that need to restructure or shut down. Second, banks need the capability to either manage their equity and assert shareholder rights, or the capability to sell equity to investors who can.
The downside of this approach could be the weakening of the banking system itself. Lipton recalled that, in Indonesia, the banks themselves had to enter the restructuring process, requiring recapitalisation. He said creation of public asset management companies to resolve NPLs needed to be seen as “a workout house” and not “a warehouse for bad loans”.
Lipton added that good governance is also critical to ensure success in restructuring. “If a country doesn’t address governance issues at the heart of a debt problem, then that problem will inevitably recur.
“Look at China’s experience. Early in this century the Government relieved the big banks of their legacy of State-owned enterprise NPLs. But here we are again, talking about the threat posed by SOE indebtedness.”
He said that while the large economies
injected liquidity into their financial system following the global financial crisis, they also brought in legislation to ensure that the same mistakes would not be repeated in future.
In the US, said Lipton, the Dodd-Frank legislation helped strengthen Government oversight of financial institutions. In Europe, key steps toward banking union are well advanced, though there is more to do there to strengthen banks.
“China’s reforms over the past several decades have been sweeping and widespread. But these reforms have done more to liberalise economic activity, creating markets and freedom to compete, than to impose disciplines and hard budget constraints on borrowers.
“In short, to shore up governance, the lesson that China needs to internalise — if it is to avoid a repeating cycle of credit growth,
indebtedness, and corporate restructuring  —  is to improve corporate governance.”
But governance is not just a matter of laws on the books, he said. It is also about how laws and regulations are implemented. It is the impartiality that transcends special interests and connections.
In a system with State-owned enterprises, proper governance also becomes a matter of making companies live within their means and ending Government subsidies, including by enforcing hard budget constraints, he said.
As the restructuring process moves forward, it is perhaps too easy to lump together all SOEs. Rather, it is important to distinguish between well run and badly run companies, he added.
“Debt can help fuel a well-run business. So it is essential to know what companies are doing with debt: Are they papering over losses? Building capacity that adds to a global surplus? What is their exposure to shadow banking products?” He acknowledged that SOE restructuring also comes with significant social implications.
“The days of China’s iron rice bowl are gone, but there is still an obligation to ensure that rice bowls are full,” Lipton said. “In this regard, it is important to note the Government’s RMB100 billion restructuring fund to absorb the expected welfare costs for an expected 1.8 million affected workers.”
Lipton warned against the temptation of merging weaker with financially strong companies so as not to undermine the profitability of the well-to-do companies.
“To sum up, China faces an extraordinary set of challenges,” he said, adding, however, that China has demonstrated an extraordinary
capacity to adapt and evolve over the past generation.