China navigating a corporate debt trap: S&P

October 20, 2021

MELBOURNE -- S&P Global Ratings believes the troubles of Evergrande hint at credit strains simmering among Chinese corporates, and a strong resolve by the Government to tackle this issue. S&P says a survey involving 25,000-plus global entities reveals that the leverage levels of China's corporate sector are significantly above the global average. "It is a US$27 trillion problem that is increasingly getting the attention of Beijing," says S&P.

The ratings agency says China's corporates have contributed almost one-third (31%) of global corporate debt, and that China's corporate debt-to-GDP leverage ratio of 159% is one of the world's highest.

"China's corporate leverage has been a challenge for the better part of a decade. China's central government has been long aware about this. The situation is coming to a head now primarily because of the Government's policy decision to reduce financial risk, especially of speculative activity, in its economic system," says Terry Chan, a senior research fellow at S&P Global Ratings.

"China's heavy-investment economic structure underpins its high corporate leverage. Furthermore, its large manufacturing sector and international trading sector (relative to GDP) calls for sizable asset financing and trade credit, respectively.

"Easy domestic financing conditions and the government policy encouragement to fund corporate and government investment projects via credit further props up leverage."

Chan says this raises the possibility the country will be caught in a "middle-income trap", where it is unable to increase its GNP per capita above the middle-income level due to a poor transition to more productive and innovative industries.

"China's corporate debt has for well over a decade mostly grown faster than its contribution to GDP," he says.

"If China is to bring its corporate debt-to-GDP to almost the current global ratio of 101% from China's current 159%, entities would need to pay down or write down about 5% of the initial debt amount each year, on an amortising basis.

"In such a scenario, China's corporate adjusted debt-to-EBITDA could improve to the current global ratio of 3.4x, from China's current 5.3x, by 2030.

"It appears that China's Central Government is leaning toward a form of 'creative destruction'-- destroying the old to make way for the new," Chan says.

Says S&P Global Ratings credit analyst Eunice Tan: "Increasingly, we see the Government preferring more market-based solutions in resolving over-leveraged private sector firms through corporate actions, such as debt restructurings.

"It would not be the first time that the authorities have addressed less-productive debt in the system.

"The last major exercise in dealing with nonperforming loans (NPLs) was post the 1997-1998 Asian financial crisis when the Government set up four state-owned distressed asset management companies to take over NPLs worth about RMB 1.4 trillion from the major State-owned commercial banks."

Adds Chan: "In 2002, we had estimated that the actual NPLs in China's banking system could be as high as 50% of total loans. By 2012, China had managed to reduce the nonperforming asset ratio down to 1.6%.

"This is not to underestimate the size of the task. "It is going to be a long and hard journey." (ATI).