China’s Slow Recovery from Debt Hangover Begins
Growth in the country’s corporate debt load has finally leveled off this year as financial conditions and regulatory oversight tighten. That’s good. But rebounding returns on incremental assets and common equity are even better.
After recently warning about a potential “Minsky moment“, China’s central bank chief has fired another shot across the bow of debt markets in the world’s second-largest economy.
Rising debt levels are generating growing risks, some of which are “hidden, complex, sudden, contagious and hazardous,” People’s Bank of China’s Zhou Xiaochuan wrote in an article published on the monetary authority’s website. As China’s total debt nears $30 trillion, or close to 270% of gross domestic product, Zhou’s latest admonition adds to a chorus of concerns ranging from the International Monetary Fund’s August alert on China’s “dangerous” level of debt to S&P’s September downgrade of its sovereign credit rating to A+ from AA- and downward revision in the country’s outlook to negative from stable. Moody’s slashed its sovereign rating on China in May to A1 from Aa3.
The clarion calls on the Middle Kingdom’s growth in total debt are well founded. China’s corporate debt pile has leveled off this year at more than 160% of GDP, up from less than 100% of GDP shortly before the Global Financial Crisis. But an interesting and important shift in the productivity of the debt appears to be taking place. The return on incremental assets has started to rise after six straight years of decline, according to research from AllianceBernstein.
“The unmistakable fact is that China is doing a lot less dumb stuff today than two or certainly five years ago,” said Michael Parker, Bernstein’s strategy head for Asia Pacific. “The capital allocation process is smarter, the utilization on the hard assets that were built is rising, and we are seeing an increasing number of China technology and consumer discretionary stocks with real management teams, balance sheets and competitive moats. The hangover from the structural slowdown in the industrial economy might just be ending.”
Another telling sign, Parker points out, is the number of large- or mega-capitalization Chinese or China-focused Hong Kong-listed stocks with sustained return on equity ratios of more than 10%. Their number has jumped from just two (Tencent and Baidu) in 2014 to 13 by July of this year. While most are information technology or consumer discretionary stocks, a broader upturn in profits generated from each dollar of shareholder equity can also be seen in the Shanghai Stock Exchange Composite Index, which is dominated by China’s generally debt-heavy, state-owned enterprises (SOEs).
To be sure, the growth in China’s non-financial corporate debt entails clear risks. Some SOEs and government officials attempt to downplay them, arguing they are mitigated by corporate assets. But as BCA Research points out in a November report, “if a company’s assets do not generate sufficient cash flow to service debt, the value of these assets will be low.” Moreover, assets of Chinese SOEs, “where most of the debt is concentrated, cannot be taken at face value,” BCA notes.
That realization may be reflected in China’s increasing corporate bond yields. Local money market rates have also been on the rise. Meanwhile, Beijing’s continuing anti-corruption campaign has invigorated banking regulators, who are intensifying their oversight of loan growth and credit quality. The upshot is that new credit origination and fixed investment better have well-founded and reasonable return profiles.
The tide in China’s rising corporate debt may be turning. Zhou’s warnings, like those of the IMF and the credit rating agencies, appear to be resonating with tightening credit conditions. Investors in Chinese stocks should not only be highly selective and discriminating, but encouraged that returns on invested capital and common equity are starting, finally, to take priority over China’s fading debt-fueled growth model.