China’s economic slowdown has been the subject of countless debates, discussions, articles and analyses. While proposed remedies vary considerably, there seems to be a broad consensus that the illness is structural.
However, while structural problems, from diminishing returns to capital to the rise in protectionism since the global economic crisis, are certainly acting as a drag on growth, another factor has gone largely unnoticed: the business cycle.
For decades, China’s economy sustained double-digit GDP growth, seemingly impervious to business cycles. However, it was not immune: The six-year slowdown China experienced after the 1997 Asian financial crisis was a symptom of such a cycle.
Today, China’s business cycle has led to the accumulation of nonperforming loans (NPLs) in the corporate sector, just as it did at the turn of the century. While the rate of NPLs is, according to official data, lower than 2 percent, many economists estimate that it is actually more like 3 to 5 percent. If they are right, NPLs could amount to 6 to 7 percent of China’s GDP.
Most of this debt is held by state-owned enterprises (SOEs), which account for just one-third of industrial output, yet receive more than half of the credit dispensed by China’s banks.
While the debt-equity ratio of the industrial sector as a whole has declined over the past 15 years, the number of SOEs has increased since the global financial crisis, to an average of 66 percent, 15 percentage points greater than other kinds of firms.
A looming recession undoubtedly spurred this debt accumulation, possibly aided by former Chinese premier Wen Jiabao’s (溫家寶) massive 2009 stimulus package. However, it was lax financial discipline that enabled the debt buildup. Banks feel safe lending to SOEs, no matter how indebted, because the government implicitly guarantees the debt. As a result, the SOEs, not surprisingly, have developed a habit of debt-financed growth.
That might not have been a problem when China’s economy was growing, but it represents a serious economic risk today, which is why the government has set deleveraging as one of its major tasks for this year.
However, execution has been slow, owing partly to China’s failure to fully enforce its bankruptcy law.
The fact that commercial banks are not allowed to hold shares in companies has also impeded deleveraging, as it prohibits the use of direct debt-equity swaps to reduce SOE debt. This should change.
China has employed debt-equity swaps to reduce NPLs in the state sector before. In 1999, it established four asset management companies (AMCs) to take on the weakest loans of the four largest state-owned banks, thereby improving those banks’ financial stability.
Given China’s high growth rates between 2003 and 2012, the AMCs made handsome profits from those shares.
Today, too, debt-equity swaps might be the only viable solution to the NPL problem. However, the government does not need to rely on government-owned entities to assume the debt. Instead, it should allow private equity funds, which have accumulated large savings as they await good investment opportunities, to act as AMCs, bidding for the NPLs at a discount.
Such an approach would not just address the NPL problem. By giving the private sector a stake in SOEs, it would also help to spur performance-enhancing reforms.
After all, despite their grim financial performance, many of China’s SOEs have a lot going for them, including state-of-the-art equipment, first-rate technical staff and competitive products. Their problem is bad governance and poor management — a problem that, as China’s top leaders recognized in 2013, private-sector involvement can help resolve.
Of course, there are some obstacles to introducing debt-equity swaps between the public and private sectors, beginning with concern about the loss of state assets.
Given the severity of SOEs’ debt problems — China Railway Corp alone holds 3 trillion yuan (US$449.6 billion) in debt — discounts are inevitable when SOE debt is transferred to private AMCs. This could cause some to assert that the private firms are realizing unjust gains.
In order to overcome this obstacle, China should engage in local experimentation — a tried-and-tested approach that has long guided the country’s reform efforts — beginning in regions where the SOE debt problem is the most acute.
The resulting revitalization of SOEs would also help quell any doubts about debt-equity swaps with the private sector.
Another obstacle is the fear that, by allowing SOEs, yet again, to escape market discipline, debt-equity swaps would set a dangerous precedent.
However, the improvements to corporate governance that would follow from the introduction of private shareholders would reduce substantially the likelihood that SOEs would continue to abuse the financial system. Moreover, their NPLs are essentially sunk costs; debt-equity swaps are pretty much the only way to claw back anything at all.
By allowing private-sector participation in debt-equity swaps, China could kill three birds with one stone: advance SOE deleveraging, strengthen corporate governance in the state sector and enhance economic efficiency. With local experimentation, Chinese authorities could map out that stone’s most effective trajectory.
Yao Yang is director of the China Center for Economic Research and dean of the National School of Development at Peking University in Beijing.
Copyright: Project Syndicate
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