China reforms stall at crossroads
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A number of issues are coming to a head in China's corporate sector, which require the government to make tough decisions about how much freedom to allow the markets and private business. There's a risk that policymakers will duck the issues, leaving the economy to drift.
There are three notable developments in China's corporate sector at the moment which, in our view, investors should monitor closely as a guide to the short-term direction of the economy and the government's reform agenda.
Two involve the state-owned enterprise (SOE) sector--a default on bond payments by a steel maker, and the potential merger between two energy companies.
The third concerns a rise in leverage among listed companies which appears to be both alarming and puzzling--alarming because of the rate of the increase, and puzzling because it's happening against a background of weak domestic demand and industrial production.
Our research suggests these developments, while not necessarily closely related, have factors in common which point to the risk of China's economy entering an extended period of drift and muddle-through.
Dongbei Special Steel (DSS), a steel maker majority-owned by the Liaoning provincial government, recently defaulted on a RMB 64.4 million (US$9.6 million) interest payment on a privately-placed RMB 870 million bond issue.
Such events in themselves are no longer unusual in China. Since 2014, there have been 18 notable defaults in the public market; of these, seven--all of them involving privately-owned companies--have made a full recovery, while none of the SOE defaults has been resolved to date.
DSS is a serial offender--at the time of writing, the company has defaulted on seven outstanding bonds totalling RMB 4.8 billion in principal, including RMB 800 million of three-month commercial paper issued in January (it has about RMB 7.7 billion worth of bonds on issue in the public market).
In this case, however, something unusual has happened--bondholders, frustrated by the lack of response from the Liaoning government, have called on regulators to suspend fundraising by the government and all corporates in the province, and on institutional investors to boycott further purchases of their debt, as a way of putting pressure on the provincial government to bail out DSS.
Bondholders' difficulties are compounded by China's lack of a clear debt resolution process and the fact the Liaoning government is in no position to fund a bailout.
This presents the central government with a dilemma: Should it help the provincial government to rescue the company, or should it allow DSS to fail?
The first choice would raise the moral hazard of "too big to fail" to a new level, encouraging other SOEs to take risks that would be shunned by companies which had no recourse to government support in the event of a crisis.
It would also undermine the credibility of the government's supply-side reforms, which aim to make the economy more responsive to market forces.
Allowing DSS to fail, however, could spark risk aversion on the part of investors which, in turn, could lead to a liquidity squeeze and exacerbate the country's economic problems.
In light of these undesirable alternatives, the government may choose to do nothing--and this is one instance where we see the potential for policy indecisiveness to increase the risk of economic drift.
Also in the SOE sector, Bloomberg reported that Shenhua Group, China's biggest coal power company, is seeking a US$204 billion merger with China General Nuclear Power.
Like corporate defaults, SOE mergers are something of a trend in China.
So far this year, mining company Minmetals has merged with infrastructure and mining construction group Metallurgical Corp of China; China National Building Material has paired with Sinoma, parent of China National Materials Group, and there have been tie-ups between Baosteel and Wuhan Iron and Steel, building materials supplier BBMG and Jidong Cement Co, and food company COFCO and textile and grains trading group Chinatex.
Business logic has played little part in these mergers, all or most of which have been at the behest of Beijing.
The best explanation appears to be that they are driven by the government's stated objective, as part of its supply-side reforms, to halve the 112 SOEs it owns directly and entirely.
This is not how most market commentators expected the reforms to be implemented, however.
Instead of reducing the SOEs' economic dominance by redistributing their resources to the private sector, letting weaker ones fail and keeping ownership of strategically important entities, the government appears merely to be conducting a crude mathematical rationalisation of the sector with no view to broader reforms.
Such an approach appears to be consistent with President Xi's recent statement that he wanted to make the state sector "stronger and better," and to bring it under tighter control by the Communist Party.
From an investment perspective, this raises serious questions as to how successful such a strategy can be, given that SOEs' inefficiency is one of the economy's most deeply-rooted problems.
We expect the economic unworkability of this approach will become apparent in time, perhaps when China faces the prospect of recession or a financial crisis.
The question will then be how quickly the reform process can be revived, if the SOE sector is under the Party's control.
In the absence of popular pressure for change, it's possible that the Party will opt to maintain the status quo--and increase the risk of the economy lapsing into drift and muddle-through.
Cashed up and ambiguous
Against this background, the build-up of leverage among China's listed companies appears to make little sense.
After all, why borrow money when the economy appears to offer little incentive to invest in productive enterprise?
On closer inspection, however, the rise in leverage appears to be driven by other considerations.
Rather than borrowing money to boost capital expenditure on fixed assets, companies are hoarding the proceeds as cash or investing in financial instruments.
At the end of the first quarter of this year, for example, listed companies held around RMB 6 trillion in cash and other investments, an increase of RMB 1 trillion over the previous corresponding period and enough to pay back 60 per cent of their total balance-sheet debt.
At the very least, this is ambiguous--the increase in leverage may reflect some optimism on the part of business owners, who wish to be ready to take advantage of opportunities as they arise; at the same time, the parking of loan proceeds in cash or financial instruments suggest some uncertainty on their part about the economy's short-term prospects.
The question is: To what extent will such fence-sitting add to the risk of economic drift that we have noted in other areas of the economy?
Policy risk is acute
We have always maintained that policy risk is one of the biggest uncertainties that China faces in its historic transition from an economy driven largely by investment, manufacturing and exports to one in which consumption and services play a greater role.
Now, as the country's slowdown weighs increasingly on the government's ability to implement reforms, that risk has become acute.
China's policy makers are at a crossroads and seem reluctant to move forward.
Instead of acting in the case of DSS, for example, and modernising and clarifying the laws relating to corporate solvency (and perhaps allowing some companies to fail), they appear to be biding their time; instead of opening the SOE sector to private enterprise, they appear to be rationalising it and bringing it further under Party control.
All this spells uncertainty for investors, and the longer such uncertainty lasts the greater the risks will become.
This applies to cashed-up Chinese companies as much as to global bond buyers--it may be only a matter of time, for example, before China's policy inertia and its companies' investment in financial instruments creates a dangerous combination of low economic growth and financial volatility.
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Brad Gibson is a portfolio manager, Asia-Pacific fixed income, Jenny Zeng is a portfolio manager, Asian credit, and Anthony Chan is an Asian sovereign strategist, at AllianceBernstein. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind.
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