China must act urgently to deal with the threat that the surge in its debt levels to 240% of GDP could trigger a crisis in its financial system, a leading credit expert has told Emerging Markets.
Christopher Lee, Standard & Poor’s chief ratings officer of corporate ratings for Greater China, said that China might have already reached a tipping point and must start manage its debt effectively or risk impacting the bond markets.
Chinese debt reached 240% of GDP this year, a dangerously high level that could only be reduced by growth, or a radical reform of its SOE sector, he said yesterday/on Monday.
“We are at a point where policy makers need to be decisive,” he said. “We’ve already seen several large defaults and it’s only a matter of time before onshore shocks start to impact the offshore bond market.”
“High debt leverage severely limits demand as corporate cut investments,” he said. “Slowing growth in the Chinese corporate sector will increase exports such as steel and aluminium and reduce imports of iron ore and coal, thus impacting global growth.”
In order to alleviate credit growth and reduce the likelihood of a hard landing, China has three options, according to Lee.
First, corporate China could grow out of the problem but with growth set to slow to 6% by the International Monetary Fund in 2017, there is little optimism that it will relieve the pressure, he said.
Second, the government’s proposed debt-equity swap programme could be rolled out across other sectors. China has touted the swap as a solution for its most troubled sectors — steel and coal — but the proposal is lacking in vital details such as which companies will qualify and how the proposal should be implemented.
NON-PERFORMING LOANS
In addition, Lee notes the systemic risk to banks that are essentially being asked to act as a buffer for the sector. “The problem may be that in some cases, the government is proposing to throw good money after bad,” he said.
“The banks are being asked to convert loans into equity, hold this on the balance sheet for a few years and then exit. If the company has no growth or recovery prospects, this may be a problem.”
The best solution, he says, was also the most painful one — China must instigate consolidation in the SOE sector.
What makes China’s debt burden so dangerous is the extent to which it is made up of non-performing loans or loans to unproductive businesses. “Those with no prospects for recover should be closed, otherwise the Government is only prolonging the pain and throwing good money after bad,” said Lee.
Coupon defaults by Shanxi Huayu Energy and Dongbei Special Steel Group, both SOEs, since the end of March have spooked investors. S&P expects the number of defaults to reach double figures this year. However, no Chinese SOE issuer has defaulted on offshore dollar denominated debt, yet.
Any spillover from the onshore markets could have repercussions for the wave of refinancing for dollar debt due in 2017 and 2019. That will not be a concern if the domestic market remains stable but a ripple effect into the offshore market with ensuing defaults and a crisis of investor confidence could make refinancing difficult.
“Onshore investors have been chasing yield in the offshore market and they’re looking at technical rather than credit risk,” said Lee. “An offshore default will surprise everyone. If a big company defaults, it will have a huge impact. We could likely see a reallocation of bond portfolios, higher funding cost for issuers and it could even shut the market for some time.”