China’s capital-intensive firms struggle to manage the new world of slower growth
There is much debate over the implications of rebalancing on China’s industrial sector. Over the past 11 years, the profit growth of industrial companies – one of the main benefactors of China’s investment growth model – averaged 33.3 percent compared with only an average of 15.3 percent growth in liabilities, allowing them to pay off their heavy debt burdens.
Now this is beginning to change. Industrial profit growth has moved from a relative low of 15.7 percent last year to negative this year, declining by 1.8 percent in the first nine months of the year.
Further a major concern with slower profits is whether the debt servicing capacity of these industrial firms will be reduced potentially leading to industrial sector bankruptcies and thus rising non-performing loans in the financial system. Policymakers are watching this dynamic closely as they seek to fine tune the speed of investment growth to meet the needs of a rebalancing agenda.
Earlier this year Li Yang, vice-president of the Chinese Academy of Social Sciences warned that the debt ratio of Chinese companies is relatively high among the world’s major countries.
His fear appears to be warranted. The overall debt burden of China’s non-financial corporate sector is high and growing. Total non-financial corporate debt to GDP (as measured by outstanding non-financial enterprise loans and outstanding corporate debt) reached 98 percent of GDP in 2010 up from 82 percent in 2008. Taking a more detailed view at the balance sheets of above-scale industrial and those service sector enterprises with comparable data available (wholesale, retail, catering, and real estate) corporate liabilities experience rapid growth after 2008, rising by 21.2 percent over the last 4 years compared with an 11 year average of 16.4 percent.
Such high debt levels could contribute to slower growth in China. A BIS study on the “real effects of debt” (Cecchetti, Mohanty, and Zompolli 2011), found that non-financial corporate debt levels above 90 percent of GDP growth would make borrowers more sensitive to changes in income and interest rates, increasing financial fragility, and as a result reduce average economic growth. This would suggest if China’s investment growth slows further there could be rise in the number of defaults among industrial firms.
The enterprises worst affected by slowing investment growth so far are enterprises in capital intensive sectors– namely real estate developers, ferrous and non-ferrous metals smelting, chemical fiber producers, refiners, and power producers. They have liabilities representing some 71 percent of GDP in 2011, while they are also some of the worst performers in terms of efficiency. Since the late 1990s the return on assets (ROA) of all industrial and selected service sector firms (a good indicator of efficiency) has improved dramatically, rising from 1.3 percent in 1998 to 9.1 percent, while, the above-mentioned capital-intensive sectors have been left in the dust only reaching 3.3 percent on average in 2011.
More importantly, this group is also showing the greatest deterioration in their balance sheets– reversing a trend of overall improvement since the late 1990s. The liabilities-to-asset ratio for selected capital-intensive sectors have risen from 67.9 percent in 2008 to 71.6 percent in 2011, compared with a ratio of 55.2 percent for all other industrial and selected service sector companies in 2011.
Yet some growing pains in an adjustment to slower growth are to be expected, and certainly does not prove that a massive string of defaults is inevitable. In spite of a trend reversal in improving ROA and liabilities-to-asset in recent years, many industrial and service sector firms are still performing much better than the late 1990s.
In particular, debt servicing costs for industrial firms have fallen considerably since the days where 47.4 percent of operating profit before depreciation and amortization (revenue net cost of goods sold, distribution fees, and administrative costs) were devoted to interest payments. Even with the recent bump up in debt servicing costs to 13.4 percent as of September of this year, in comparison to the 1990s firms are still holding on to more than three times as much operating profit before depreciation and amortization.
In spite of these improvements, it is clear that high corporate debt levels will make China’s task of rebalancing more complicated. Many companies will need to apply all they have learnt from efficiency gains during China’s golden growth period, in a new more challenging era of slower growth. Much will also depend on the ability of policymakers to manage the pace of China’s rebalancing to avoid increasing the stress levels for industrial and service sector firms still dependent on investment-led growth. So far the leadership appears to have done an effective job stabilizing the slowdown in investment growth this year but this is only the beginning, affected sectors will need to be watched closely to see how debt levels are managed over the medium-term.