Rebalancing China: International Lessons in Corporate Debt
IMF News, June 10, 2016
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- Authors: David Lipton
- Published: June 10, 2016
Introduction
- Speech by David Lipton, First Deputy Managing Director, IMF, delivered at China Economic Society Conference On Sustainable Development in China and the World, June 11, 2016, Shenzhen, China.
- Shenzhen is used as a symbol of rapid rise and the changing economic and financial landscape in China.
- Rebalancing requires timely actions to allow the new to grow and to downsize what is outmoded or overbuilt.
- Purpose: discuss corporate debt through three themes:
- IMF view of China’s economic rebalancing effort;
- scale of the debt issue;
- strategies for addressing corporate indebtedness drawing on international experience.
Assessing Rebalancing
- Growth remains strong by any standard, with the caveat of China’s own last 25 years.
- External adjustment:
- Current account surplus down from the peak of 10 percent of GDP in 2007 to around 2-3 percent in recent years.
- Contribution of net exports fluctuating around zero.
- Last year’s surge of capital outflows has slowed; effective exchange rate broadly stable.
- Renminbi included in the Special Drawing Rights basket after IMF determined it is a freely usable currency.
- Domestic rebalancing:
- Moderate progress reorienting from investment to consumption.
- Consumption contributed about two-thirds of growth in 2015.
- Growth is driven less by heavy industry and exports and more by services and manufacturing for household consumption.
- Limited progress in addressing corporate indebtedness and restructuring despite SOE reform plans and announced capacity reduction targets in coal and steel.
- Rapid increase in credit growth in 2015 and early 2016 and continued high rates of investment have expanded the problem.
China’s Debt Problem — Key Statistics and Facts
- Overall total debt: about 225 percent of GDP.
- Government debt: about 40 percent of GDP.
- Household debt: about 40 percent of GDP.
- Corporate debt: about 145 percent of GDP.
- IMF calculation: state-owned enterprises account for about 55 percent of corporate debt while representing 22 percent share of economic output.
- Many SOEs are far less profitable than private enterprises; declining earnings plus rising indebtedness undermine debt servicing and supplier payments.
- Banks are holding increasing nonperforming loans (NPLs); recent credit boom extends the problem.
- IMF Global Financial Stability Report estimate: potential losses for Chinese banks’ corporate loan portfolios could be equal to about 7 percent of GDP (conservative estimate, excludes potential problem exposures in the “shadow banking” sector).
Lessons from International Experience — Three Broad Lessons
- First: act quickly and effectively, or the problem will worsen — company debt problems today can become systemic tomorrow, potentially leading to much lower growth or a banking crisis.
- Second: deal with both creditors and debtors — addressing only bank balance sheets or only corporate viability is insufficient; fix both sides together.
- Third: address governance problems in corporate and banking sectors that gave rise to the problem — without governance reform, debt relief is temporary and a new debt bubble can re-inflate.
Acting Quickly
- Chinese government recognizes need to address “zombie firms” and “debt overhang” (as cited from an interview in the People’s Daily with an “authoritative person”).
- Quotation: “NPLs are like ice cream cones. If you don’t get rid of them, they melt all over your hands, and you don’t have anything left to sell.” — head of Huarong Asset Management.
Deal with Creditors and Debtors — Enhanced Work-Out Framework
- Effective response often requires an “enhanced framework” led by government but relying on technical expertise for assessment and mediation; business judgment should guide the process, not political favor.
- Corporate insolvency framework should:
- facilitate rehabilitation of viable firms and speedy liquidation of nonviable ones on a company-by-company basis;
- provide an enforcement regime enabling creditors to enforce claims predictably, equitably and transparently;
- use both carrots and sticks to enforce payment discipline;
- ensure banks prudently recognize losses and have adequate loss-absorbing capacity.
- Regional precedent: Indonesia, Korea, Malaysia, and Thailand used such frameworks after the 1997-98 crisis; government support but restructuring largely out of court.
- Korea example: controlling shareholders of chaebol lost power through court-supervised and out-of-court restructuring; not bankrupted but restricted from extensive borrowing from their own banks.
Debt-Equity Conversion and Asset Management Companies
- Debt-equity conversion can deleverage firms and realign banks’ claims if two conditions hold:
- banks can assert creditor rights and triage viable vs non-viable firms;
- banks can manage equity or sell it to investors who can.
- Challenges where banks lack incentives to assert creditor rights due to cross-ownership, conflicts of interest, or political factors; government intervention may be needed.
- Banks entering restructuring may require recapitalization (as occurred in Indonesia).
- European insolvency pressures have led to legal reforms and incentivized out-of-court restructuring in countries such as Italy, Spain and Portugal, constrained by competition law.
- Public asset management companies (AMCs) have been used in many crises, including Eastern Europe and earlier Chinese NPL resolution efforts:
- An AMC should be a workout house, not a warehouse for bad loans;
- AMCs should lead to restructuring or sell assets to new owners pressing for restructuring.
- Challenges for AMCs: asset valuation difficulties, thin markets for asset sales, social and political pressures; strong governance and commercial principles are essential.
Fix It for Good — Governance Reforms
- Governance is essential to prevent recurrence: “Those who cannot remember the past are condemned to repeat it.”
- China previously relieved big banks of legacy SOE NPLs; the same pattern is repeating with SOE indebtedness.
- Governance must include:
- robust legal framework for insolvency and enforcement to create payment discipline;
- regulatory and supervisory policies promoting proper assessment and pricing of risk at individual loan level;
- robust accounting, loan classification, loan loss provisioning, and disclosure rules;
- avoidance of moral hazard.
- Implementation matters: impartial enforcement transcending special interests; commitment to fix system flaws before crises emerge.
- Strengthening institutions of corporate governance: enhance shareholder rights and prioritize public disclosure.
- In systems with SOEs, governance requires making companies live within their means and ending government subsidies by enforcing hard budget constraints — cited precedent: Poland and other Central European countries in the 1990s.
- Distinguish well run from badly run SOEs; debt can fuel well-run business. Critical questions for firms:
- Are they papering over losses?
- Building capacity that adds to a global surplus?
- What is their exposure to shadow banking products?
- Restructuring must be based on hard facts and independent expert analysis (valuation, restructuring, debt workouts).
- Social implications:
- Policies should mitigate impacts on workers and families during restructuring;
- Government’s 100 billion Renminbi restructuring fund to absorb expected welfare costs for an expected 1.8 million affected workers.
- Caution on M&A: merging a weak SOE with a stronger one can simply subsidize losses unless the strong SOE has authority to restructure the loss-making company; otherwise letting the company fail may be preferable.
Conclusion
- China faces extraordinary challenges: growth is slowing but remains enviable by advanced-economy standards; corporate debt is a serious and growing problem requiring immediate and sustained reforms.
- IMF and global experience offer expertise from transitions from state-dominated to market-driven economies; the key is political will to avoid repeating mistakes and implement reforms to reinvigorate growth.
- Confidence expressed that China can adapt and ensure the “new normal” is sustainable development benefiting China and the world.
IMF Communications Department. Media Relations.