Debt Drags on China’s Growth; Interest Costs Leave Companies With Less Cash to Invest; China Construction Bank encountered a surge in overdue loans during the first half of the year and could face a “hidden crisis”

August 26, 2013, 1:24 p.m. ET

Debt Drags on China’s Growth

Interest Costs Leave Companies With Less Cash to Invest; the Case of Shougang Group

TOM ORLIK

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As worries over China’s debt problem mount, the burden of paying off those loans could be the trigger that tips runaway credit into slower economic growth and financial stress. Few areas illustrate the problems better than the old industrial sector, where state-owned steel plants and cement kilns continue to borrow and expand even as overcapacity grows. With debts high and profits low, some companies, such as state-owned steel giant Shougang Group, are using new loans to repay old ones, according to Dagong Global Credit Rating Co. Shougang Group declined to comment.Nationwide, four-and-a-half years of breakneck growth in lending has significantly increased China’s debt burden. Outstanding borrowing by businesses and households rose to 170% of gross domestic product at the end of 2012 from 117% in 2008, according to data from the Bank for International Settlements. The 2012 figure for the U.S. was 157%.

Assuming interest rates of 6.9% on outstanding credit—the average in June—and repayment over the next decade, interest and principal payments on business and household debt currently absorb around a third of China’s GDP. At the end of 2007, on the eve of the financial crisis, the equivalent debt-service ratio for the U.S. was 21%, a figure that was broadly unchanged at the end of 2012, according to the BIS.

There are few signs of imminent crisis. Bad debt levels in China’s banks are low. A high savings rate means bank deposits continue to accumulate, and a tightly controlled capital account makes it hard for funds to go anywhere else.

And Beijing has multiple tools to manage problems. In many cases, lenders and borrowers are both state-owned. Central government debt is low.

Even without a crisis, though, rising costs of repayment still threaten to choke growth, already testing a 20-year low. If money is used to service debt, companies can’t invest as much as they otherwise would and local governments might have to limit what they spend on crucial public services. Heavily indebted companies and governments are more likely to default, especially if economic growth continues to slow.

That adds fragility to an overstretched financial sector, which might have to slow lending if bad debts mount. Bank loan books have already doubled in size since the end of 2008.

A shift to higher interest rates, which could come either in response to an increase in inflation or as regulators liberalize the banking sector, would add to the pressure.

Given existing debt levels, an increase in lending rates of one percentage point would add almost two percentage points of GDP to the annual burden of repayment.

A key fault line is the repayment capacity of China’s local governments. Since the 2008 financial crisis, town halls around China have borrowed heavily to pay for a splurge in spending on roads, railway and airports. With many of those projects generating little or no returns in the short term, repayment is a challenge and some local governments are taking on more borrowing to repay existing loans.

As of the end of 2012, Kunming Transport Investment Co., just one of several financing vehicles for the government of Kunming, a city in southwestern China, had taken on 37.9 billion yuan in debt, more than the city’s entire tax revenue, according to China Chengxin International, a credit-rating company. With Kunming Transport’s earnings little more than enough to cover interest payments, “the debt burden is heavy,” Chengxin said in a rating report. Kunming Transport declined to comment.

In the corporate sector, it is firms in heavy industry—steelmakers like Shougang, aluminum smelters and cement kilns—that have racked up some of the highest debts. Data from FactSet, a provider of financial information, show that net debt for firms in the sector rose to 30 times net earnings in 2012, from 10 times in 2011, as debt continued to mount and profits fell sharply away. Global competitors such as steel firm Arcelor Mittal have substantially lower and more stable debt-to-profit ratios.

China also appears to be getting less bang for every dollar that is borrowed. Credit expanded about 20% year on year in the first half of 2013, while GDP increased just 7.6%. One possible reason: New debt is being used to repay interest on loans rather than make productive investments.

China’s central bank appears little fazed, explaining that it takes a while before credit gets into the economy, causing growth to pick up. Private analysts are less sanguine.

“It’s a debt trap, firms will have to borrow more and more just to repay loans,” said Wei Yao, China economist at Société Générale, whose own calculations put the cost of servicing China’s debt at around 38% of GDP at the end of 2012.

China’s government and firms also have assets that they could sell to pay down debts. Kunming Transport and Shougang Group both have assets in excess of their liabilities.

But analysts say those safeguards may be more illusory than real. In a crisis, assets are tough to sell at anything like their face value.

The heavy debt load could also weigh on China’s efforts to tilt its economy away from heavy spending on infrastructure, often paid for with borrowed money, and towards a rise in consumption. If the country needs China’s household savers to bail out indebted businesses—by keeping interest rates low, for example—it would be a step in the wrong direction, said Société Générale’s Ms. Yao.

“If they do that, we can throw out all thought of rebalancing,” she said.

 

Updated August 26, 2013, 11:34 a.m. ET

China Construction Bank Sees Bad-Debt Risk

Chairman Sees ‘Big Pressure’ as Overdue Loans Increase

BEIJING—China Construction Bank Corp. encountered a surge in overdue loans during the first half of the year and could face a “hidden crisis” if the situation worsens, its top official warned on Monday.

The comments on Monday from China Construction Bank Chairman Wang Hongzhang underscore rising concern in China about heavy debt and the increasing potential for sour loans as economic growth slows.

Speaking at a news briefing on Monday, Mr. Wang said nonperforming loans remain a small portion of outstanding total loans. Still, he said, nonperforming loans at CCB had risen rapidly compared with a year earlier.

At the end of June, China Construction Bank held 90.4 billion yuan ($14.77 billion) in overdue loans, accounting for 1.12% of the lender’s outstanding loans. The overdue loans were 13.4 billion yuan higher than at the beginning of the year, the bank said.

“Though our nonperforming loan ratio has been held below 1%, we still face big pressure from rising bad loans,” he said. There has been “a big rise in overdue loans, and that is a hidden crisis for nonperforming loans.”

Loans are generally classified as overdue before a bank categorizes them as nonperforming.

Vice President Pang Xiusheng said the bank would write off more loans this year than last year. He didn’t provide an estimate. CCB said in its interim earnings report on Sunday that the rise in overdue loans was mainly due to the slowing economy.

Investors, analysts and industry watchers have warned that China’s banks could face worsening problems if the slowing economy hurts borrowers’ ability to pay back their obligations. Chinese banks report low levels of nonperforming loans, at 1% or even lower, but critics say many have resorted to extending maturing loans to avoid defaults.

China Construction Bank is the first of China’s four big state-run banks to report its results, and investors will be watching keenly to see how China’s economic slowdown affects their loan books. One smaller bank, China Merchants Bank Co., reported 29.5 billion yuan in overdue loans by the end of June, accounting for 1.41% of the total loans, and 8.1 billion yuan higher than at of the beginning of the year.

On Sunday, China Construction Bank said first-half net profit rose 13% from the same period a year earlier to 119.71 billion yuan, boosted by higher interest income and commissions. The result was slightly higher than the average forecast of 118.07 billion yuan among four analysts surveyed by Thomson One Analytics.

The bank reported nonperforming loans remained steady at 0.99% of loans outstanding at the end of the first half, but it also said it had stepped up efforts to write off bad assets. In the first six months of the year, the bank wrote off a total of 5.38 billion yuan in bad loans, more than four times the 1.17 billion yuan total from the same period last year.

China Construction Bank executives told reporters at the briefing that the bank didn’t transfer any bad loans to asset-management companies in the first half, but that they couldn’t rule out doing so later in the year. In 1999, China set up four state-owned asset-management companies to take bad loans from the Big Four state banks, allowing them to clean up their balance sheets before they publicly listed their stock.

CCB executives said nonstandard wealth-management products accounted for about 30% of total wealth-management products outstanding at the end of the first half, lower than the 35% limit imposed by regulators. Wealth-management products are typically high-yield investments that offer a popular alternative to traditional bank deposits.

The proliferation of such products, a lack of disclosure about them and the fact that they are riskier than bank deposits has prompted regulators to tighten rules on the sector.

Regulators in particular have expressed concern about so-called nonstandard products, which aren’t traded on exchanges and have no fixed trading units. They want wealth-management products backed by standard investments, such as bonds and money-market instruments, to account for a bigger share of banks’ offerings.

China Construction Bank executives also said 18.51% of loans during the first half were at interest rates below the central bank’s benchmark, and 41.08% were above the benchmark. The benchmark rate for one-year loans is currently 6%.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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