议程

Deleveraging Requires an Integrated Solution

Li Yang

 Chairman of the National Institution for Finance and Development (NIFD)

The global financial crisis that erupted in 2007 has caused the stagnation of the world’s economy. The US Federal Reserve’s indecisiveness to raise interest rates and the recent Brexit referendum cast shadows over global economic recovery.

In this context, China’s real economy is expected to be confronted with the growing perils of economic slowdown, overcapacity, mounting real estate inventory, struggling businesses and rising unemployment. Financial risks in the making are manifested in the increase of leverage ratio, debt burden and non-performing assets.

In coordination with the efforts to address overcapacity, real estate inventory and zombie firms, China’s financial policy should be dominated by the following priorities: disposal of non-performing assets, steadily deleverage, and detect and prevent lurking debt problems from triggering systemic financial crisis.

1. China's Leverage Ratio: Aggregate and Structure

By the end of 2015, China's debt aggregate amounted to 168.48 trillion yuan and debt-to-GDP ratio stood at 249%, which is not high compared with major economies like the United States, the United Kingdom, France and Japan.

Structurally, the leverage ratio is 39.9% for the household sector, 21% for the financial sector, 57.1% for the government sector (including 17.7% for local financing vehicles), and 131% for non-financial firms. As can be revealed from international comparisons, the excessive leverage ratio of non-financial firms is the most striking. 65% of corporate debts are attributed to state-owned enterprises (SOEs). It is fair to say that the excessive leverage ratio of SOEs is the key to China’s debt conundrum.

    It needs to be particularly noted that accounting local financing vehicle liabilities as local government liabilities is methodologically flawed. In China, local financing vehicles and the origin, functions and roles of their liabilities are as varied as is their murky legal status. Despite their status as independent legal entities, local financing vehicles are very closely tied to local governments, giving rise to their complex attributes and functions that elude regulation. Such elusiveness is evident in the steep rise of the liabilities of local financing vehicles in the first half of this year to the bafflement of regulatory authorities. Launched by the government as independent legal entities, local financing vehicles assume certain public functions and operate to some extent according to market-based rules.

In order to check the wild growth of local financing vehicle liabilities, we propose the following policy recommendation in light of international experience and above-mentioned characteristics: a “Government Institution Bond” should be created under a special law to be enacted (or with the special authorization of the National People’s Congress) subject to the regulation of a special agency (the Ministry of Finance) and the supervision of the National People’s Congress.

2. China is Currently Free from a Debt Crisis

Most discussions on China’s debt problems dwell on the scale of China’s debts and its ratio to GDP (leverage ratio). Such analysis is very important yet despite its advantages (sufficient data and international comparability, etc.), the drawbacks are also significant. First of all, comparing inventory (debts) and flow (GDP) offers vague economic significance. Second, there is always a reason to borrow and borrowed money usually yields output. Therefore, analyzing debt without relational inclusion of assets appears to be superficial.

Putting debts into perspective of assets is particularly important for China. While the governments of advanced economies engage in debt financing to offset public spending deficits, finance pension systems and redistribute income, the debt financing of the Chinese government is primarily intended to fund public investments.

Different methods of financing will lead to drastically different economic consequences:

·         If borrowed funds are used for consumption.

·         The capital for debt service will have to be financed elsewhere.

·         Aggravating the future burden of government.

In contrast, if borrowed funds are used for investment, the assets created through investment will generate cash flow that undergirds debt service.

Following a broad statistical scope, by the end of 2014, China’s sovereign assets totaled 227.3 trillion yuan and sovereign liabilities amounted to 124 trillion yuan, with the net value of assets reaching 103.3 trillion yuan. If the state-owned assets of government-affiliated institutions are deducted (13.4 trillion yuan) and the assets of national land and resources in 2014 (65.4 trillion yuan) are substituted by land transfer revenue (4 trillion yuan) in the same year, China’s sovereign assets will drop from 227.3 trillion yuan to 152.5 trillion yuan. Hence, following a narrow statistical scope, the net value of China’s sovereign assets stands at 28.5 trillion yuan. These assets mainly comprise foreign exchange reserves, precious metal reserves and the liquid assets of Chinese enterprises listed in major world capital markets.

Based on the analysis of China’s debts under the framework of a balance sheet, the following conclusion can be drawn: a debt crisis is an unlikely probability for China. Even if default occurs on a massive scale, China is still well-positioned to cope with its aftermath, therefore averting any major repercussions to its economy.

Our argument that China is free from a debt crisis is also supported by two other reasons. First, China has been known for its high savings rate. Even after a decrease in 2015, China’s savings rate is still as high as 47%. The implication is that the major source of China’s debt financing is its domestic savings. According to statistics, foreign-currency debts account for less than 3% of China’s total liabilities. Given that most of China’s debts are owed to domestic creditors, debt service is immune to external interference. Second, China’s debts are primarily financed by its relatively stable bank deposits, i.e. indirect financing. This determines that China’s financial industry risks are concentrated in liquidity rather than solvency. Based on this financial structure, as long as the high savings rate is sustained to support colossal capital flow, China’s debt problems are unlikely to evolve into a systemic financial crisis.

3. Disposal of Non-Performing Debts Is the Key

Leverage cannot be indiscriminately seen as a scourge. Relying on external financing, i.e. leverage operation, is integral to the normal functioning of an industrial society. Thus, the essence of debt management is to maintain sustainable debt.

At the micro level, the ratio between debts and earnings before interest and tax (EBIT) can be used to measure corporate solvency and debt security. In other words, as long as firms keep generating profits sufficient to service debts, then debts will be sustainable. At the macro level, the ratio between debts and income flow for interest coverage can be used to measure debt sustainability. Due to a multitude of involved entities, income flow for interest coverage can be defined differently. Various methods for measuring debt sustainability are mutually supplementary. As long as the interest rate of debt service is below economic growth rate, the cash flow generated from debts will be able to support the payment of interest, thus making debts sustainable.

Another common indicator is the “interest / debt coverage ratio”, i.e. the ratio between national savings and debt balance. The basic implication is that for a country, the financial resources for interest payment derive from its national savings. Therefore, the ratio between savings and debt balance can effectively measure the sustainability of a country’s debts. Regardless of the method of measurement, the basic fact is that the macroeconomic conditions for China’s debt sustainability still exist. However, there is no doubt that with the slowdown of China’s growth, the affordable level of debt is also on the decline as well.

Non-performing debts as the price of China’s previous crude pattern of growth inevitably gave rise to debt risks, which have to be offset with superior assets. As a result, national wealth will suffer net losses. Obviously, the scale of superior assets to write off non-performing assets constitutes the upper limit of debt capacity. As mentioned before, China’s economy has amassed a staggering amount of net wealth over the past three decades of rapid growth, constituting a strong material foundation for the disposal of non-performing debts. The unitary political system also endows us with the capacity to dispose of non-performing debts.

4. Options of Deleveraging and Leverage Transfer

In practice, deleveraging can be achieved through the following six channels:

·         Promoting economic growth

·         Creating inflation

·         Offsetting non-performing debts with superior assets

·         Debt writing-off

·         Asset accumulation

·         Re-evaluation of existing financial assets

With a closer look, despite the multitude of deleveraging options, none of them can be achieved immediately or without cost. The fundamental solution of deleveraging is to maintain a certain rate of economic growth to increase the denominator of the leverage ratio. Yet China’s economic growth is debt-driven: the increase of lending and/or deficits is an inevitable option to spur economic growth, both of which have the side effect of pushing up leverage ratio. Obviously, this situation puts us into a dilemma. Finding a desirable equilibrium point between deleveraging and maintaining economic growth is a tremendous test to our wisdom. For this reason, deleveraging will be a long-term action for which we must be well prepared.

In reality, we may still make certain adjustments to the leverage ratio at the structural level among different entities, i.e. leverage transfer. In summary, central bank acceptance, government acceptance, debt-to-equity conversion and non-performing asset securitization are the three pathways of leverage transfer.

Although the central bank and/or government acceptance can exempt concerns over escalating leverage ratios in some sectors, these debts do not disappear and in essence, the problems are simply pushed forward to the future. Thus, leverage transfer through central bank or government intervention must properly balance the relationship between present and future.

Debt-to-equity conversion and non-performing asset securitization should be conducted even more cautiously. Debt-to-equity conversion should be conducted for entities with the prospect of sustainable business operation and must be supported by a stringent plan of financial reorganization and governance mechanism and a plan for the protection of creditors. Non-performing loan (NPL) transaction market should be created as the premise for NPL securitization. The diversification of asset pool and NPL pool, the proactive participation of creditors and the reorganization of companies with non-performing bonds are all necessary conditions for the promotion of NPL securitization. In a word, debt-to-equity conversion and NPL securitization operations must strictly follow market rules and proceed under the rule of law. The prevention of fraud, debt evasion and the hazards of zombie firms represent the key to success.

5. The Debt Conundrum Requires Integrated Policy Maneuvers

As far as the relationship between financial industry and real economy is concerned, non-performing assets correspond to overcapacity, excess inventory and zombie firms in the real economy. They are two sides of the same coin. At the strategic level, the central government must develop a coherent, comprehensive and coordinated top-level design of deleveraging strategy. At the operational level, the following key messages must be stressed:

(1) Debt disposal should be carried out in parallel to SOE reform;

(2) State-owned and private enterprises should be treated equally in the process of deleveraging, given the objectives of the current round of debt disposal to improve corporate business environment, manage financial risks and propel economic restructuring;

(3) In the context of China’s deepening reform to establish the decisive role of market in resource allocation, the deleveraging process must carefully implement the principles set forth in the Third and Fifth Plenary Sessions of the 18^th CPC National Committee and abide by market-based rules;

(4) In the context of China’s commitment to developing the rule of law, the deleveraging process must carefully implement the principles set forth in the Fourth and Fifth Plenary Sessions of the 18^th CPC National Committee and be carried out strictly on the basis of law;

(5) China is striving to build an open economy and must therefore give more prominence to the role of international investors in the disposal of debts and deleveraging process. Hence, debt disposal transparency and policy reliability must be improved in line with market-based practices and the rule of law.