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Will the PBOC Reforms Cause More Harm than Good?

 Will the PBOC Reforms Cause More Harm than Good?

As China’s Central Bank rolls out fresh reforms with the purpose of redirecting financing to sectors where credit is usually scarce, some investors question if now is the time to boost borrowing in China.

The People’s Bank of China (PBOC) recently announced that they were cutting the requirement ratio (RRR) for lenders so they could extent financing facilities to small enterprises and the agricultural sector. The Chinese Government is attempting to increase lending to SME’s through the regular banking channels by linking a reduction in the reserve requirement for lending that goes to SME borrowers.

The new measures announced at the end of September will apply to all major banks, 90% urban commercial banks and 95% of rural commercial banks.

And while these measures would seem reasonable for any country that is trying to give access to a sector of the economy that is struggling to secure financing, the case of China is not as simple, given the state of its debt profile.

Since the financial crisis of 2007-2008, China’s debt has skyrocket, mostly due to access to easy credit enabled by the government to bolster consumption and boost the economy.  However, now many analysts have warned about the deterioration of China’s credit profile, which has already led to the country’s rating being downgraded in September.

According to Gene Ma, China’s Chief Economist at IIF, China’s debt problem is mainly due to large state-owned companies and not small business.

“The small businesses are not overly leveraged. With nominal GDP at 11.4% in 1H, the debt/GDP ratio is likely to be flat this year. Lacking credit history and collaterals, small businesses account for smaller share of total debt yet create disproportionately more jobs. The problem is that the credit risk of small business loans is indeed higher”.

This is why Gregory Saichin, Global Head of Emerging Markets Fixed Income at Allianz Global Investors, believes that no matter how much the government tries to sweeten the deal, banks still won’t lend to SMEs.

“This measure in my view is meant to offset the administrative measures related to increased repo costs to banks that lend to the shadow banking channels as a conduit for SMEs to fund themselves. We conclude that the banking system has been using its balance sheet to buy government securities and lend to SOEs and blue chips, with very little space in their balance sheets for SMEs.”

“As some capital goes off balance sheet into structured products to fund SMEs the government has attempted to reduce this leverage through enforcing these measures. In my view, the odds are that banks will not lend to SMEs no matter how attractive the offer is,” Saichin concluded.

However, this policy so far sits well with other investors, who agree with the path set by Beijing. They believe this is the type of regulation the government should be rolling out if they want to maintain the current growth path - China is set to grow around 5% this year.

“These measures tell me that the Chinese authorities are on the ball. They want to maximise growth without creating unacceptable risks. The fact that they protect the vulnerable sectors while they deleverage tells me that they are paying attention to detail. That is exactly what you want to see,” Jan Dehn, Head of Research at Ashmore Investment Management, stated.

He explains that while China’s debt to GDP is high by EM standards, it is low compared to developed markets; he does admit however there has been a mounting pressure from the central government to moderate lending.

“Whenever this happens banks inevitably tend to scale back lending for small enterprises before scaling back lending for larger ones. This is why this measure is put in place. They are trying to avoid a disproportionate punishment of small companies, which is also the sector that creates most jobs that will be needed when they embark on reform of the State-Owned Enterprises (SOEs), following this month’s upcoming party conference,” Dehn argues. 

The Path to Reform

The measures announced in September are part of a larger effort from the Chinese officials to reform the world’s largest economy.  And while it is very difficult for them to actually lower their debt to GDP ratio – neither the US, EU or Japan have succeeded in this endeavour- they certainly can impede its rise.

According to Ma, China has enacted policy to this end and has been successful – where Japan and the Eurozone failed - to reflate the economy. The nominal GDP growth of 11.4% in 1H was 6.9% in real growth and 4.5% in inflation.

However little has been achieved in controlling the debt of State-owned companies: regardless of the government efforts it still rose by 16% last year, which was cited by both Moody’s and S&P as the biggest threat to China’s debt profile.

“The lion’s share of the debt we are talking about is SOE and local authority related as the only bankable debt out there. There is a certain cadence in this leverage cycle and some of the leverage is related to the viability of these SOEs and LA entities. The Central Government has a plan to restructure unviable entities over the medium term with social harmony in mind, as these entities provide material employment in certain regions.

The excess leverage attributable to shadow banking for consumption and mortgages is already undergoing some form of administrative policy restriction, but then again, nothing that the Chinese Central government does is in a rush,” Saichin explained.

And while the debt is definitely being a cause for concern, because China is a very closed economy – only 2% of its RMB bonds are owned by foreign capital holders - investors do not expect any global shocks.

“Even the bankable SOEs have a marginal portion of their overall funding going through USD bond markets, with their main funding coming from domestic RMB bonds,” Saichin said.

And even with the rising debt, global markets and investors alike seem to trust China. The price of Chinese assets has actually gone up since the downgrade and investors are positive of the government’s reforms.

“China’s debt is sustainable. In addition to the solid domestic funding of the bank credit you can also try to put the debt stock, growth rates and interest rates into a classic debt sustainability model. You will find that the debt stock is entirely sustainable. The main thrust of reforms in China – in addition to SOE reform – are interest rate and price liberalisation, as well as capital account liberation and financial deepening. These policies will massively increase the efficiency of resource use in China and therefore increase productivity and the sustainable growth rates,” Dehn mentioned.

As long as China maintains its current growth, and the government continues to tackle the overheating of the market, we will not see any surprises from the Asian giant… yet.

 

 

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