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As Chinese businesses emerge cautiously from the grip of Covid-19 controls and regulatory crackdowns, concerns are rising about a potential balance-sheet recession, similar to what Japan experienced after its economic boom.
The argument suggests that China’s current situation in 2023 bears resemblance to Japan’s after the collapse of its real estate bubble in the 1980s. Following a debt-fueled boom, China’s property market has come to a standstill, and its recovery is not expected to be immediate. Consumers, still affected by pandemic restrictions and skeptical of the real estate market, are reluctant to make new home purchases.
Similarly, private businesses, battered by the pandemic and concerned about low demand, are hesitant to invest. Banks are burdened with property and related assets, as well as loans to struggling sectors like local government finance vehicles, which have invested in low-return infrastructure projects.
Some argue that these factors set the stage for a Japan-style balance-sheet recession, where everyone, from companies to individuals, focuses on paying off debt simultaneously, leading to a downward spiral of economic growth. However, a recent study by French bank Natixis, analyzing the balance sheets of 3,000 listed Chinese companies, suggests that the situation may be more nuanced.
Contrary to expectations, Chinese mortgages and corporate borrowing have remained subdued during the past few years, despite relatively low interest rates, indicating a low demand for debt. Unlike Japan, China has not seen a crash in home prices; instead, they have gradually declined in recent months.
The overall financial health of Chinese companies remains relatively stable. Their primary challenge is the sluggish economy, which hampers revenue generation and reduces their ability to repay debt. According to Natixis, Chinese companies’ earnings before interest, taxation, depreciation, and amortization (EBITDA) to interest expense ratio is approximately six times, half the global average.
However, within China’s corporate sector, certain segments, notably private property groups and local state-owned enterprises, are faring much worse. These entities may already be experiencing what Natixis analyst Gary Ng refers to as “balance-sheet deterioration.” Repayment capacity for these private real estate developers and local government state-owned enterprises is relatively low, with an EBITDA to interest expense ratio of less than four times. In contrast, non-property private sector companies and central government state-owned enterprises have an average ratio of more than six times.
Another study by Gavekal, analyzing over 6,000 annual reports from onshore and offshore non-financial Chinese companies, further highlights the challenges. Listed developers have reduced their debt-to-equity ratio from a peak of 1.2 times in 2018 to less than 1 times currently. However, their debt of about Rmb5.7tn ($790bn) is overshadowed by non-debt liabilities, such as pre-sales of apartments and accounts payable, which amount to over three times the debt.
Gavekal points out that the shocks of recent years have led to an increase in “zombie companies,” which generate insufficient earnings to cover interest payments. These zombie companies now account for 9% of listed businesses, three times more than in 2018. Many private real estate groups fall into this category.
While certain sectors of China’s economy, like capital goods and tech hardware producers, continue to perform well, they are not substantial enough to offset the impact of the struggling property market and weakened domestic consumption. Policymakers may need to take swift action to incentivize growth in the more productive areas of the economy. This would involve supporting the private sector as a whole, including industries outside Beijing’s strategic objectives, such as ecommerce. According to Gary Ng, China should consider allowing more room for the private economy to grow to minimize the risk of following Japan’s path in the late 1980s.
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