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China’s State-Owned Enterprises Will Take Larger Strategic Role

AS TENDS TO be the case with the IMF’s Article 4 reports on the Chinese economy, there is little that is controversial in the overarching analysis and prescriptions of the latest one, released on January 28.

This is the nub of the report:

China’s recovery is well advanced—but it lacks balance and momentum has slowed, reflecting the rapid withdrawal of fiscal support, lagging consumption amid recurrent COVID-19 outbreaks despite a successful vaccination campaign, and slowing real estate investment following policy efforts to reduce leverage in the property sector.

Regulatory measures targeting the technology sector, intended to enhance competition, consumer privacy, and data governance, have increased policy uncertainty.

China’s climate strategy has begun to take shape with the release of detailed action plans. Productivity growth is declining as decoupling pressures are increasing, while a stalling of key structural reforms and rebalancing are delaying the transition to “high-quality”—balanced, inclusive and green—growth.

If anything caught this Bystander’s eye, it was the report’s comments on state-owned enterprises (SOEs) and the somewhat prickly response from China.

These came in a section on how market participants view the wave of regulatory measures mentioned above as undercutting the role of private enterprises. It raises concerns, the report says, about state intervention using non-market-based measures. At the same time, there has been little or no progress in core areas of market-enhancing reforms, such as removing implicit guarantees for state-owned enterprises.

Indeed, there are signs that SOEs will continue to play a significant role in implementing government priorities going forward—for example, with regard to improving technological self-reliance and implementing the climate agenda.

The report’s view is that China’s slowing productivity growth and market dynamism — the entry of young, innovative firms has declined in recent years — is unlikely to revive without SOE and competitive neutrality reforms. China’s business dynamism has declined since the early 2000s, with the still-large role of SOEs a key factor.

SOEs are, on average, 20% less productive than private firms in the same sector, and the decline in business dynamism is particularly pronounced in industries and regions with large SOE presences.

The role of SOEs in the economy remains significant, the report notes, even as profitability is declining, reflecting SOEs’ contributions to economic stabilization efforts during the crisis and their implicit obligations to help implement state climate goals and increase R&D spending for the development of homegrown technologies.

Restarting SOE reform, the report says, could help close the large productivity gap between SOEs and private firms and potentially raise output by around 4% over the medium to long term.

Overall, the profitability of SOEs is weak, and about one in three make losses. Fiscal risks from SOE debt are rising and exacerbated by often illiquid SOE assets. More profitable SOEs could also boost dividend payments to government budgets to provide further resources to meet pressing social spending needs.

Needed reforms include ending preferential access to credit and implicit guarantees for SOEs to ensure competitive neutrality between private and state-owned firms, and improving SOE governance to limit the potential economic and fiscal costs of weak management and mismanagement.

A gradual and well-communicated approach to reform would be required, especially in regions with weak public finances.

A series of defaults by local SOEs has already created investor uncertainty about state support. However, the government response has been stricter supervision rather than reform.

Chinese authorities agreed with the IMF staff preparing the report that there is a need to deepen reform efforts to counteract a declining trend in productivity growth. They pointed to SOE reforms to improve corporate governance and competition policies to address local protectionism. However, they stressed that external decoupling pressures are adding critical headwinds to productivity growth which, in their view, necessitate an increased role for SOEs in strategic sectors.

Should the SOE-focused R & D strategy fail, that greater role would come with an elevated medium-term risk of a faster decline in productivity growth, especially if technological or financial decoupling increased due to external tensions.

In his formal response to the report, Jin Zhongxia, China’s Executive Director at the Fund, defended the progress made in the three-year (2020-2022) SOE reform plan, claiming 70% of its goals had been achieved by the end of 2021.

Yet he pushed back firmly against the recommendation to phase out ‘implicit guarantees’ to SOEs, claiming they were more perceived than real. He stated that SOEs are separate commercial entities from the government and that there are no implicit guarantees.

Jin also took a swing at the interest and exchange rate policies of ‘major developed countries’ (for which read the United States primarily), which he said provided ‘a blanket subsidy to all their companies’, adding:

Large private companies in some major developed countries can legally lobby and collude with politicians and can enjoy implicit protection and preferential procurement. In addition, China’s companies, both public and private, are victims of unfair competition in the form of technology and supply sanctions and market restrictions under the name of national security.

The words pot, kettle and black come to mind.

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China’s State-Owned Debt Problem

WHEN, AS IS expected later this year, the U.S. Federal Reserve starts to raise interest rates, it will put renewed strain on emerging economies’ debt management. Those most vulnerable are countries with high levels of dollar-denominated external debt and those with high public debt.

Where does that leave China? As so often, slightly oddly placed.

China’s external debt exposure is low. Foreign debt is estimated to be equivalent to less than 10% of GDP. That modest figure by international standards is because China funded its infrastructure building domestically and not by borrowing from abroad. Thus it has avoided one of the textbook potential triggers of an emerging market debt crisis. It helps that China has a financial system that is semi-detached from global capital markets.

On the other hand, China’s domestic borrowing is huge. Total debt, including debt of the financial sector, nearly quadrupled between 2007 and 2014, by the reckoning of the McKinsey Global Institute (MGI), rising from $7.4 trillion to $28.2 trillion, or from 158% of GDP to 282%. This increase was a consequence of the investment-driven stimulus Beijing launched to offset the 2008 global financial crisis and which was funded by bank credit, albeit domestic not external borrowing.

That new debt was largely taken on by non-financial corporations. MGI calculates that that set’s debt accounts for 125% of GDP. Rating agency Standard & Poor’s estimates that China surpassed the United States as the largest corporate debt borrower in 2013.

China’s non-financial corporations are a broad church, however. Their debt is concentrated within state-owned enterprises, not anymore in private companies with the one significant exception of firms in the property sector. MGI estimates that approaching half of non-financial corporate debt connects in some way to real estate development, with 60 firms accounting for two-thirds of it.

An IMF Working Paper on corporate indebtedness in China published by Mali Chivakul and W. Raphael Lam in March puts it thus, “while leverage on average is not high, there is a fat tail of highly leveraged firms accounting for a significant share of total corporate debt, mainly concentrated in the real estate and construction sector and state-owned enterprises in general.”

Chivakul and Lam go on to argue that development and construction firms could withstand a modest interest rate shock, but other corporations in the wider economy would feel the knock-on effect of a slowdown in the property sector. “The share of debt that would be in financial distress would rise to about a quarter of total listed-firm debt in the event of a 20% decline in real estate and construction profits,” they say.

A separate report from economists at the Hong Kong Monetary Authority comes up with a similar analysis — that China’s debt problem is largely an SEO debt problem — and points the finger at  ‘policy driven lending’. “SOEs’ leveraging has been mainly driven by implicit government support amid lower funding costs than private enterprises,” they say.

There is now less such politically driven new lending than before. That partly reflects the passing of the post-2008 stimulus but also a recognition that private firms create the new jobs that are critical to social stability. It also reflects the shuttering, particularly since 2012, of small, inefficient and heavily polluting and indebted SOEs in industries such as steel, cement and mining.

A further round of such ‘SOE reform’ seems likely. And to this Bystander, the corruption investigations into SOEs seems in part an attempt to accelerate those reforms, given that  SEOs are seen as acting as a drag on the wider push for reform and economic rebalancing.

From SOEs it is but a short step to China’s other deep pool of domestic-debt concern — local government borrowing. Outstanding debt has reportedly reached 16 trillion yuan ($2.6 trillion), up 47% from June 2013. Overall, government debt is equivalent to 55% of GDP, again not a concerning high level by international standards. But it is concentrated in pockets, closely tied to real estate, and a further drag on an already slowing economy.

Beijing has both the political will and the financial wherewithal to underwrite local government defaults and forestall any threat of financial systemic risk. However, policy makers will use the mere hint of it to push local government finance reform and deepening municipal bond markets.

Local governments have relied on land sales for revenue, and also seek to turn a yuan from commercial activities conducted through captive off-balance-sheet special financing vehicles, which have borrowed heavily from both mainstream and shadow banks. So the threat of contaigion is real. Rising interest rates will only make it more so, and aid the cause of local government finance reform.

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