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Editorial: Deleveraging is the Correct Top Priority

By Hu Shuli

The financial market has had both good news and bad news at the start of the New Year. In the last two weeks of 2016, the market was rocked by news that Sealand Securities, a midsize brokerage firm, will pull out of a “disputed” bond deal worth 10 billion yuan ($1.44 billion) that’s blamed on rogue traders. It fueled a mini-bond rout as jittery investors were concerned over an erosion of trust in the interbank market. But the market has calmed after the settlement of Sealand’s messy bond saga. Investors also cheered when lenders such as the Bank of China and China Construction Bank inked debt-to-equity swaps with lumbering state-owned giants, a positive step toward slashing the country’s massive corporate debt. These developments signal that authorities have set their eyes on reducing leverage in both financial and non-financial sectors.

China released a torrent of credit to buoy the economy during the 2008 financial crisis, which led to overcapacity, “zombie companies” and a property bubble. The central government started stressing the importance of draining excess liquidity and trimming debt in late 2015, but few concrete steps were taken until late last year. In October, the State Council, China’s cabinet, issued guidelines on cutting the corporate-leverage ratio. Two months later, the Central Economic Work Conference, a meeting of top policymakers that sets the annual economic agenda, put deleveraging high on the government’s list of priorities for 2017.

Deleveraging is not only about reducing the debt pile of local governments, companies and households, or the real economy. It is important to understand that corporate leverage is closely linked to the financial market. Companies rely on a healthy, rational and well-regulated financial market to raise funds through equity sales. Excess leverage can artificially pump up stock valuations, spawn asset bubbles and create systemic risks, which hurt the real economy. Therefore, the central government has underlined the urgent need to control financial risks while reducing the country’s overall debt-to-GDP ratio.

Institutions at home and abroad that have studied China’s debt problems agree that the country’s overall leverage ratio has remained at a moderate level compared to international standards. But it has increased rapidly since 2009, after the government ordered banks to open their taps to cushion a blow from the global financial meltdown. The availability of cheap credit fueled a borrowing binge and unhealthy expansion.

The leverage ratio of the country’s non-financial companies has exceeded that of most other countries in the world, and local government debt has risen to a risky level. Researchers also found that large, government-backed companies, especially those in heavy industries and real estate, are straddled with the tallest piles of toxic debt. These problems can be solved only through institutional reforms and efforts to transform the country’s underlying growth model, which requires removing the governments’ implicit guarantee on debt payments and tightening oversight over local government spending.

The leverage ratio is also partly pushed up by stimulus policies and China’s economic slowdown. As investment yields in the real economy decline, capital then flows into the financial market, seeking higher profits through highly leveraged investments. The recent bond market turmoil revealed the mounting risks of this trend. Huge amounts of money flooded the bond market through wealth management funds and other complicated investment funds as the market boomed over the past three years, pushing up leverage. Since 2016, cases of bond defaults have risen sharply, and the recent Sealand incident led to the already fragile confidence in the interbank market to collapse, triggering a sudden market rout.

The bond market is not the only place that borrowed money has been invested in. Loaned money flooded into the stock market in 2015 and the property market in early 2016. Some property agents and financial institutions have even lent money to help homebuyers pay their initial down payments, reminding us of the 2008 subprime crisis in the U.S. that later spread globally.

The task of cutting excess leverage is a test of the governments’ resolve to walk the talk. Since the third quarter of last year, the focus of monetary policy has shifted toward deleveraging and structural adjustments to the economy. In August, the central bank reopened 14-day and 28-day reverse repurchase operations in a bid to lift money market rates to tighten liquidity controls in the interbank market. The bank also enhanced supervision of off-balance-sheet wealth management products by including such products in its Macro Prudential Assessment (MPA) system, a point-based framework adopted in 2016 to gauge the risk exposure of banks. These measures had some effect, and regulators are expected to further tighten control on banks’ off-balance sheet businesses by setting stricter limits on lenders’ capital reserve requirements to rein in excessive credit.

A rapid increase in debt in a short period of time has historically been a good predictor of imminent financial troubles. Stricter financial sector supervision can serve as an early-warning system to spot emerging risks. But the fundamental solution to stimulate real economic growth, while discouraging financial speculation, is to improve investment yields in the real economy through reforms. Otherwise, speculative capital will only jump from one sector to another, creating new bubbles.

Many investors have pinned high hopes on the debt-to-equity swap programs as a measure to cut corporate leverage. While such arrangements can spare the economy short-term pain, it leaves it with chronic ailments. Whether lenders can reduce losses from souring debt by exchanging it for equity depends on whether these companies can return to profitability.

China’s quick march toward progress was borne on the shoulders of low-paid factory workers, but this model is not sustainable. Future growth can only be achieved through meaningful reforms in areas such as fiscal policy and taxation, state-owned enterprises, the social welfare system and the government-controlled land market. These changes would help boost productivity and help the economy pick up steam. And ongoing efforts to cut leverage will pave the way for these future reforms.

Hu Shuli is the chief editor of Caixin Media.

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