Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market. Learn more about Prevailing Winds.
In September 2018, a former banker posted a short essay on Chinese social media calling for the private sector to withdraw in favor of a more state-centric economy. The article touched a nerve in China, generating widespread criticism and leading to several disavowals of the author’s ideas by state newspapers. The strength of the reaction highlighted the sensitive position of the private sector in China right now. Private sector firms are feeling disadvantaged relative to state-owned enterprises (SOEs) in many areas, the most important of which is access to finance.
China’s deleveraging effort has been underway for over two years now and the effect is being felt across the economy. While tighter credit conditions are impacting companies of all types, there is a growing sense that a disproportionate share of the tightening is falling upon private enterprises. Both small and large private enterprises are facing financing challenges across a variety of fronts.
Small and medium enterprises (SMEs) face funding difficulties in most economies and China is no exception. With smaller loan sizes and higher risk profiles, SMEs are often ignored by banks. It is easier and more profitable for banks to make large loans to established borrowers. In China, SMEs find it particularly hard to get credit due to the underdeveloped national credit system. Banks in China often have limited information on potential SME borrowers, making lending decisions difficult.
These structural problems are being compounded by the contraction of the shadow banking system. Over the past several years, the shadow banking system has served as a lifeline for many SMEs, providing credit when traditional lenders would not, albeit often at exorbitant interest rates. China’s financial crackdown has caused many areas of the shadow banking sector to recede, including peer-to-peer (P2P) lending platforms, bankers’ acceptances,1 and loans from non-bank financial institutions. While much of the shadow banking activity was risky and ill-advised, its disappearance has created a financing gap for many SMEs.
SME financing troubles are being further exacerbated by the slowdown in the economy. As economic growth slows, banks naturally become more risk averse and cut off lenders that are more likely to default. Unfortunately, this shift is reducing lending to SMEs at precisely the moment when other sources of credit have become more difficult to access. Figure 1 shows the recent slowing of credit growth to SMEs.
Large Enterprise Financing
Large private enterprises are finding their financing options constrained as well. The decline in shadow banking has not only affected SMEs, it has also reduced access to credit for many large private enterprises that are not able to obtain bank loans (usually due to sector exposure constraints imposed on banks by regulators).
One of the main targets of the financial crackdown has been private firms engaged in high-profile overseas acquisitions. Regulators went after several private firms that were borrowing aggressively to make these acquisitions. Authorities also targeted a major source of funding for these firms, Huarong Asset Management, which is currently being forced to restructure its business away from this type of lending. At a high level, reducing unsustainable increases in leverage is sound policy, but the implementation appears to have fallen harder upon private enterprises than SOEs. These actions have also increased the perception that lending to private enterprises is more politically risky than lending to SOEs, further reducing their access to credit.
Fundraising by private companies in the capital markets has likewise come under pressure. In the stock market, stricter rules on private share placements have limited the ability of many private companies to raise funds via this method. Another source of funding frequently used by private entrepreneurs is pledged share lending, which involves using the shares in the company as collateral for bank loans. The market correction this year has not only reduced the amount that can be borrowed, it has also led to a negative feedback loop where falling prices force the liquidation of shares held as collateral, further dragging down share prices. This has made banks more reluctant to engage in this type of lending. There are currently around $654 billion worth of pledged shares outstanding.2
China’s private sector firms represent a small but growing percentage of the total bond market. The rising number of bond defaults, which are concentrated among private borrowers, has cooled market demand for new issuances. Conditions are similar in the offshore bond market where many companies, particularly real estate developers, have found limited demand for new issuances.
Government Response to the Financing Crunch
The official response to the private sector financing crunch has thus far been carefully calibrated. In an attempt to deflect calls for additional credit stimulus, regulators have been quick to point out that credit to the private sector continues to grow in the aggregate. There is desire amongst Chinese regulators to avoid returning to the old days of rapid credit growth and accumulating of financial risks.
Over the past several months, the People’s Bank of China (PBOC) has been active in formulating new policies to support the private sector. The central bank has cut the required reserve ratio four times this year and a portion of the funds released were earmarked for SME financing. The PBOC has also announced two separate tranches of 150 billion renminbi (RMB) in relending and rediscount quotas to support SME lending. The central bank has also implemented a tax exemption for interest income on loans to certain small borrowers.
Regulators have given banks window guidance to not increase interest rates on SME loans and to lend more to private enterprises. China’s chief banking regulator, Guo Shuqing, even went so far as to suggest quotas for lending to the private sector: one-third of loans at large banks, two-thirds of loans at medium-sized banks, and reaching 50% of all corporate loans over the next three years. Implementation of such a proposal is likely to occur more via moral suasion than through explicit lending targets.
Steps have also been taken to address financing problems in the capital markets. Policymakers have called for simplifying the registration system for bond issuances, and the central bank has put together a guarantee fund to support debt sales by private companies. The restrictions on private share placements are being eased in order to revitalize this source of funding. Shenzhen and several other localities have put together funds to provide support to local enterprises and prevent the forced liquidation of pledged share loans. At the national level, the Securities Association of China is putting together a similar fund.
Perhaps most importantly, China’s top leadership is trying through both words and actions to change the perception that the private sector plays second fiddle to SOEs. Both President Xi Jinping and China’s top economic minister Liu He have declared “unwavering support” for the private sector. In early November, Xi convened a meeting with private entrepreneurs to discuss issues affecting private firms. During that meeting, Xi acknowledged that the private sector is responsible for most of China’s gross domestic product (GDP), employment, and technological innovation. He announced several support measures for private firms including lowering taxes, increasing access to finance, leveling the playing field between private firms and SOEs, and protecting property rights. A recent State Council meeting called upon government ministries and SOEs to promptly pay money owed to private firms. As the economy has slowed, many SOEs have extracted extended payment terms from their private suppliers, increasing the financial stress upon these firms.
While some of the policies mentioned above may ease the pressure felt by private firms, it will take much longer to address the structural inequalities within the Chinese economy. Truly leveling the playing field between private firms and SOEs will require difficult reforms and take years to implement. This includes ending the implicit guarantee of government support enjoyed by many SOEs that allows them to be perceived as better credit risks than private enterprises. In the meantime, private firms in China will continue to feel the pinch.Nicholas Borst Seafarer Capital Partners, LLC
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
As of September 30, 2018 the Seafarer Funds had no economic interest in the entities referenced in this commentary.
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- Wind Information. As of 16 November 2016.