Companies need stable capital

There is an interesting article in yesterday’s Xinhua headlined “Capital shortages top risk for China’s SOEsOpen in a new window.” This seems at first counterintuitive given China’s rapid reserve accumulation, but the explanation may be in the article itself. According to the article:

Lack of capital was the biggest risk facing China’s centrally-administrated State-owned enterprises (SOEs), according to a risk assessment report released by the State-owned Assets Supervision and Administration Commission of the State Council (SASAC) on Monday.

A lack of capital worried most SOEs, especially those in electricity, petroleum, steel, investment, energy and real estate, said an expert participating in the evaluation of the report. The expert, who declined to be named, attributed the shortage of funds to the tightening of credit, materials price hikes and reckless expansion.

The rapid expansion of some SOEs was believed to have resulted in the capital scarcity as the continuous tightening of monetary policies and bank loans failed to slow acquisitions and mergers. SASAC director Li Rongrong warned against the “strong expansion impulse”, saying investment beyond main business lines and capacities as well as investments with very low returns must be prohibited.

The SOEs, which traditionally get almost all of their funding from the large commercial banks, are being affected by the lending caps, although I suspect that these caps are likely to be relaxed in the upcoming months. It is interesting to me that one of the reasons cited for the capital shortages is “reckless expansion.”

The capital allocation mechanism in China is weak, and one normal consequence of excessively cheap money tends to be overinvestment and excessively rapid expansion. It seems that SOE expansion may have reached the point where the debt servicing costs exceed the returns on investment to an extent that it is putting a burden on SOE capital needs.

This is particularly likely to be the case if we start seeing a build-up in inventories. So far we have only seen this in the real estate sector and the automobile industry, as far as I know, but I suspect we will see references to inventory build-up more often in the coming quarters. The need for capital under current conditions also raises questions about how Chinese companies will deal with capital requirements if we ever were really to have “tight” monetary conditions.

Meanwhile Jake van der Kamp has an article (”Policymakers grappling with inflation monster”) Open in a new windowin today’s SCMP with which I am in broad agreement. One of the interesting points he makes is in an attached graph that shows CPI inflation from 1983 to the present. The article and the graph, which I can’t insert here, indicate at least two things that I find interesting. They demonstrate the fallacy of the way-too-common argument that for all the naysayers China has been able to run very smoothly without serious economic problems or crises for the last thirty years, so it is unreasonable to expect anything to go wrong now.

In fact, there have been several periods that are only not called crises by Westerners because the links between the Chinese economy and the rest of the world were too small for the rest of the world to be affected. The graph also shows how quickly inflation can surge – from very low levels to well above 20% in two or three years.

Meanwhile the stock market seems to be ignoring the government’s recent injunction against bad news. It dropped 1.8% yesterday and drifted down another 0.5% today, to close at 2837.

On a very separate note, and for those interested in some of the smaller corners of China’s financial system, I have probably said it more than enough times before, but I am really fortunate in having so many incredibly smart former students from Peking University and Tsinghua University in the world of Chinese finance. They have been able to keep a close eye on the nuts and bolts of finance and come up with very useful information. One of my smartest kids, now a rising star at a major private equity group, sent me the following (slightly edited) email late last week:

As we have invested a substantial amount of capital in a financial leasing company in China, I’ve gotten to know this industry well and would like to share with you some observations. Basically, financial leasing companies here provide 2-3 year asset-backed financing for equipment purchases, with ticket sizes anywhere from RMB 1 million to RMB 50 million. The company in which we’ve invested focuses on the RMB 1-2 million segments, with the underlying assets being construction equipments, printing equipments, etc. Our customers are SMEs which are either too small to obtain bank financing, or have exhausted their real estate as collateral.

Obviously those are also the companies most vulnerable in period of a downturn. It is interesting to see that our financial leasing company has sort of become an informal bank, charging its customers an interest rate of around 25%, and funding itself at 7-8%. The credit default cost will definitely be higher than normal, although we don’t have a clear view as to how high it can go. Hopefully, after deducting the credit default cost we can still make decent returns.

There are at least three things to note there. First, the business is very risky but can be very profitable. A credit spread of 17-18% can tolerate a lot of defaults. It is also growing very quickly, albeit from a small base, at a rate exceeding 30% a year.

Second, I am not sure about, but am very interested in, linkages between these kinds of activities and the rest of the financial system. I assume that the leasing companies get at least part of their funding from banks, and my student confirms that they do (in fact banks are aggressively entering the market), but since the SMEs turn to the leasing companies precisely because lending caps at the banks have cut them off from bank financing, I would guess that much of their funding is direct and not intermediated by the banks. Still, as they mortgage their assets to raise financing from leasing companies, they are effectively putting the commercial banks in a junior position in case of payment difficulties. This means that defaults in the SMEs will have a bigger-than-expected impact on losses in the commercial banks.

The third thing worth mentioning is that neither minimum reserve requirements nor interest rate controls – two of the main tools used by the PBoC to manage monetary conditions in China – are likely to have any direct impact on the loan activity of the leasing companies (or indeed any of the other informal banks). As they increasingly take up the slack forced by the lending caps and minimum reserve requirement hikes, they further marginalize the PBoC.

Originally published at China Financial Markets and reproduced here with the author’s permission.