Rebalance China’s two financing legs
Chairman Mao believed the economy needs to run on two legs, but when it comes to corporate financing, China is advancing in a series of giant hops. Its banks are flooding the market with credit, while equity markets actually supply less capital as a proportion of the whole.
Chinese banks lent out a whopping 7 trillion yuan ($1 trillion) during the first half of this year, tripling the amount during the same period last year. In comparison, new capital raised through the stock market was merely 10 million yuan ($1.46 million), down 50 percent from last year.
This is worrying. Excess bank liquidity has arguably severely overheated the equity market. Companies traded in China command a hefty 40 percent premium to the price of the same shares traded in Hong Kong as cheap loans have lowered the required cost of return and propped up stock prices.
Meanwhile, the uneconomic allocation of credit has squeezed out equity as a method of financing. This debt-dependent system advantages state-controlled firms over a vibrant private sector.
The key to the problem lies in Beijing’s hands. By giving the market more freedom to grow, Beijing will help reduce the debt level of the economy and more importantly, give private companies a channel to raise money needed for growth.
As things stand, tradable equities account for only a little more than a third of gross domestic product, tiny when compared to U.S. market capitalization which is 107 percent of GDP. Meanwhile China’s banking sector looks bloated — total loans outstanding are close to the risky level of 120 percent of GDP. In most countries, the ratio is below 100 percent.
Admittedly, Germany and Japan also feature similar banking-dominant financing models, whose merit is that by consolidating power and resources they can achieve faster economic growth. But the risk is the government and banks become too powerful, and neither of the two are successful allocators of capital in China.
State-owned banks favour large state-owned firms, which use 84 percent of total bank loans, even though they only contribute 45 percent of GDP and employ merely 25 percent of the labour force. By funding more overcapacity, banks are throwing good money after bad — large industrial enterprises in China already have an average debt ratio of as much as 60 percent.
Large firms are so flush with credit that they have started punting on stocks and properties, while China’s small enterprises are so short of credit that they pay double the legal lending rate for unofficial loans.
In a sign that small firms are being starved of credit, 108 companies applied on the first day that applications were accepted to be admitted to a new start-up stock market which is scheduled to be launched in October. In the past two years, more than 300 companies filed for initial public offering approvals with the main board.
All stock market listings need to be approved by the China Securities Regulatory Commission. At the current approval rate, it will take three years for all 300 of them to come to market.
China is one of the few countries in the world where regulators decide when is the best time for companies to raise money. The argument is that because China’s stock market is retail-driven, regulators should protect shareholders by making decisions for them.
Moreover, authorities fret that an enlarged share base could lead to falling stock prices which could in turn lead to social instability. There is even a school of thought that some bubbles are healthy because the wealth effect will help stimulate domestic consumption. But the wealth effect from stocks will do very little because it mainly enriches the well-off who are unlikely to drive big increases in spending.
Another downside of the bank-dominant financing model is that that China is a lot less efficient in terms of using capital than countries where the stock market plays a larger role. After growing at twice the U.S. rate for at least a decade, China’s broad money supply M2 is poised to pass that of the United States for the first time this year, yet this huge flood of liquidity only supports a GDP one third of the size of America’s.
The need for China to move towards a more balanced financing model has never been this urgent. The lending spree, despite a weak real economy, has put banks at a greater risk of mounting bad debt in a few years’ time. To rebalance China’s economic structure, the country needs to start walking on two feet, not just hopping on one.
— At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund —