A China Debt Fix Investment Bankers Will Love

Companies might want to consider raising $750 billion in equity to deleverage and $750 billion in long-term bonds, JPMorgan says.

Here's a solution for China's debt-laden companies that investment bankers will love: Sell more stocks and bonds.

The nation's share market may be the world's second-biggest by value after the U.S. but its firms haven't exactly proven foreign-investor magnets, as the lack of interest in the Shanghai-Hong Kong stock exchange trading link has shown.

Now, JPMorgan folk have come up with a solution -- make highly leveraged companies cut their reliance on short-term loans and switch to longer-tenor bonds and/or equity instead. Debt levels would be reduced and profitability also potentially enhanced, according to a primer on Chinese firms' financial policies released by the bank Wednesday.


Chinese firms' return on equity is well below companies in the West, and also falling faster

Source: JPMorgan

Note: Data include all non-financial companies in each index.

Specifically, authors Marc Zenner and Peter McInnes say that to bring their balance sheets in line with global peers, Chinese companies 1 might want to consider raising more than 5 trillion yuan ($750 billion), or about 17 percent of their market capitalization, in equity in order to deleverage, or, merging with another, less indebted company could have a similar effect if a stock sale's not possible. They should also consider selling about 5 trillion yuan of bonds to reduce their reliance on loans plus extend debt maturities.

"Modifying financial and operational policies in such a major way could be challenging for all stakeholders, and cause some potential dislocation in the short run. It is, however, a path that can ensure that Chinese companies create the most value in the long run."

According to the New York-based financial institution, companies in China typically have a third or less of their debt in bonds versus as much as 75 percent for large German firms and about 90 percent for big U.S. and U.K. corporations. As much as almost half the debt of mainland-listed Chinese companies is short-term loans, compared with just 1 percent in North America.

At the moment, with the world awash in negative interest rates, that dependence on bank advances may be fine, and Beijing's implicit guarantee for state-owned enterprises means such borrowing can, in theory, continue ad infinitum. But Chinese companies are missing out on locking in ultra-low borrowing costs via long-tenor bonds. A booming onshore note market doesn't solve that problem either considering most domestic securities mature in three or so years versus an average of about six for U.S. debentures.

Little Note Love

Bonds make up a much smaller portion of the debt held by Chinese companies compared with U.S., U.K. and German firms

Source: JP Morgan, Bloomberg

Note: Data as of Dec. 31, 2015. Only 38 of 962 Shanghai companies and 11 of 1,670 Shenzhen companies report loan and bond debt composition data.

As Gadfly has noted, companies in the industrials, materials and energy sectors are the biggest culprits when it comes to taking on piles of debt.

Selling more of the stuff, along with equity, isn't such a bad solution, however, and not only for investment bankers looking for fees. If it results in healthier balance sheets, it may even make Chinese companies more attractive on the international stage.

Time to Catch Up

Chinese stocks have underperformed their U.K., U.S. and German counterparts over the past five years

Source: Bloomberg

The problem, as JPMorgan also points out, is that raising funds is only half the answer. The other half -- improving operational efficiency -- may be a lot harder. Zenner and McInnes coin it "The Great Rebalancing Act," and say it could take several years for firms to modify their capital structures to be more comparable with global counterparts.

As anyone who knows how glacial change in China can sometimes be, several years may prove an understatement. Regulatory approval for equity issuance isn't always easy and what's the incentive to sell longer-maturity bonds if your cheap loans keep getting rolled over and Big Brother has your back?

Lip service to SOE reform aside, China is taking steps in the right direction, and the upcoming Shenzhen-Hong Kong connect is one example of that. But as the 2008 credit crisis showed, an over-reliance on short-term debt can be a highly dangerous thing, especially when liquidity dries up.

Mainland treasurers and CFOs, investment bankers are waiting for your call.

(Corrects JPMorgan's recommended debt issuance figure in the fourth paragraph, originally reported by the bank as about 1 trillion yuan.)
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
  1. JPMorgan's primer excludes banks and property developers, whose leverage is off the charts. Even so, at three times debt-to-Ebitda for the rest of the market, that's still higher than the two times average in the West.

To contact the author of this story:
Nisha Gopalan in Hong Kong at ngopalan3@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net

Before it's here, it's on the Bloomberg Terminal.