Finance

Shuli Ren is a Bloomberg Gadfly columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.

Andy Mukherjee is a Bloomberg Gadfly columnist covering industrial companies and financial services. He previously was a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.

Higher interest rates are a weapon that cuts broadly through an economy, and China's has a soft underbelly in its unreformed state-owned enterprises. Stop wincing, for never the twain shall meet.

The 19th Communist Party Congress concluded last week with a consensus among investors that Beijing is serious about deleveraging. Not only did outgoing People's Bank of China Governor Zhou Xiaochuan add fuel to the fire by warning of a potential Minsky moment, he even lit a match under the bond market this week by letting the 10-year sovereign yield shoot past 3.9 percent, a level unseen since late 2014.

En Garde
China's government bond yields shot up after the 19th Party Congress
Source: Bloomberg

At next month's Central Economic Work Conference, where top-level economic policies for the coming year are set, the central bank may even be urged to raise rates to wean China Inc. off its addiction to debt.

Still, it's hard to imagine borrowing costs being the weapon of choice. The simple reason is that SOEs, which are at the heart of the problem, won't be able to take it.

Of 871 state entities listed in mainland China, the median company has a net debt-to-Ebitda ratio of 1.6 times, while 20 percent need at least 6.6 years of operating profit to pay off their net borrowings. By comparison, the median firm among 2,000 listed private entities has no debt. 

Ugly State
China's median state-owned enterprise is less profitable and more indebted than its private counterpart
Source: Bloomberg

Muddling through and hoping to outgrow the leverage problem over time remains the preferred approach. A few defaults (20 this year) are being tolerated, lest complacency once again reign supreme. There's no scope for that. Assets of state entities have swollen from a little more than $2 trillion at the end of 2012, just before President Xi Jinping took office, to $3.6 trillion currently -- without much of an additional equity buffer.

Rare privatisation deals -- like that of Dongbei Special Steel Group Co. -- are supposed to further buttress the impression of tough love. Yet, investors aren't expecting a violent shakeout of SOEs; they know the authorities won't risk it.

And when onshore liquidity is tight, the bond market can throw out nasty surprises, most recently, the default of Dandong Port Group Co. on its 1 billion yuan ($150 million) bond due Oct. 30. Dandong Port, which manages the largest Chinese trading harbor with North Korea, is profitable, posting a 15 percent operating margin on 4.9 billion yuan of sales for the first nine months this year. The problem is, almost half of its 9.5 billion yuan debt is due within a year. Dandong doesn't have enough cash on its balance sheet, and wasn't able to refinance quickly enough.

In October 2014, the 10-year government bond yield was at 3.9 percent, just like it was this week, and creditors demanded an extra 1.4 percentage points to hold corporate debt. By contrast, the premium now is just north of 1 percentage point. If China allows more defaults, the spread surely will widen. The benchmark government yield settled back to 4.86 percent on Thursday. 

Safe House
AAA-rated corporate bonds yield only 1 percentage point more than sovereign debt
Source: Bloomberg

The risk premium can't be allowed to go much higher. An average corporate bond in China has five years to maturity at issuance; for a triple-A-rated borrower, the yield to maturity is 4.9 percent. If the central bank tightens and the interest cost rises to 6 or 7 percent for top-rated borrowers, imagine the plight at the bottom.

That's where China Inc. has a serious debt-servicing challenge. The median SOE spends 1.4 percent of revenue on interest; at the 80th percentile, the burden rises to 4.6 percent. In fact, out of 871 SOEs, 116 pay more interest to creditors than they earn in Ebitda.

At even slightly higher interest rates, refinancing of debt would become impossible onshore. Even if markets offshore are more forgiving, Beijing won't want the worst of its borrowers to swap yuan liabilities for dollars. 

A slight liquidity squeeze helps rein in animal spirits and prevents already over-indebted SOEs from lunging for even bigger balance sheets. But for the People's Bank of China to boldly swing its cost-of-capital blade would lead to far too much blood.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the authors of this story:
Shuli Ren in Hong Kong at sren38@bloomberg.net
Andy Mukherjee in Hong Kong at amukherjee@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net