China deleverages while the sun shines

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Beijing’s warning to fintech and property firms to raise equity and pay debts will hit stocks now but lift their long term prospects

https://asiatimes.com-by David P. Goldman

China’s economy and stocks have outperformed Western counterparts during the Covid recession. Image: Twitter

China’s regulators are fixing the roof while the sun is shining. With the economy in full rebound from the second-quarter Covid recession, Beijing has warned fintech and property companies to raise more equity and pay down debt.

That’s good news for China’s financial system but mixed news for some of this year’s best-performing stocks, including food-delivery service Methuan and smartphone maker Xiaomi. Financial stocks, by contrast, turned in their best relative performance of 2020 during the past month.

Reduced leverage in corporate balance sheets is likely to restrain China’s world-beating equity market rally. A US dollar proxy for China’s CSI 300 Index, the ETF ASHR has gained 45% during the past year including reinvested dividends, while the S&P 500 returned 20%. Deleveraging is good for the Chinese economy in the long term, but it puts a drag on equity price gains in the short run.

Equity markets as a rule like leverage. Western equity markets rallied this year after central banks poured an unprecedented volume of fresh funds into capital markets, pushing nominal interest rates in the US to zero and real (inflation-adjusted) interest rates below zero.

In Europe and the US, central bank purchases of corporate debt have pushed the nominal borrowing cost of the lower-rated investment-grade borrowers to an historic low of around 3%. China, by contrast, has kept monetary policy stable and its stock market boomed without central bank stimulus.

Central bank largesse has allowed American companies to take on unprecedented amounts of leverage. In the most credit-sensitive sector of corporate America, small-capitalization companies represented in the Russell 2000 Index, the leverage ratio, or net debt divided by earnings before interest and taxes, has nearly tripled during the present recession.

China has kept monetary policy neutral, by contrast, and is encouraging private as well as state-owned firms to reduce leverage in the context of a strong economy.

Chinese regulators signaled their caution about leverage in the financial system with the November 4 suspension of Ant Financial’s planned initial public offering, which would have been the biggest in history. Regulators demanded a larger capital buffer and tighter lending controls for a firm that claimed to have a superior artificial intelligence-based system for managing credit risk.

Chinese authorities also indicated less tolerance for financial risk by allowing state enterprises to default on bond issues rather than allow state-owned banks to roll over loans and cover up problems.

In contrast to all the other major economies, China has maintained a neutral-to-tight monetary policy, rather than rely on zero or negative interest rates and central bank asset purchases to stimulate economic activity.

A wave of secondary offerings provoked sharp drops in some of the largest constituents of the Hang Seng China Enterprises Index (HSCEI) this week. Property developer Longfors dropped 12%, the worst performer in the HSCEI, after it announced a $2.3 billion equity offering shortly before the market’s close.

That follows a similar step by another property company, Evergrande, which raised additional funds through a Hong Kong subsidiary. Chinese regulators have expressed public concern about excess leverage in the property sector.

In a recent article, the head of China’s Banking and Insurance Regulatory Commission Guo Shuqing observed that of the 130 financial crises since the start of the 20th century, 100 stemmed from the property market and warned that a “bubble” in Chinese property presented the greatest risk to the financial system.

A company’s stock price usually falls when it issues new equity, diluting the existing shareholders and distributing the company’s earnings over a larger number of shares. Two of China’s best-performing tech names also fell sharply after announcing top-up equity sales.

The budget phone manufacturer Xiaomi, which became a market favorite after American export controls threatened Huawei’s handset business, fell 7% on Wednesday after selling $4 billion in a combination of equity and bonds convertible into equity.

Xiaomi had been the year’s best-performing stock on Hong Kong’s Hang Seng Index with a 143% rally prior to the Wednesday plunge. Xiaomi has no known financial difficulties—on the contrary, it has more cash than debt—and the issuance of new equity suggests an extremely conservative approach to capital structure in a tighter regulatory environment.

The best performer in the HSCEI during the past week, by contrast, was the Industrial and Commercial Bank of China, up 12% during the period. The outperformance of financial stocks during the past month indicates that markets view the regulatory crackdown on excess leverage as a step to strengthen the financial system.

Chinese regulators also worry that financial deregulation and the gradual opening of Chinese capital markets to the world will generate dangerous bubbles. In an interview with the Chinese news site guancha.cn on Wednesday, an adviser to the State Council, Ding Yifan, warned that developed countries’ “super-loose” monetary policies might spill over into China.

“In the face of the flood of liquidity and the liquidity bubble, we now have to further open up the market at our pace, according to pledges previously made by the government, or free trade agreements we signed, such just-signed RCEP,” Ding said in the interview. “These agreements include provisions on financial opening and financial liberalization, which means that China has an agenda for continuously opening up its financial market.”

On the suspension of the Ant Financial IPO, Ding added: “On the one hand, we must realize that Alibaba has played a great role in our financial innovation in the past few years. Our financial services used to lag behind others. However, because Alibaba took the lead in setting up the Alipay system, China has caught up with other countries and even moved ahead of the world in electronic payment.

“This is the benefit that financial innovation brings to everyone in this field and the benefit to China. But on the other hand, although Ant Financial is a financial innovation, it also brings huge risks, because it levers its capital 100 times leveraged capital. If our financial market is opened and such enormous leverage cannot be controlled, it may cause a disruption in the Chinese market.”

As an ex-banker, I appreciate Ding’s concerns. Every innovation on the part of the American financial industry turned into a bubble, including mortgage-backed securities, derivatives of mortgage-backed securities and collateralized debt obligations.

In theory, these innovations made markets more efficient by allowing investors to take exactly the degree of risk that they wanted. But the opaqueness and complexity of the innovative financial structures masked a mountain of leverage that ultimately led to the 2008 global financial crisis.

Regulatory pressure against leverage is part of a policy mix that includes other measures to force Chinese companies to adapt to a competitive environment. Most important among these, I argued in a November 25 analysis, is the eventual opening of China’s protected internal markets to tariff-free imports from Japan and South Korea.

That will reduce the cost of goods for Chinese consumers and compel China’s industrial companies to compete with highly efficient firms from its neighbors.

 

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