China, the Trade War and Capital Misallocation

Given the recent trade tensions between the two, you’d be surprised to learn that Beijing and Washington share a common goal: channel more loans to China’s private sector. Could this be the most direct approach to reach a sustainable trade truce? It will be interesting to see what Beijing does next.

China’s 13th National People’s Congress (NPC) held in early March was centered on stability, and after posting 6.4% GDP growth in the first quarter of 2019, Beijing’s efforts appear on track.

But as political analysts argued, Beijing’s message at the NPC is that fiscal and monetary policies will remain loose, reneging on previous reform attempts that were aimed at deleveraging the economy and removing systemic risks from financial systems.

A balancing act between two superpowers

Beijing’s stability pursuit may be difficult to achieve as the Trump administration is pushing for unilateral penalty enforcement along with snapback options. Essentially, the US would play both the judge and the jury, removing the stability component that China desires.

Beijing’s response has been to increase liquidity to protect growth. However, this strategy is misplaced and only exacerbates geopolitical tension. Incrementally, any rhetoric to support private companies is directionally positive, including comments from the country’s top banking regulator allowing higher non-performing loans from smaller entities.

The focus to help private companies is evident. Private enterprises in China have an outsized impact on the overall economy. They account for about 50% of tax collected, 60% of economic activity, and 80% of new urban job creation. But despite this heft, they only rake in less than 25% of total new bank loans, according to the China Banking and Insurance Regulatory Commission.

Politics and credit don’t mix well

Commercially, private companies are perceived as higher risk, since they have neither local nor national government backing. Yet bank lending is highly political. Helping a government-related entity normally curries favours from central authorities, providing a goodwill component that benefits financial institutions.

This practice not only crowds out more efficient investments but also spurs a moral hazard with a false sense of risks. This is evident in the current economic climate, where it takes more than six times the amount of credit to create the same unit of growth than it did a decade ago.

Beijing is its own worst enemy

Pushing more credit into China’s private sectors would assuage Washington’s trade concerns that subsidies are being indirectly channeled into government entities that create an unfair advantage for foreign investors. But redirecting loans counters Beijing other political projects, including its Belt and Road Initiative (BRI) and Made in China 2025 campaign.

Ironically, pulling back on its BRI may prove to be ideal for Beijing, as it addresses concerns that China is using debt diplomacy to attack the sovereignty of recipient countries. This flexibility is already evident following Beijing’s decision to lower the cost of the East Coast Rail Link in Malaysia by a third, from RM 66.7 billion to RM 44.0 billion.

But this is occurring simultaneously as Beijing continues to push money towards state-owned enterprises (SOEs) over private firms. In the first quarter, credit flows were dominated by SOEs and local governments. Net issuances by SOEs exceeded RMB 750 billion compared to RMB 741 billion by corporates of all types, according to data from Wind, a Chinese data provider.

Looking for efficiency

Though large private companies have access to foreign capital, it’s neither sufficient nor addresses the structural bias in the banking system. For investors, this would be credit negative as loans fail to generate productive assets that benefit the economy.

If these SOEs produce profits less than the amount that subsidies or cheap financing provide, this creates real economic consequences. As China’s policymakers grapple with headwinds in an economy that is the second-largest in the world, it’s worth investors’ time to actively monitor the Hong Kong market to see where the most efficient (and productive) listed Chinese companies exist.



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