Looking at the demand side of growth, China has long relied on infrastructure investments to support its economy. Investments accounted for 48.0% of China’s nominal GDP in 2011, reaching an all-time high, and still contributed to 44.4% of that in 20171.
Chinese state-owned enterprises (SOE) used to over-invest to keep production up and keep unemployment rate down, as managements tend not to be return conscientious. The capacity and scale obsession leads to overcapacity, poor profitability and pathetic returns. China launched its “going global” strategy 18 years ago to encourage domestic enterprises to invest overseas2. China’s outbound investment hit a record high of US$183bn in 2016 and the country became the second largest overseas investor in the world3. While there are successful stories of Belt and Road projects to export excess industrial capacity and increase local employment, we see many overseas deals fail due to Chinese enterprises’ lack of understanding about outbound investment risks or weak corporate governance.
Is China resuming its old habit?
Bank loan is one of the main sources of corporate funding for investments, especially for SOEs. If these investment projects fail, the loans may turn into bad debts, which has a negative impact on banks’ asset quality. Hence, the growth-oriented domestic investments and “irrational” overseas investments may increase risks in the entire financial system.
Faced with the increasing risk of demand uncertainty, China has been introducing a series of stimulus measures, including infrastructure investments, to provide a cushion for growth. China’s fixed asset investment (FAI) growth slowed to a historic low (5.3%) in the first eight months of the year4. October NBS data show FAI increased by 5.7% in January to October of 2018, which marked a growth rebound for the second consecutive months and Industrial Production was up by 5.9% YoY, an increase of 0.1% from last month4. Some worry that China is resuming its old habit, which may hinder the country’s progress in deleveraging and make the debt problem worse. Nevertheless, China’s FAI growth averaged 20.05% from 1996 to 2018 and Industrial Production growth averaged 12.12% from 1990 to 20184. Current growth rate is way below the historical average level.
Why is this time different?
From our point of view, besides improved economic fundamentals, as compared to 10 years ago when China embarked on infrastructure sprees, one key factor that will make the difference this time is sound risk management. The government, banks and corporates are becoming more aware of risks and operational discipline in recent years.
The government has been pushing through structural reforms to address the economy’s structural deficiency and implementing policy tools to regulate investments, which in turn help enterprises strengthen governance and build the risk management capabilities. There are numerous examples and we would highlight a likely development in the foreseeable future which shows that when appropriate measures are taken, there are good scopes for China to fix its inherited issues. This is about the government’s latest efforts to reform the social security system. China’s pension fund is faced with a shortfall of 600 billion yuan this year and the deficit keeps widening as population ages5. In late 2017, the government published the implementation plan for transferring 10% of the shares of large and medium-sized central and local SOEs and financial institutions to the Social Security Fund (SSF)5. The dividends paid annually become a stable funding source to help fill the pension gap. If the transfer speeds up, the SOEs being put under the SSF would have to pay better dividends and make less investments for the latter to meet its pension liabilities. Since November 2016, China has been increasing its scrutiny of outbound direct investment made by domestic companies. Further guidelines came into effect from August 2017, standardizing the financial management of SOEs throughout the investment process and requiring SOEs to specify rules on feasibility and financial due diligence. We expect such measures to help SOEs make better investment decisions and improve corporate governance in the medium to long term.
De-risking has been a top priority for Chinese banks given the country’s deleveraging campaign. People’s Bank of China announced four reserve requirement ratio(RRR) cuts this year6, keeping liquidity ample and reasonable under its prudent monetary policy. But the slumping SHIBOR rate indicates the unwillingness of banks to make new loans to the real economy despite sufficient liquidity. These banks are adopting more stringent lending criteria – loans for projects that feature high energy-consumption, high pollution or low profitability are difficult to get approved. According to 3Q18 results, most of the state-owned banks reported lower bad-debt ratios. In addition, the expansion of “shadow banks” that used to help the local government funding vehicles (LGFVs) issue LGFV bonds has been substantially curbed since the new regulations governing the asset management business kicked in. Local government funding vehicles are companies established by Chinese local governments and agencies to raise funds for municipal projects. Local governments used such vehicles to get bank loans as well as issue the urban construction investment bonds (known as Chengtouzhai in Mandarin), which usually have weaker credit profile and less transparency. The local infrastructure projects funded by LGFVs often take long time to generate returns and some of which are even potentially loss-making, increasing the risk of default. Local governments now are issuing bonds directly instead of LGFV bonds to finance infrastructure projects with reasonable cash flow forecast, which reduces unknown risks. With tax reduction measures and other accommodative policies implemented, we expect economic activities to be stimulated progressively; hence business confidence is likely to pick up and demand for loans to recover amid a relatively rosy outlook. When the liquidity released is used to support better quality investment projects, the whole value chain will see a steady and healthy growth.
Meanwhile, Chinese enterprises have been enhancing their risk management capabilities and focusing more on the quality of their investments rather than on the pace if its expansion. According to EY’s survey on risk management for overseas investment, “perform thorough due diligence”, “establish highly effective and reasonable organizational structures and management processes adopted by international markets” and “establish risk prevention and control systems with cooperation from government and third parties” were chosen to be the three most effective actions to prevent and address risks in outbound investment 7. From recent on-the-ground research, we’re encouraged to see Chinese companies pursuing positive changes in operation and risk management. For example, some highly-leveraged real estate companies are re-evaluating their business models, optimizing cash flow and paying more attention to workplace safety issues. Although the market has barely noticed this incremental change, we believe such change is beneficial to improving business’ financial position, and in the medium and long term, it will be conducive to creating a healthier economic system in China.
 Source: CEIC, as of Dec 2017
 Source: Overseas Chinese Affairs Office of The State Council, as of 2011
 Source: Xinhua net, as of June 2017
 Source: Trading Economics, as of Nov 2018
 Source: SCMP, as of Feb 2018
 Source: Reuters, as of Oct 2018
 Source: Ernst & Young, as of April 2017
This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.
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