Chinese equity markets are beginning to crackdown on loss-making companies. The Shenzhen Stock Exchange recently delisted two loss-making companies – Jiangsu Chinese Online Logistics and Powerwise Information Technology Co. These were the first two companies be delisted from mainland exchanges since December 2007.
The delisting procedures were part of efforts by the China Securities Regulatory Commission (CSRC) to remove loopholes and better enforce delisting of companies on the Shanghai and Shenzhen exchanges. Earlier this year both exchanges issued more stringent requirements designed to remove poor performing companies.
Delisting is a necessary step to improve the functioning of China’s equity markets it forces investors to be more careful in evaluating risk. Delisting companies – even if they are mostly small, private companies listed on the Shenzhen exchange – sends a signal to markets that there is now a risk that shareholders could lose all the money in their investment.
However, these efforts by the CSRC to improve equity markets are not nearly enough to resolve misallocation of risk in the Chinese financial system. The especially risk-averse regulatory approach to financial markets in China traditionally favors subsidizing poor performers rather than requiring investors to assume the costs of failure. Such a seemingly risk-free environment leads to misallocation of capital to less efficient segments of the economy, and ultimately creates more systematic risk in the financial system.
Although addressing this problem in the stock market is a step forward, to truly fix this issue something must be done to improve the pricing of risk in bank financing and debt issuance.
Banks are by far the most important source of financing in China. Foreign and local currency bank loans accounted for 60.2 percent of social financing as of November of this year. In contrast, direct financing from corporate bond issuance and equity financing only represent 15 percent and 2 percent of all social financing, respectively.
Yet even a decade after the sector was last overhauled, banks still struggle to accurately price the risk of loans. The continuation of China’s ceiling on deposit interest rates perpetuates an environment of easy lending. The deposit rate cushion disincentives banks to build up their skills in assessing credit risk, often leading them to lend a disproportionate share of loans to large-medium sized corporations at relatively low rates. In September 2012, banks lent 71.2 percent of all enterprise loans to large and medium enterprises. If the costs of capital were higher, banks would need to increase their loans to smaller enterprises because the returns are higher.
Moreover, the unwillingness of banks to accept the defaults on many loans perpetuates lending to relatively poor performing entities. It is common to delay classification of loans as non-performing by classifying a loan a notch above non-performing or “special mention” status to avoid drawing extra reserves to protect against loss. Caixin reported statements by CBRC officials in November suggesting that some 10 percent of loans classified as “special mention” loans - one notch up above non-performing - should actually be classified as non-performing. These “special mention” loans represented 2.94 percent of total loans for the Industrial and Commercial Bank of China (ICBC) – China’s largest bank – compared with only 0.94 percent non-performing loans in 2011. Other times banks extend the repayment period of loans that would otherwise default. Some suggest many questionable loans made to local government financing vehicles during the 2009 stimulus will simply be rolled over for another four years to avoid a string of defaults when some 38 percent of those loans mature in 2014.
Similar to the banking system, the pricing of risk for corporate debt offerings is also under-developed. The corporate bond market has flourished over the past year as regulators - CSRC and National Development and Reform Commission (NDRC) - have released new rules supporting the growth of the market. This past year corporate bond issuance has especially boomed. Accumulated net corporate bond issuance rose by 68 percent in November 2012 compared with the same period in 2011. Corporate bond issuance now represents 14.4 percent of all social financing in China, up from 1.5 percent 9 years ago.
Yet underlying this rapid growth in corporate bond demand is an assumption of limited risk inherent in corporate bond offerings. The corporate bond market has never experienced a default and credit ratings are notoriously high and uniform. The reason for this is twofold: First, historically most corporate bond offerings have been by state-owned enterprises, suggesting an implicit sovereign-backing. Second, at every moment over the past few years when enterprises came close to defaulting on their corporate bonds, they have been bailed out by their guarantors or local governments. These conditions create an environment of moral hazard, leading investors in corporate bonds – increasingly fund management companies this year– to assume that all corporate bonds share little or no risk.
Riskless financing is a fallacy perpetuated by regulators. In the past, examples such as the bankruptcy of Guangdong International Trust and Investment Corp (GITIC) in 1999 – the second largest trust company after CITIC at the time - should have acted as a shockwave for domestic investors yet most of the impact was borne by foreign creditors. Domestic investors - the minority creditors – were prioritized in the bankruptcy proceedings, leaving foreign creditors to assume the majority of the $5.6 billion in losses. More recently, regulators are attempting to decide whether or not to force Huaxia bank to payout money to investors to cover losses from the default of RMB 1 trillion in non-guaranteed wealth management products sold by their Shanghai branch. They fear that if investors were to know the actual risk of these products, contagion will spread across the sector leading investors to pull out of seemingly riskless bank wealth management products.
Regulators at the CSRC have made an important step towards improving the pricing of risk in equities markets by delisting poor performers. Now their counterparts at the Peoples Bank of China (PBoC), China Banking Regulatory Commission (CBRC), and NDRC should commit to enforcing more strict rules governing the defaults of bank loans and corporate bonds. Ultimately financial regulators will need to do a better job in enforcing market rules and allowing investors to assume the full risks of their investments to ensure capital misallocation does not become a barrier to future economic growth.