Why do state-owned enterprises (SOEs), which are considered the “backbone” of the Communist Party of China (CPC), default on their debts so often? Today, we will talk about the fat SOEs, the blindly confident government officials, and the huge debt risk.
Fat SOEs
Let’s start with the fat SOEs. In August 2020, Fortune released its latest list of the world’s top 500 companies. At that Time, the Beijing authorities excitedly announced on the official website of the State Assets Supervision Commission of the Communist Party of China (CPC) State Council that the number of companies on the list in mainland China, including Hong Kong, reached 124, surpassing for the first time the U.S., which had 121 companies on the list, and that 48 of the central enterprises under the CPC State Council State Assets Supervision Commission were on the list among these 124 companies. For this ranking, the CPC is very happy to say that the development of central enterprises has led to the rise of Chinese enterprises as a group.
So, what are the rules for ranking the world’s top 500 companies? This ranking, basically, is based on the size of enterprises, where size is either measured by sales revenue or by the size of net assets. However, it is important to note that large size does not necessarily mean that the enterprise is strong, what does it mean? It’s like a person who weighs a lot, but it doesn’t necessarily mean a strong body, it’s the same thing.
Fortune also pointed this out in its report saying that companies in mainland China, on average, have improved their sales revenue in 2020 compared to 2019, however, Chinese companies have lower levels of profitability.
Let’s look at the specific data, in 2019, the average profit of the 124 Chinese companies on the list is less than $3.6 billion, which is about half of that of U.S. companies and, also, below the average profit of $4.1 billion of the 500 largest companies in the world. If you look at the average return on sales, the average Chinese company on the list has a return on sales of 5.4%, which is lower than the 8.6% of U.S. companies. Looking at the average return on net assets, the Chinese companies on the list are 9.8%, also lower than the 17% of U.S. companies.
Return on sales is the ratio of net profit after tax to sales revenue, and return on average net assets is the ratio of net profit after tax to average net assets. In other words, for every $100 of sales revenue generated by the Chinese companies on the list, the final after-tax net profit is $5.4, compared to $8.6 for U.S. companies; at the same time, these Chinese companies can generate an average of $9.8 of after-tax net profit for every $100 of net assets, compared to $17 for U.S. companies. Therefore, it is clear who is more profitable and who is less profitable, and the situation of these Chinese companies on the list illustrates the fatness of Chinese state-owned enterprises in general.
However, the CCP naturally avoids talking about the truth of the “low profitability of Chinese enterprises”. In addition to the low profitability, we have seen that CCP SOEs, especially AAA investment grade SOEs, have recently defaulted on their bonds one after another, so this also shows that the debt risk of CCP SOEs is also very huge. Let’s talk about this debt risk next.
State-owned enterprises default frequently
Media reports indicate that in 2020, the size of bonds defaulted by Chinese companies in the domestic market, as well as the offshore market, reached $30 billion, up 14% year-on-year from 2019.
In mainland China’s bond market, for example, the National Finance and Development Laboratory, a national-level think tank of the Communist Party of China, gave data that in 2020, the amount of bond defaults incurred by Chinese SOEs reached RMB 71.8 billion, accounting for 51% of the overall default amount, a new high since 2014.
Let’s briefly review the SOE defaults. 2020 February, Beifang Founder bond default; November, Henan Yong Coal, Brilliance Auto, Tsinghua Ziguang, successive debt defaults. By March of this year, Hebei State-owned Jizhong Energy, wholly owned by the Hebei Provincial State-owned Assets Supervision and Administration Commission, technically defaulted, followed by Chongqing Energy, 100% owned by the Chongqing State-owned Assets Supervision and Administration Commission, whose notes were overdue.
Here we explain what Jizhong Energy calls “technical default”, which refers to a situation where a bond issuer has the ability to repay, but fails to do so in a timely manner due to improper scheduling of funds or operational timing. However, many analysts say that some “technical defaults” in the mainland China market do not conform to the international understanding of “technical defaults”, but are more like substantive defaults. Some companies, under the banner of “technical default”, will cover up their poor liquidity and high financial leverage.
As we can see, from last year to now, the Chinese Communist Party‘s state-owned enterprises (SOEs) have been defaulting on their loans in droves.
High Debt Amid Easy Credit
Over the past 20 years, the Chinese Communist Party has repeatedly eased credit. The most typical one was in 2008 when the CCP launched a 4 trillion fiscal stimulus policy, under which the scale of social financing rose rapidly, followed by several credit expansions in 2012, 2015 and early 2020, and the growth rate of social financing scale all rose.
The Communist Party’s People’s Daily Online has reported that after the 4 trillion investment plan, banking was extremely generous and almost chased state-owned enterprises to lend. And state-owned enterprises have thus embarked on a path of highly indebted operation.
On one side, there is a large amount of low-cost borrowing, while on the other side, there is a lack of high-quality projects, so the enterprises gradually accumulate a high amount of debt, resulting in high financial costs and interest charges, and this situation is very common among the Chinese Communist Party’s state-owned enterprises and central enterprises, and a financial director of a central enterprise once lamented that, after a year, the net profit after tax is not as high as the interest charges.
Let’s take some of the CCP central enterprises that are in the top 500 in the world as an example and see how their figures look like at the time of 2019. For example, the Communist Party of China (CPC) Minmetals Group, in 2019, listed a whopping $14.1 billion in interest expense on its consolidated income statement, while the company’s net profit after tax for the year was only $10.4 billion. China Huaneng Group’s interest expense was 26.1 billion while net profit after tax was only 11.5 billion; CCP Aluminum Group’s interest expense was 15 billion while net profit after tax was only 3 billion ……
For those who are interested, you can check how many of these Chinese companies in the top 500 are the ones whose net profit is not enough to pay the interest charges in a year? The result may be a shock.
In addition to high financial costs, high debt brings high leverage and high debt risk. According to the rating report provided to Minmetals Group by China Credit, we learn that Minmetals Group’s gearing ratio reached 76.5% in 2019, and the total debt is 8.24 times the EBITDA, meaning that it would take about eight more years to repay the debt on its body by its own operation.
So how do these highly leveraged and risky companies pay back the money? The main way, is through refinancing, which, to put it bluntly, means borrowing money to pay back the money. They either issue another bond in the bond market to pay back the money, or borrow money from banks. But when SOEs default on the bond market one after another, then it will directly impact the confidence of investors in the bond market, making it more difficult for companies to raise money in the bond market. According to IFC data, 771 credit bonds were cancelled or postponed in 2020, more than 300 more than in 2019. And mainland media reported that 77 AAA-rated bonds have been cancelled as of March 19 in 2021, accounting for nearly 40%.
With the frozen financing environment in the bond market, what to do? Companies have to turn to banks, which are also mostly owned by the Chinese Communist government, and there is a high probability that they will continue to support SOEs for the sake of the government. However, this seemingly reasonable logic was broken by the overdue bank notes of Chongqing Energy this year, so many investors wondered whether the CCP still supports its SOEs or not.
Market-based handling of risks
The CCP government’s support for SOEs in debt repayment often comes through the banks. The government may step in to help the enterprises coordinate with the banks. Some governments have even issued direct red-headed documents asking banks not to draw loans to continue supporting certain SOEs, but banks are also faced with bad debt overhead. in early March, Guo Shuqing, chairman of the CCP’s CBRC, said that from 2017 to 2020, China’s banking sector disposed of 8.8 trillion yuan of non-performing loans, more than the previous 12 years combined. Among them, 3.02 trillion were disposed of in 2020 alone. Therefore, the risks faced by banks should not be underestimated. It can be said that in this situation, borrowers and lenders are both the CCP, which side should be helped?
In this regard, the CPC has proposed a “market-based” solution to the debt, but many people worry that this “market-based” provides the possibility for state-owned enterprises to evade the debt. For example, when enterprises raise funds, investors invest in state-owned enterprises, to a large extent, considering the possible government support behind the enterprise, so why, when it comes to repayment, the Communist Party, in the name of “marketization” to let the enterprise default and not pay?
When Yong Coal defaulted last year, an online article criticizing Henan’s finance and economics officials went viral. The title of the article was “Confident and smart”, which refers to “schizophrenia”. What does self-confidence mean? The article quoted a paragraph of Henan government officials who said that the debt problem of Yong Coal was mainly caused by market-oriented operations. In the past, they might have borrowed money to help companies pay off their debts, but now the government is more confident and will not bail out companies because they have defaulted on their debts, but will force them to reform.
This paragraph made countless netizens spit blood, lamenting the confidence of the Chinese Communist government is really unique, can “confidently” let Yong Media default. There may be many such CCP officials who have been deceived by the CCP’s boast of the top 500 enterprises to swell their confidence, but large size does not mean that the enterprises are strong, let alone financially healthy.
For the CCP, the frequent defaults of state-owned enterprises are definitely a bad thing, because once investors completely lose confidence in CCP state-owned enterprises, the CCP can no longer try to circle money.
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