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Many investors were reassured by China’s recent decision at the National Financial Work Conference (NFWC) to create a super-regulator to oversee the financial system amid rising worries over systemic risks. The creation of this organization is further evidence of China’s continued efforts to refocus financial activity on economic outcomes; financial activity is welcome as long as it promotes growth. As China’s stock of debt has grown, the linkage between the main business of the financial system- namely making loans to corporations-and growth has weakened. The readout of the NFWC contained a recommitment to SOE reform, to both eliminate unproductive debt and improve economy-wide efficiency. In light of this restatement, we think investors could benefit from a status check on the state-owned corporate sector and an examination of what these continued reforms could mean for China’s economy and investor portfolios.
Corporate debt: SOEs vs. private companies  China’s rising debt has been a growing concern, particularly the mounting pile of corporate sector debt. Government and household balance sheets are in relatively better shape given their comparatively low levels of debt (Exhibit 1). 

According to the International Monetary Fund in 2016, SOEs accounted for roughly 55% of total corporate debt despite only producing 22% of economic output. As a result, deleveraging SOEs would seem an easy first step in deleveraging the whole economy.
SOEs concentrated in “old China”
Reforming SOEs serves a related goal of the government-the transition to a more consumption-led economy. SOEs, and therefore corporate leverage, are concentrated in heavy industries. Maintenance of these inefficient companies has taken its economic toll, as funding their activities diverts resources from companies that are focused on faster-growing, less-industrial sectors. Steps have been taken to improve China’s corporate balance sheet, but these efforts have yet to be significantly reflected in SOE balance sheets. Overall financial leverage, measured by liability-to-asset ratios, for industrial firms has been declining since 2013. However, this was primarily driven by improving non-SOE balance sheets, as shown in Exhibit 2, while SOE liability-to-asset ratios remain elevated. Meanwhile, the overall return on assets (ROA) of these same firms has deteriorated, dragged down by the poor profitability of SOEs, shown in Exhibit 3 to the right. 
  
If we examine corporate balance sheets by sector, we find that high leverage is concentrated in a few sectors: (1) heavy industries and utilities suppliers, which are dominated by SOEs, and (2) property developers. In contrast, the health care, consumption and information technology (IT) sectors are among the least leveraged. 
As shown in the table below, this high leverage is especially concentrated in a few heavy industrial sectors dominated by SOEs, mainly due to the high capital expenditure requirements of these industries and continued leverage accumulation (Exhibit 4). These same highly leveraged industries also suffer from severe overcapacity and post among the lowest ROAs. Coal mining is the most extreme example of this falling leverage-to-return relationship. Despite increasing its leverage from 59.5% in 2011 to 68.7% by June 2017, its ROA fell from 16.8% to 5.6% over the same period. 
 
Raising assets on SOE balance sheets or returns from existing assets could put SOEs on more solid footing, but the outlook for these firms is challenging given the global environment for commodities. Therefore, authorities are left with debt. Lowering the amount of debt held by SOEs would seem to be a beneficial step, but this may not deal with the wider issue authorities want to tackle. The figures presented here are for SOEs versus private firms in the industrial sector only. But China’s economy has expanded far beyond industrial activity; consumption drove over 60% of China’s GDP growth last quarter. 
SOEs are not the whole problem
Making SOEs more efficient and reducing the misallocation of capital are clear economic positives, but SOEs account for just over half of China’s corporate debt. The real drivers of the recent sharp increase in China’s debt load are the real estate and financial sectors. Debt accumulation in the real estate sector has been accelerating since 2009. Data on property firms is not as robust as for the industrial sectors, but statistics drawn from the statements of the listed companies- theoretically the most successful-show worrying borrowing patterns. Net debt-to-equity ratios of listed property developers shot up from 39% in 2009 to 124% in 1Q171. By comparison, the average net debt-to-equity ratio for all listed A-shares companies was 51% in 1Q17. Property and financial firms are unlikely to reduce their borrowing outright, but the increased focus on financial stability from regulators should cool some of the more speculative activity. Reforms in the name of SOE clean up are unlikely to touch these sectors, and as a result SOE reforms alone may not enable the government to achieve its wider goal of reducing leverage in the economy.
Means to an end
The overarching aim behind these reforms to the state-owned sector is to relink credit and GDP growth. For much of its modern history, ratcheting up credit growth was a reliable way for China to boost flagging economic growth. In the 2001 to 2008 period, the ratio of credit growth to economic growth was 1.9:1, but this ratio has more than doubled to 4.0:1 post the Great Financial Crisis, meaning credit is less effective at generating growth (Exhibit 5, next page). While this decline in credit efficiency can be attributed to a large number of factors-including, but not limited to, rising unproductive investments, a commodity-price linked industrial boom and then bust, increasing usage of credit for financial speculation- the result is that one of the government’s most reliable tools for reaching its economic goals no longer works as well as it once did. Naturally, authorities would like to re-establish this instrument’s utility. 
 
SOEs hold a lot of debt on their balance sheets and can be reliably counted upon to borrow more when directed. However, the recent rapid accumulation of debt has been driven by non-SOE entities, namely financial institutions engaged in creating wealth management products, real estate-linked companies financing China’s continued property boom and local governments (through linked corporate entities) spending on policy priorities. While these activities may seem supportive of growth, the ever-mounting pile of debt they incur has reduced the effectiveness of the transmission of credit growth to GDP growth. By targeting SOE balance sheets as a means to relink economic growth and credit, authorities may be missing the real target. Instilling better governance and discipline at China’s SOEs is an important goal, but it may not have the result the government desires in this instance.
Investment Implications
SOEs are overrepresented in internationally accessible equity and bond markets and will continue to be the targets of government-directed reforms. While these reforms may not have a large overall economic impact, individual names, especially in the most-leveraged industrial sectors, may face lean times. As such, active investors may want to identify and consider firms that will likely not suffer from a greater regulatory crackdown on SOEs and which boast stable and strong balance sheets. Non-SOEs in sectors serving China’s more consumption-driven economy, such as health care, consumer discretionary and IT, will not feel as much of a pinch from a regulatory crackdown and have been posting higher returns for investors already. Regulatory changes aimed at relinking economic and credit growth will likely continue, but we expect these to remain focused on the highly indebted sectors, such as heavy industry, for the time being. Reforms aimed at financial and real estate companies are already underway to a degree and we expect regulatory focus on them will only grow in the future, something investors should keep in mind when making investment decisions about China in the coming months.
The Market Insights program provides comprehensive data and commentary on global markets without reference to products. Designed as a tool to help clients understand the markets and support investment decision making, the program explores the implications of current economic data and changing market conditions.

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Originally published by J.P.Morgan Asset Managment

Authors: Marcella Chow, Global Market Strategist & Hannah Anderson, Global Market Strategist

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