China: SOE Reform, RMB, and A-Shares

Published on June 22, 2016

Key Takeaways

China’s top leadership has signed off on a plan to shutter regional SOEs at a pace nearly double the 154 that were shut down in 2015

Officials continue to manage the currency below the 6.6000 USD/CNY level, and see limited room for devaluation. The latest FX reserves data continues to show an abatement of pressure from speculators.

Despite disappointment that China’s A-shares were again not included in the MSCI basket this month, officials are likely to still announce the opening of the Shenzhen-Hong Kong Stock Connect link in the next few weeks.

With indications that policy actions taken to date have stabilized the economy in the 6.7-6.8% GDP range, and sensitive to the need to address concerns that some of that stabilization has come from a deliberate decision to expand credit growth despite concerns over local and corporate debt levels, Chinese officials are turning their focus now back onto reform of the bloated State-Owned Enterprises.

*** From what we understand the State Council has drawn up a “comprehensive plan to solve the corporate debt problem” in coordination with all 31 provincial-level governments. According to the plan, drafted last month, an expected 250-300 companies owned by municipal or provincial governments will be shut down, which would be at least 100 more than the 154 that were closed down in 2015. ***

*** The plan addresses key elements in managing the process of corporate restructuring, mergers, bankruptcies, asset auctions, refinancing where needed with government financial aid or support, and allowing some SOEs to take on “mixed ownership.” From a macro perspective, it also includes plans to help affected laid-off workers find new jobs and create job training and placement services. ***

Addressing Debt Concerns

According to the Ministry of Finance, at latest count China has some 150,218 SOEs owned by the central government and at the provincial, city, county, town, and village levels.

Out of the 150,000 plus SOEs, 28,439 are directly under the “2016 budget management” of the central government, and out of these, 106 are non-financial enterprises administered by the State-owned Assets Supervision and Administration Commission (SASAC).

For 2016, the State Council is planning for between 250 and 300 SOEs which are owned by municipal or provincial governments to be shut down, almost twice the pace of last year.

Part of that resolution process will by definition entail the central government assuming a portion of the debt that is currently held by local governments and corporations.

Sensitive to speculation over the true level of China’s debt overhang, senior officials point out that according to their calculations China’s total debt including central government, local government, financial institutions, non-financial institutions, and households is no more than 230% of GDP as of today.

They point out that China is also a country with a very high savings rate, with its debt held almost entirely domestically, a vastly different profile from countries with low savings rates and debt that is widely held by foreigners.

Furthermore, they note that China’s government debt ratio stood at 41.5% of GDP last year, significantly below countries such as the US, Japan, France or even Germany, with the central government’s portion of that debt as low as 20%.

Perhaps most to the point, they believe China still has substantial room to boost government borrowing to lower corporate sector debt levels, with limited risk.

Indeed, they expect China’s deficit will rise to 3.5%, 4%, or even higher of GDP over the next few years, from the 3% target this year.

And when it comes to the admittedly problematic debt that is held at the provincial and local levels, MOF sources note that 70% of local government debt is estimated to be in the form of investments with expected returns, and that of the 31 provinces, 25 are obligated by statute to repay their debt, the total amount of which has not exceeded 35% of those provinces’ GDP.

Of course we can fully expect private sector economists to continue to challenge Beijing’s figures.

Currency Levels and Flows

Chinese officials believe the room for RMB devaluation this year continues to be fairly limited. They continue to expect the RMB to trade between 6.5500 and 6.6000 to the USD in the near future, with some of the upside pressure (selling pressure on the CNY) to have clearly eased as the Federal Reserve moderates its expected path of rate hikes for this year and beyond.

As you will recall, officials had warned that the CNY could trade above the 6.6000 level if the Fed were to hike as expected this year, but that even if the Fed were to hike on the more aggressive two hike pace for the year, they had expected the CNY to trade no weaker than 6.7000, on the outside, for the remainder of this year (SGH 5/24/16, “China: Fed Hikes and the Sliding RMB”). That pressure has of course abated.

They do continue to expect to experience some rounds of volatility still for 2016, but they expect those to be limited compared to the volatility of late 2015 or early 2016, as markets gradually adapt to two-way RMB markets, price in modest Fed expectations, and continue to buy into expectations for a more stable financial environment and expectations for Chinese growth and reform.

Those rather benign expectations may not just be wishful thinking, and seem to be borne out, at least for now, in the most recent FX reserves data.

According to the latest figures, China’s FX reserves shrank by about $28 billion in May, a modest drop by Chinese standards, and as fully expected by the PBOC, (SGH 4/26/16, “China: FX Reserve Reversal”). To be precise, China’s FX reserves dropped from $3.219668 trillion in April to $3.191736 in May.

But just as some of the uptick in the reserves data the previous month had been due to the impact of changes in the value of the dollar, almost all of the fall in reserves this month was due to the valuation effect – this time of a stronger dollar – and not to outflows.

Specifically, weakness in the major currencies – Euro, Sterling, and yes, even the Yen – against the USD led to a valuation loss of $25.2 Billion in China’s reserves in May, compared to a paper gain of $15.3 billion in April.

Chinese individuals did purchase a larger amount of dollars on expectations of higher US rates, but even those purchases were modest, estimated at $3.8 billion in May, from April’s $3.3 billion. And net capital outflows actually eased, despite Fed expectations, with the PBOC estimating $3.5-4.0 billion of “hot money” outflows in May.

Perhaps most importantly, all this was accomplished with minimal intervention in the FX markets, at least as measured officially.

The PBOC did not sell dollars on the spot market for the entire month except for on May 30, when the central bank sold $560 million. That represents the second smallest monthly intervention level since August of last year.

A-Shares and the Shenzhen-HK Link

There is no question Chinese officials were severely disappointed, if not outright angered, at the decision on June 15 by the MSCI, despite rumors and expectations to the contrary, to hold off on including China’s A-shares in its Emerging Markets Index.

While they understood that decision may have had limited real immediate impact – expecting inclusion to have been only 5% of a full inclusion that would still be a year away – they believed it would represent an important symbolic step and psychological boost to Chinese markets.

And Chinese officials believe they had gone out of their way to demonstrate a political commitment on their part in granting the United States a 250 billion yuan quota under the existing Renminbi Qualified Foreign Institutional Investor (RQFII) program at the US-China Strategic and Economic Dialogue earlier this month.

They note that the granting of this RQFII quota which allows US financial institutions to invest in China’s markets was a largely symbolic and friendly gesture in that many other channels for investing in China’s domestic assets have already been opened up since the program was first launched in December of 2011.

Despite their disappointment at the MSCI decision, from what we understand, Chinese officials are still likely over the next few weeks to go ahead with their plans to announce the launch of the Shenzhen-Hong Kong Stock Connect program designed to link the markets together.

The link as proposed by China’s CSRC (China Securities Regulatory Commission) has been formally approved already at the highest levels – by Premier Li Keqiang and Vice Premier Ma Kai – which was confirmed earlier this month with Ashely Alder, CEO of the Hong Kong Securities and Futures Commission, and Carlson Tong, the SFC’s Chairman.

It is expected that the SZ-HK Stock connect program will take three to five months to implement once it is formally announced.

Compared to the Shanghai market, the Shenzhen market is largely made up of medium to small market cap companies, but it has relatively active turnover and liquidity. Officials tout the Shenzhen market’s growth potential due to its sector composition that leans towards new materials, IT, pharmaceuticals, and consumer stocks.

And indeed, over the last three years, foreign investment in the Shenzhen market has already tripled, from 50 billion to 170 billion yuan, through the QFII program.

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