Treasury Today Country Profiles in association with Citi

China: a delicate balance

Guiyang, China skyline at Jiaxiu Pavilion on the Nanming River

As China enters a brave new era and looks to gain even greater political and economic prominence around the world, new opportunities and challenges will emerge for organisations doing business in the country. Treasury Today Asia analyses the forces driving the country’s transformation and looks at what this all means for treasury.

President Xi Jinping heralded the dawn of a “new era” for China at the recent 19th Party Congress. He proclaimed that thanks to decades of “tireless struggle”, China stood “tall and firm in the east” and it was time for China to transform itself into “a mighty force” that could lead the world on political, economic, military and environmental issues. He called this the “China Dream”.

Xi’s words come at a time of broader global upheaval, with uncertainty awash in the world’s other great spheres of power. It is therefore possible that Xi is being opportunistic and taking advantage of the chaos elsewhere to further China’s ambitions. Xi has certainly positioned himself as the opposite to US President Donald Trump by denouncing isolationism and championing cooperation among nations, which gives weight to this claim.

Yet a broader analysis of Chinese political and economic systems shows that rather than being opportunistic, Xi is simply guiding China on a course that it has been on for over a decade now. And as China spreads its wings, gaining even greater political and economic prominence around the world, new challenges and opportunities will emerge. Indeed, rather than just bringing a “new era” for China, the country’s ambitions may usher in a new era for the world. As a result, corporates, perhaps more than ever, need to keep a close eye on what is happening.

Changing economic direction

China’s economy – the world’s second largest – powers the country’s global aspirations. However, it is an economy currently in transition. This has seen growth in China’s economy slow down, with growth rates dropping from double digits to between 6% and 8%. A decade ago, the 6.9% GDP growth posted in 2016 would have spelt trouble for China’s leadership, which measured its success on these numbers. Today, China’s economic ambitions are different and these numbers are regarded as the “new normal”. The focus for the government is on quality and sustainability, rather than the pace of China’s economic growth.

Driving the shift to quality economic growth is the rebalancing of the economy. The objective of this structural transformation is to reduce the dependence on investment and manufacturing and shift towards a more service, innovation, and household consumption-driven economy. “This is something the government has been pursuing for some time and the evidence of this is starting to come through,” says Louis Kuijs, Head of Asia Economics at Oxford Economics. “For example, the role of consumption in the economy is rising whilst the role of investment is declining in line with what we all would like to see. There has been a pronounced trend towards a larger role for the service sector in the economy.”

Debt held by non-corporates in China stands at US$18trn

This positive news has seen China enter 2018 on a decent footing. However, some sizeable risks still exist. “When it comes to China, sentiment often changes faster than the underlying risks,” says Kuijs. “High levels of debt, which is the big risk people were emphasising a year ago, have not gone away. If anything, debt is still only rising as a share of GDP.”

These debt levels saw China’s long-term sovereign credit ratings cut by one notch to A+ from AA- last year by S&P Global Ratings. And the rating agency still has concerns about China’s macro-credit path, calling it “unsustainable”.

“Credit growth remains higher than nominal GDP growth, although the gap has narrowed in the past year or so,” says Paul Gruenwald, Chief Economist at S&P Global Ratings. “Although there is a healthy rebalancing toward consumption taking place, GDP growth targets need to be lowered below 6% in the medium term and reform of the credit-heavy state enterprise sector needs to be accelerated.”

Balancing risk and growth

The careful balancing of risk and growth is what Julia Wu, President of J.P. Morgan Chase Bank China and Head of Corporate Banking for J.P. Morgan China, pinpoints as the biggest trend in China right now. “The government has publicly stated that preventing systemic risk is its top priority,” she says. “This is why it is pushing local corporates to deleverage, pushing the banks to bring off-balance sheet items back onto the balance sheet, and strengthening the regulatory regime.”

China’s vast shadow banking sector is one area that has come under particular scrutiny. This has led the regulators to put several reforms in place to curb risks. One of the most notable for corporates has been the measures introduced by the CSRC to strengthen China’s money fund industry – which has total assets under management of around RMB6.5trn. These measures impose tighter limits to reduce concentration risk, limit a fund’s exposure to any single borrower and reduce a fund’s ability to invest in assets with a lower credit rating. Asset managers are also no longer able to promise investors a guaranteed rate of return.

Another area of China’s shadow banking industry impacted by the regulators is the use of entrusted loans – loans that are made from one company to another with a bank earning revenue by guaranteeing and arranging the transaction. Towards the end of 2017, Beijing began to clamp down on these products, meaning that banks are no longer able to provide guarantees for the loan. They have also stopped the loans from being used to buy equities, bonds or derivatives by the company borrowing.

Whilst these moves are clearly a step in the right direction to drive risk out of China and align the country more closely with ‘international standards’, there is a fear that they will negatively impact growth. However, with China’s economy growing faster than expected in the fourth quarter of 2017, this isn’t happening just yet.

Mobile payments in China totalled RMB81trn for the first ten months of 2017

China is also balancing its regulatory tightening by loosening its grip on other parts of the economy. Notable moves include the launch of bond connect – a mutual market access scheme that allow investors from mainland China and overseas to trade – which further integrates China’s financial markets with international markets. Elsewhere, China has said that it will remove foreign ownership limits on banks, while allowing overseas firms to take majority stakes in local securities ventures, fund managers and insurers – a move that will make China’s banking sector more competitive.

Local impact

J.P. Morgan’s Wu says that local Chinese corporates will feel the biggest impact of these changes. “They are clearly going to have to deleverage faster than they might have initially expected,” she says. “These companies, especially those heavily engaged in or reliant on the shadow banking sector, will also be required to rethink their processes and operations.”

This will accelerate a broader evolution within many Chinese companies that are looking to adopt best in class principles to ensure they also achieve lasting and sustainable growth. “Many local corporates are moving overseas and expanding their operations,” explains Wu. “At the same time, they are also refocusing to ensure they concentrate on their core business.”

Both these trends are requiring enhanced treasury capabilities, says Wu. “Treasury teams of local corporations are very interested in how global businesses manage risk and liquidity when operating across many different markets. They are then coming to us and asking for solutions that provide them with visibility, efficiency and that also enable them to hedge risks.”

Tied to this uptick in treasury sophistication, Wu is seeing many companies looking to centralise their treasury activity. “Hong Kong is becoming a very attractive destination now for Chinese corporates looking at establishing regional or global treasury centres,” she says.

In focus: the debt pile to end all debt piles?

Corporate debt is a problem in China. A big problem. Data published by the Bank of International Settlements (BIS) at the end of 2017 highlights this, showing that debt held by non-financial corporates in China stands at US$18trn.

This debt is making people nervous. The IMF has called it “dangerous”, whilst Zhou Xiaochuan, Governor at the PBOC, has acknowledged that companies in China have taken on too much debt. The fear is that with corporate debt in China continuing to grow faster than the economy, the bubble will eventually burst. The impact of this on the Chinese and global economy could be devastating, potentially creating another global financial crisis.

The good news is that the risk of a near-term crisis is relatively low, according to Paul Gruenwald, Chief Economist at S&P Global Ratings. “Owing to its high savings rate and current account surplus, China is a self-funded country,” he says. “As long as domestic confidence remains high – which remains true at present and shows little chance of changing – the risks of an economic crisis are contained.”

This doesn’t mean that the problem doesn’t need to be solved by the Chinese authorities. “There has been a large accumulation of bad debt in the economy,” says Louis Kuijs, Head of Asia Economics at Oxford Economics. “Around a quarter of this is found in sectors with weak financial indicators where there are sub-par rates of return and high debt to equity ratios. But these firms continue to borrow and it will become increasingly harder for them to repay.”

The Chinese government is aware of these issues and has issued various statements calling for Chinese companies to reign in debt. One such statement came in August last year when the finance ministry issued directives saying that state-owned companies should improve returns, control risks and make sure that “projects are financially viable before decisions are made”.

“SOEs are heeding the central government’s directive to control debt leverage and they made tentative progress in 2017,” says Christopher Lee, Analyst at S&P Global Ratings. “We expect SOEs to put in a bigger effort to control debt leverage in 2018-2019 because the regulators have recently announced that SOEs need to reduce leverage by 200bp over the next two years. We expect SOEs to raise equity, sell non-core assets and undertake debt-for-equity swaps to improve their leverage.”

It’s clearly a delicate balance for the Chinese authorities. On one hand, they want to curb risks that exist in the economy because of corporate debt. On the other, they do not want to stifle economic growth. The IMF has noted that growth will come first and the Chinese authorities will do what it takes to attain the 2020 GDP target. As a result, it expects China’s non-financial sector debt to exceed 290% of GDP by 2022.

Highs and lows

The move to align the Chinese economy more to international standards can only be a good thing for international corporates. However, treasurers at these companies are not getting carried away or expecting that operating in China will be like operating in Singapore or Hong Kong anytime soon. Recent experience has shown them that in China, things can change very quickly.

This is especially true when it comes to currency controls. “For a while, the regulatory environment was relaxing and we were able to move money into and out of China quite freely,” says Anthony Osentoski, Head of Corporate Treasury and Insurance, Asia Pacific at Solvay. “Then in late 2016/early 2017 things changed and the regulators introduced rules that brought in tight quotas, limiting the amount of CNY they could transfer offshore.”

For treasury teams, this ‘window guidance’ has had multiple impacts. For example, some corporates had spent considerable time and effort building cross-border cash pools that overnight they were no longer able to use. For Osentoski, window guidance meant that Solvay had to readjust its processes. “We were working on rolling out all of our intercompany payables to be paid in CNY — buying into this vision of CNY being a world currency,” he says. “When window guidance came in we had to roll all this back and revert to using the US dollar for cross-border settlement.”

With window guidance lifting, Osentoski is hopeful for the future and expects things to become easier for treasury teams. However, he is cautious that China could, at any time, put the brakes on again. “Despite the challenges that window guidance created for many treasury teams dealing with China, the policy ultimately worked and allowed the authorities to regain control over cross-border cash flows. Therefore, if something like the events of late 2016 happened again, I think we might see the reintroduction of these rules. So, whilst the opening of China is positive, we must always remember that this is happening with an underlying control mechanism ready to be put in place whenever needed. This is very different from many other developed economies.”

Leading the world

Another area in which China is different from other developed economies is the development of its digital payments ecosystem. China is arguably leading the way when it comes to being a cashless society thanks to the rise of platforms such as WeChat Pay and Alipay.

Whilst in the corporate space the initial impact of this development is being felt largely by B2C companies, the entire corporate ecosystem in China is beginning to find value in the use of digital payments. To provide an example, Sam Xu, Head of Transaction Banking, China at Standard Chartered, talks about the work the bank has done with a company that services elevator shafts across China.

“This company uses contractors to carry out maintenance,” he says. “Traditionally, the building owners would pay the contractors in cash, and the contractors would then be required to take the cash back to the company that hired them. The issue for the company was that the contractors were often slow in bringing the company the cash, and, in some cases, misplaced it.”

Chinese SOEs have been asked to reduce leverage by 200bp over the next two years

This created a big problem for the treasury team, which was solved by a solution that utilises WeChat Pay. “Each elevator now has a QR code that the contractor’s scan once they have completed the job,” says Xu. “This automatically initiates a digital payment for this work that goes straight to the company. In addition to removing the risk posed by asking contractors to handle cash, this solution has also added-value by allowing the treasury to achieve automated and straight through reconciliation of payments.”

It must be noted that given the incredible surge in popularity around QR code-based forms of payment in China, the regulators are paying attention. In a bid to encourage payment companies and merchants to adopt better and more secure technology, at the end of last year, the Central Bank introduced rules to set daily payment limits for individuals across all their registered mobile wallets. The limits are tiered based on level of security, with static QR codes capped at CNY500 and dynamic QR codes capped at CNY1,000 per day to uncapped for transactions verified with two or more authenticate factors. “This is a positive move,” says Xu. “It will increase protection to consumers and give room for mobile payments in China to continue their impressive growth.”

Looking ahead

With so much happening right now in China, it can be difficult for businesses to think too far ahead. But as previously mentioned, the only way to be successful in China is to keep one eye on the future and understand the direction in which the country is heading.

For Oxford Economics’ Kuijs, the future is looking bright for China. “Despite some of the difficult issues and reforms that China needs to tackle, I am relatively optimistic on China’s outlook,” he says. “If you look at what is happening in the real economy, there are lots of positives – and China is well placed to do well in the global economy.”