Why China should reduce reliance on credit growth

China's debt level ballooned to 250% of GDP this year.

Chinese policymakers have been taking steps to address potential credit risks stemming from the country's growing corporate and local government debt load. But while BMI believes that their efforts will aid in alleviating credit risks, it cautions that a continued reliance on credit growth to maintain real GDP growth at above 6.5% would negate such efforts.

The research house argues that only a reduced dependency on credit, together with deeper structural reforms, will help China transit towards a more sustainable growth path.

Here's more from BMI:

China's overall debt level continues to rise, jumping to more than 250% of GDP in 2016, from around 150% of GDP in 2008, and Chinese policymakers are turning some of their attention towards tackling potential credit risks within the economy. In our view, the rapidly growing debt load (particularly headed towards inefficient state-owned enterprises [SOEs]) over the past couple of years remains one of the biggest risks to the Chinese economy, particularly as economic growth is on a downtrend.

The majority of overall debt in China lies within the corporate sector, standing at 169.1% of GDP in Q116, and in our view, the market-driven guidelines announced by the State Council on October 10 will help to gradually reduce credit risks .

The main aim of the government appears to be 'eliminating the weak, and strengthening the strong', with the debt-equity swap (DES) programme gaining traction among market participants since the announcement.

The SOEs that have been reported to be involved in the DES programme so far are mainly those provincial level SOEs that have strategic importance in their individual sectors, but are facing short-term financial difficulties.

For example, according to Xinhua News, China Construction Bank (CCB), one of the country's big five state-owned banks, has signed DES agreements worth around CNY95bn (USD13.8bn) with various central and provincial SOEs, as of November 17.

Out of the CNY95bn, the deal with Shandong Energy Group Co (China's fourth largest coal producer and also the province's largest SOE) alone was worth CNY21bn.

However, an overall turnaround of the performance of these Chinese companies still largely depends on various factors. Firstly, the implementation of each individual agreement remains key to the success of the DES programme.

Secondly, profitability at these firms would improve if management were able to reduce excess capacity and improve their competitive positions, following the reduction in financial costs. For example, if the state is the key investor in the DES agreement, political and social stability considerations such as unemployment could still result in inefficient operations as the government heavily influences management decisions.

Allowing for a greater number of bankruptcies through the Enterprise Bankruptcy Law enacted in 2007 is also one of the ways that the Chinese government aims to lower corporate leverage. In our view, there is likely to be an increased number of defaults over the coming quarters (at a gradual pace), but bankruptcies even for zombie companies are likely to be used as a last resort by policymakers, if other approaches such as negotiations with creditors or merger and acquisitions (M&A) fail. For example, in the case of Dongbei Special Steel Group (a local state-owned from Liaoning province), the company was driven into bankruptcy in September after creditors rejected plans to restructure the firm's debt (swapping debt for equity).

That said, we expect the companies that are most likely to go bankrupt will be those that are of lesser strategic importance and are smaller in size due to continued political considerations