The ugly Minskyan microstructure of the Chinese economy

 

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Macquarie, the Australian investment bank, has published this week a report on the financial state of the Chinese corporate sector. Unfortunately, the report is not public and I will have to rely on the summary written by Tyler Durden.

The report is especially important because it is based on an analysis of 780 Chinese companies, so, unlike most of the reports on the financial health of the Chinese corporate sector that take a macroeconomic perspective (as we did here), Macquarie’s report takes a microeconomic approach, focusing on the Chinese commodity sector. Given that Chinese national accounts data has been lately under the scrutiny of the international financial community because of its unreliability, the micro approach of the Macquarie report can shed some additional light on the financial health of Chinese corporations.

Now, the numbers (go here for the graphs, which are even more impressive). The total “uncovered” debt of commodity companies in 2014 amounts to CNY5 trillion. Uncovered debt belongs to companies that cannot cover their interest expenses with their operating profits in a single year. In financial jargon, it means that the interest/EBIT ratio (which is a useful guide to measure the ability of a company to meet its interest payments) is above 1. Obviously enough, companies in this group are usually considered to be in a very bad financial health. To see the evolution of the Chinese commodity sector and how it was propelled by the Chinese investment-led growth strategy since 2008, it is worth looking at the evolution of the debt in that sector. According to Macquarie, as of 2007, the amount of uncovered debt in the commodity sector was less tan CNY1 trillion (with just 4 companies being “uncovered”), while in 2013 the amount of uncovered debt soared to CNY4 trillion (with the share of uncovered companies being about a third of all corporations).  And that’s not the end of the story: we are now in 2015, and the Chinese deceleration over the last few months may have posed additional problems for these companies. As Macquarie notes:

Given the slumps in metal and coal prices so far this year, it’s quite likely the curve will have deteriorated further for commodity firms this year, with total debt getting better in the meantime.

In plain English, it is likely than more than 50% of the Chinese commodity sector is in extremely dire financial conditions right now.

A “Minsky” crisis?

In a previous post, we linked the Chinese rebalancing process and its (lack of) prospects for being smooth with the financial health of the corporate sector. We claimed that:

Probably the area in which the corporate sector insufficiency of internal resources will first unfold is in those companies of the construction and capital goods sector, for two reasons: first, these firms exhibit the highest leverage ratio among their peers and, second, because investment will not increase as the economy moves towards higher consumption levels, their cash-flow generation will shrink (firms selling consumption goods will have better prospects). At any rate, the possible channels through which early minor defaults spread to provoke a generalised collapse are multiple and, as in any “Minsky moment” with excessive corporate leverage, of unpredictable nature. Therefore, we conclude that any possible rebalancing scenario will come together with a “Minsky moment”; in that case, financial difficulties in the corporate sector will become crystal clear.

For many readers, the mention of a “Minsky moment” will be a cliché. Nowadays, if you want to seem to be informed about current macroeconomic financial developments, you just have to bring up the word “Minsky”. However, unlike many analysts (and economists), I really think that the examples of typical Minskyan crises are not many; actually, it is quite difficult to find perfect examples of a Minsky crisis in which the past investments of the corporate sector are not validated (as Minsky would say) by the current and future streams of cash-flows. In other words, it is not so easy to find prime examples of crises produced by the corporate sector (in a future post I will explore this topic). Therefore, our paragraph has to be read as implying that the Chinese case will be a prime example of a Minsky crisis.

In any case, I want to pursue here a different issue: the relation in a Minskyan model between debt, profits and investment and its relevance for the Chinese case. In the Minskyan model, higher investment leads to higher leverage ratios in the corporate sector. However, we know (and Minsky knew too) that higher investment expenditures leads also to a higher volumen of profits, through the Levy-Kalecki profit equation. If a higher level of investment leads to higher profits, why firms should see a deterioration in their balance sheets if they still enjoy a healthy generation of profits? To my knowledge, the Canadian economist Marc Lavoie (here and here) was the first one to point out this logical inconsistency in the Minskyan framework. Unless you come up with a different mechanism, it is unlikely that higher levels of investment lead to higher leverage ratios, because, as Kalecki would say, the investment finances itself.

Recently, the British economist Jo Michell (here) has proposed an original explanation for this incompatibility between the Minskyan theory and the Levy-Kalecki profit equation. He argues, using a microfounded agent-based model, that even if the leverage of the corporate sector as a whole does not increase (due to the cash-flows generated by investment expenditures), the distribution of that debt between small and large firms will probably be crucial for the number of bankruptcies taking place in the corporate sector (in Minskyan parlance, firms move from hedge financial structures to Ponzi structures, defined by Minsky as a situation where firms cannot even cover their interest payments). Therefore, even if things are OK at the sectoral level, the dynamics for every firm can be very different, because many of them will become “Ponzi”.

Even after considering how large the ratio of corporate debt to GDP is in China (a number that by itself should be worry), I really thing that the sectoral level, and how the debt is distributed across firms, will also play a major role on how the Chinese crisis will unfold. But rather than being the distinction between small and large firms the relevant one, what will be crucial in the Chinese case will be the distribution of debt across sectors. The reason is that, in China, the dynamics of debt cannot be understood separately from the rebalancing process. As China moves from investment to consumption (and it will certainly move, one way or the other, almost as a matter of arithmetical necessity, as Michael Pettis often points out), the distribution of revenues between firms will also change. As we explained here, even assuming that China can sustain for the next 10 years GDP growth rates of around 5% in average (it would implicitly imply abnormally high consumption growth rates of around 10% together with the assumption of no growth in investment), which is certainly an optimistic scenario at least as far as GDP and consumption growth rates are concerned, firms in the capital goods (and commodity) sector will not generate enough cash-flows in order to keep up with the debt. Therefore, from the point of view of the triad “investment, debt, cash-flows”, the Chinese case does not seem to have a solution. A soft landing for the Chinese economy seems to be very unlikely, once one takes into account the demanding requirements of the rebalancing process for the revenues of a big chunk of the corporate sector.

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