Skewed Chinese ‘Great Wall of Debt’ figures causing unnecessary fear for investors

Investors are avoiding good opportunities in emerging markets due to ‘unnecessary scaremongering’ over Chinese company debt levels, Al Bryant, portfolio manager at River and Mercantile has said.

Bryant, Head of Emerging Market (EM) Equities at River and Mercantile, believes corporate debt levels in China are acceptable and actually lower than some developed markets (DM). As demonstrated in the graph below, of the 258.7% of China’s total non-Financial debt, 149.3% is defined as non-financial corporate debt, an amount which is below France’s 153.2%, especially when the overall percentage of debt is taken into account.

“There’s unnecessary fearmongering over emerging markets at the moment. The scare story circulating is that there is some kind of debt implosion coming in China. This is typically evidenced with data focused on the growth of non-financial debt versus GDP, as depicted in the chart to the upper left”, he said.

“The lack of willingness among investors to invest in China at the moment may be undermining the valuations of the nation’s firms,” Bryant says.  

“What this data tends to show is a doubling of non-financial debt relative to GDP in countries such as China in the last 10 years,” Bryant adds.

“What this suggests, on the face of it, is that the level of corporate debt in China has exploded in the last decade. It would seem there are a lot of really over-leveraged companies in China. This is then used to form a negative narrative – beware Chinese equities, the debt is too high, etc. It’s a well-worn path of concern.

“Investing in China, we’ve never had trouble finding a broad array of really well-run companies. If you drill down into the aggregated debt figures you find that much of this debt is in fact held by Chinese state and municipal entities, it’s not actually corporate debt.

“Charts looking at debt for Chinese firms can show that they have very high levels of non-financial debt. In fact, the reality is that local authorities in China have different tax raising powers, so they tend to set up shell companies in order to raise debt to finance projects.”

Bryant believes the failure to understand structural differences in emerging markets economies, like the debt issue in China, is leading to a misrepresentation of the risks posed to investors.

“In the US or UK, the taxing authority raises its own cash from taxation and holds debts on its balance sheets. But in China, local government entities raise money through private sector debt placements. In effect, municipalities create private sector, state-owned, shell companies to hold their debt.

“This is where the data confusion arises. The debt of a company like China Mobile and the city of Shanghai are two quite different things, but on paper can look exactly the same when aggregated. If you actually pull the two figures apart, instead of Chinese corporate debt looking on the high end of the scale, it in fact looks firmly in the middle of the pack for corporate indebtedness globally. Chinese corporate balance sheets are in fine shape, essentially.

“In fact, drilling down into the numbers you’ll find that Chinese debt, and emerging market debt by and large, is in better shape than developed market debt. While interest rates in these countries is a little higher, in reality there is still comfortable room for these corporates to take on more debt. There really is no systemic risk in these numbers.”

He said the result of this is an underestimation of the quality of Chinese, and emerging market stocks more generally thanks this hawkish interpretation of debt figures. In reality, with EM stocks undervalued thanks to this narrative, there were plenty of opportunities for investors to obtain a position undervalued but strong businesses.