China's economic slowdown. The Chinese economy has been slowing in recent years, the pace of growth dropping from more than 10% in 2010 to 6.9% in 2015. But fears of a much sharper slowdown from the world's second-biggest economy started to surface last year...
The Chinese authorities' response was to follow the same recipes of investing in real estate and infrastructure that they had used in the past to stimulate growth. These investment programmes have mainly been financed by debt, contributing in its turn to further weakening the system. This has often led to the appearance of "zombie" companies. These are companies that have no long-term viability and are artificially kept afloat by bailouts and/or particularly low interest rates, purely to prevent a knock-on run of business failures and massive redundancies. Cement, mining, steel, glass and construction are the main sectors propped up in this way.
Bad-debt ratio by sector above industry average (2015)
Source: CLSA, Bloomberg, Wind, based on EBITDA interest coverage below 1x
State-backed banks continue to lend them money at very – indeed over-favourable – rates, even though they know that sooner or later the businesses will be unable to repay their debts. This situation will inevitably result in a massive increase in bad debts hitting the banks and waves of stock market recapitalisations. Nevertheless, we don't believe that the Chinese banks will fail as, sooner or later, the Central State, their major shareholder, will come to their rescue and inject the necessary funds. The State still has sufficient resources to bail out the banking system.
However, this assertion comes with a caveat. Direct government debt to GDP in China is approximately 55% (versus nearly 90% in developed countries). But if you add the corporate debt of State-owned companies, the figure quickly climbs to over 100%. And if you add the total debt of other players in the Chinese economy, the figure comes to nearly 300% of GDP (see graph below). Although this is a challenging figure, even more challenging is the speed with which this debt has spiralled, significantly faster than nominal growth. In concrete terms, this means that China is building up debt faster than it is accumulating wealth (recent data research shows that around four units of debt are needed to generate a single unit of GDP).
China's debt (debt to GDP ratio in %) and international comparison (2014)
Source: MGI Country Debt Database, Mc Kinsey Global Institute Analysis
How can high-quality companies hold their own in this environment?
The problem with the political determination to keep handing a lifeline to a host of unprofitable companies is that, one day when the first domino falls, the whole economic edifice could come tumbling down in a chain reaction. If China's financial system disintegrates, companies that are over-dependent on banks are likely to fall into financial difficulties. This is why we favour companies with sound balance sheets, generating positive cash flow, which ensures they are not dependent on banks to finance continuing operations.
The daily reality is that in recent years we have seen a steady increase in "receivables" on company balance sheets, implying that businesses are finding it harder to meet their suppliers' payment deadlines (see graph below). This makes working capital requirement (WCR) increasingly important as weaker final demand contributes to swelling inventories.
Asia ex Japan vs China for non financial companies: Inventory + AR days
Source: Factset, CLSA
When we talk about high-quality companies, we often refer to competitive advantages. These same competitive advantages enable high-quality companies to extract shorter payment times from their customers and for the most part to operate on a lower or even negative WCR – in other words, they can pay their suppliers later, after delivery, while their customers pay earlier.
We think that this point has a critical bearing on the current situation in China. So we have started to keep a very close eye on "receivables" before investing and only to shortlist companies that present the least risk in this respect. The risk for a company with high "receivables" is that sooner or later its receivables won't be paid. This boils down to writing off a portion of their income stream in just the same way as a bank's doubtful debts.