Are China's Corporates Repeating The Debt Excesses Of 1980s Japan?

Primary Credit Analyst: Terry E Chan, CFA, Melbourne (61) 3-9631-2174; terry.chan@standardandpoors.com Secondary Contacts: Osamu Kobayashi, Tokyo (81) 3-4550-8494; osamu.kobayashi@standardandpoors.com Christopher Lee, Hong Kong (852) 2533-3562; christopher.k.lee@standardandpoors.com

Table Of Contents
The Average Chinese Corporate Is Less Indebted But Low Interest Rates Mean Japanese Corporates Are Better Able To Service Debt Distributions Of Debt And EBITDA Similar But More Chinese Corporates Have Negative EBITDA The Average Japanese Corporate Has Lower Net Interest Expense Danger Of Higher Interest Rates Managing A Dichotomy Of Growth Related Research

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Many experienced investors remember the days when Japanese corporates were poised to rule the world. But then came Japan's economic stagnation during the 1990s (the so-called "lost decade"), and many of the corporates' ambitions came to naught (with the outlying exception of the automotive and robotics industries). That history leads us to pose a question: Is that story set to be repeated by China's corporates in this decade? In recent years China's GDP had overtaken Japan's, fueled in large part by fast credit expansion to corporates. But now, as China's economy steps down to a lower medium-term growth trajectory (transitioning from an investment-led economy to a more balanced one), how will China's corporates fare? And in terms of their standing against Japanese corporates, will the Shinzo Abe administration's attempt to reflate the economy, known as Abenomics, return Japan's corporates to the fore, leaving China's behind? We believe their comparative credit strength will determine the outcome. Looking at the balance sheets (based on data provided by S&P Capital IQ), the average listed Chinese corporate has less indebtedness than its Japanese counterpart. However, viewing the income statements, China's corporates are on average weaker than Japan's in two respects. First, the percentage of loss-making listed Chinese corporates is 4x that for the Japanese, implying a higher number of corporates could default. Second, the lower interest rates in Japan provide the corporates there with an advantage over their Chinese peersalthough, ironically, this makes the Japanese corporates more sensitive to potential significant interest rate hikes of a hundred or more basis points. We analyzed the financials of the top 2,000 listed Chinese corporates and 2,000 listed Japanese corporates by their market capitalization levels at March 7, 2014. We conducted our survey in response to some investors' concerns that the debt build up by China's corporates, which helped drive the country's GDP to surpass Japan's in recent years (see our "Is China's Economy Really Besting Japan's? A Look Beyond GDP"), has reached a critical level. They also worry that China's highly indebted corporate sector, in combination with potential problem exposures to local governments (see "China And Japan: Similar Ratings But For Different Reasons") and shadow banking issues, may contribute to the Chinese banks repeating Japan's 1990s lost decade experience although we don't think that's necessarily so (see "Why Chinese Banks May Avoid Repeating Japan's Lost Decade"). OVERVIEW The indebtedness of the average Chinese listed corporate is slightly lower than that of the Japanese corporate. This is implied from the average debt-to-EBITDA ratio of 3.6x for the former and 3.9x for the latter. However, the Chinese corporate pool has a higher risk of default, given that 10% of the sample reported negative earnings before EBITDA for at least two years, which is about 4x the ratio of the Japanese sample. In addition, the average Japanese corporate enjoys better debt-servicing ability than the Chinese because of Japan's lower interest rates. This has allowed Japanese corporate earnings to better cover interest expense compared to their Chinese counterparts.

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The Average Chinese Corporate Is Less Indebted But

Sourcing the most recent financial data for 2,000 largest listed Chinese corporates and 2,000 largest listed Japanese corporates from S&P Capital IQ (a Standard & Poor's Ratings sister unit), we found that the indebtedness of the average listed Chinese corporate is lower than the average listed Japanese corporate when measured by debt-to-EBITDA. Table 1 shows that the sample of listed Chinese corporates has a weighted average debt-to-EBITDA ratio of 3.61x compared to the Japanese corporates' 3.92x. That implies the average Chinese corporate is slightly better able to support its debt from earnings, all other things being equal. Netting cash and equivalents from gross debt, we find that the average Chinese corporate is even better placed, with a weighted average net debt-to-EBITDA ratio of 2.28x compared to the Japanese corporates' 2.85x. This might reflect a greater appetite for Japanese corporates to borrow for funding due to the weak performance of the domestic equity market for the past 20 years or so and the very attractive funding cost of borrowing in the domestic debt market in recent years. Chinese corporates, on the other hand, are also predisposed to use debt as domestic banking liquidity, but they have also tapped equity--mainly in the offshore equity market in Hong Kong. The Chinese corporate pool's ratio of cash and equivalents to total debt averages 0.42x, compared to just 0.30x for the average Japanese corporate. We surmise that the higher cash holdings at Chinese corporates result from the uncertain funding conditions in China's still-developing debt capital markets and shifting government policies regarding domestic credit availability.
Table 1

Comparison Of Indebtedness And Debt Serviceability: China And Japan Sample Of Corporates
Sample (number) China (2,000) Japan (2,000) Cash/Debt (latest annual) 0.42x 0.30x Debt/EBITDA (latest annual) 3.61x 3.92x Net Debt/EBITDA (latest annual) 2.28x 2.85x % of sample with negative EBITDA 10.30% 2.60% EBITDA/net interest (latest annual) 12.8x 45.6x

Note: Because the samples contain unrated entities, we have not adjusted the debt, EBITDA or net interest expense of the entities as we would do for a pool comprising entirely of rated entities. EBITDA earnings before interest, tax, depreciation and amortization. Data source: S&P Capital IQ

Low Interest Rates Mean Japanese Corporates Are Better Able To Service Debt
However, all other things are not equal. One of them is the much lower interest rates in Japan for corporates. This has meant that the EBITDA-to-net interest expense ratio of the average Japanese corporate is an astonishing 45.6x compared to the more typical 12.8x for the average Chinese corporate (see table 1). The difference is best captured by the World Bank's estimate that average borrowing cost for corporates in China is about 6% and 1.4% for Japan. So, despite a slightly higher relative debt burden, the average Japanese corporate has better capacity to service interest costs.

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Distributions Of Debt And EBITDA Similar But More Chinese Corporates Have Negative EBITDA
The distributions for debt levels of the 2,000 listed Chinese corporates and 2,000 listed Japanese corporates are not dissimilar (see chart 1). A clustering around the modal range of US$80 million-US$320 million appears for both the Chinese and Japanese samples. Again, the distributions for EBITDA levels of the Chinese and Japanese samples are not dissimilar (see chart 2), with a clustering around the modal range of US$0-US$25 million for both.
Chart 1

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Chart 2

However, the percentage of the sample of Chinese corporates with negative EBITDA, at 10.3%, is 4x the 2.6% ratio for the Japanese sample (see table 1 and chart 2). This may reflect very competitive and fragmented industries in China versus Japan. For example, China's largest players in consumer products, retail, building materials (cement, glass, etc.), and industrials (auto and auto parts, etc.) have relatively small market shares compared with similar industries in Japan. Until recently, China's economy had been growing at a relatively high rate, which appeared to have encouraged banks to support the weaker companies, especially privately owned small/medium enterprises (SMEs), in the hope that they will outgrow their weakness. However the Chinese economy's slower growth trajectory implies that the Chinese banks are likely to have higher problem loans arising from such lending compared to their Japanese counterparts.

The Average Japanese Corporate Has Lower Net Interest Expense

While the mode for the distributions for net interest expense levels of the Chinese and Japanese samples are similar, at US$0-US$5 million (see chart 3), the Japanese distribution has higher percentages at the two categories of US$0-US$5 million net interest expense and US$0-US$5 million net interest income. Despite the Japanese pool having a higher

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weighted average debt than the Chinese pool, the low interest rates in Japan seem to partly contribute to the weighted average Japanese corporate's net interest expense being only US$4.83 million compared to US$13.6 million for the average Chinese corporate.
Chart 3

Interestingly, about 34% of the Chinese corporates and 40% of the Japanese report net interest income rather than net interest expense. Partly explaining this are the high cash and equivalent levels some corporates hold (see chart 4). Such holdings allow them to earn interest income that can more than offset interest expense if they enjoy a net cash rather than net debt position. The average cash and equivalent for the China and Japan samples are US$316.7 million and US$360.3 million, respectively.

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Are China's Corporates Repeating The Debt Excesses Of 1980s Japan?

Chart 4

Danger Of Higher Interest Rates

While the average Japanese corporate may be better placed in terms of debt servicing than their Chinese counterparts, both Japanese and Chinese corporates may need to cope with higher interest expense in the near future. In Japan, Abenomics could lead to a rise in lending interest rates, which could significantly affect the debt-servicing ability of some Japanese corporates given the low interest rates they've enjoyed for a very long time. Bank of Japan Governor Haruhiko Kuroda says the central bank will stick to accommodative monetary policy unless inflation reaches and constantly remains 2%. We expect short-term interest rates are likely to remain low for two to three years. However, the danger is stagflation--when inflation and interest go up but earnings do not, leading both leverage and debt servicing to deteriorate. Additionally, the worsening of the fiscal balance could lead to a hike in long-term interest rates. We have observed a general trend in the past few years among top-tier Japanese corporates to shift to longer-dated and fixed-rate debt funding with better-balanced maturity distribution, and we believe they are better prepared for the potential rise in funding costs compared with a few years ago. Still, Japanese corporates would be sensitive to potential interest rate increases because they have enjoyed such low borrowing costs for a long time with relatively

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high dependence on short-term borrowings, which they've typically rolled over given their favorable relationships with their main banks. Japanese banks, however, will benefit from higher lending rates. On the other hand, a sudden rise could reduce their unrealized gains in securities and weaken their capitalization, which could diminish banks' lending capacity in some cases. Meanwhile, in China we have observed that the average lending rate has been trending at a higher level over the past six months compared with the prior half-year. Should such rates be sustained, some of the more highly leveraged Chinese corporates could come under stress. That said, further interest rate increases of less than 100 basis points will affect profitability somewhat, but not substantially, because Chinese corporates already have relatively high effective-borrowing costs, at around 6% from domestic banks.

Managing A Dichotomy Of Growth

Corporates in both China and Japan are grappling with problems of growth: the Chinese with lower demand due to slower economic growth and severe overcapacity in some sectors, and the Japanese with a possible rise in interest rates attending faster nominal GDP growth. A possible scenario in which China and Japan corporates could improve their credit strength would be one whereby the governments let the markets play a greater role in allocating credit and setting resource prices. For China, this would involve cutting loose the support for loss-making corporates and letting them close, thereby permitting more productive enterprises to replace them. For Japan, this would involve letting those corporates unable to adapt to higher funding costs to fail rather than continuing the Japanese tradition of banks supporting marginal companies. The failure to let the market play its role for China increases the risk of its own "lost decade," and for Japan, it heightens the risk of returning to economic stagnation. We'll wait to see if one, the other, or both play out. For queries about the data used in this report, please contact Clemens Thym, of S&P Capital IQ, on (852) 2533 3515.

Related Research
Is China's Economy Really Besting Japan's? A Look Beyond GDP, April 8, 2014 China And Japan: Similar Ratings But For Different Reasons, April 8, 2014 Why Chinese Banks May Avoid Repeating Japan's Lost Decade, April 8, 2014 Reforms Could Help Japanese And Chinese Banks Sidestep Potential Pitfalls, April 8, 2014

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