China’s real interest rate surges to post-crisis high

No wonder China’s economy is cooling fast. In spite of Beijing’s three interest rate cuts over the past six months, the real cost of capital has surged to its highest level since the aftermath of the financial crisis as the country’s grinding deflation deepens.

Not only is this anomalous in a world where about $2tn in global bonds are trading at negative yields, it is also inflicting disproportionate punishment on the weakest parts of corporate China as the economy slows.

The real lending rate (the weighted average lending rate plus producer price deflation) rose to 10.8 per cent in March, its highest level since September 2009, according to a research note from Mizuho Securities in Hong Kong (see chart).

The main impact of the higher real rates is to pile further pressure on industrial enterprises that are suffering declining profits while contending with a welter of debt service charges. In the first quarter of the year, industrial profits fell 2.7 per cent to Rmb1.25tn ($200bn), after rising 3.3 per cent during the whole of 2014 to Rmb6.47tn, according to official statistics.

In nominal terms, China’s weighted average lending rate was 6.56 per cent in the first quarter, meaning that companies will have to pay about $812bn in debt service charges this year on non-financial corporate debt estimated by McKinsey to have totalled $12.5tn — or 125 per cent of GDP — at the end of last year.

But if calculated in real terms, the debt service charge on non-financial corporate debt would come to $1.35tn this year. To put that number into context, it is not only significantly more than China’s projected total industrial profits this year but also slightly bigger than the size of a large emerging economy such as Mexico.

Such is the sand in the gears of China’s growth engine. Many companies are paying out more in debt service charges than they are taking in profits as deflation depresses the prices of the products that they produce. Since September last year, deflation measured by the producer price index (PPI) has deepened from minus 1.29 per cent to minus 4.24 per cent in March this year, far outstripping the 90 basis points in interest rate cuts over the same period.

What’s more, the PPI’s descent shows no sign of abating, registering a fall of 4.6 per cent in April to push real lending rates higher.

The burden of surging real interest payments falls unevenly on corporate China, penalising most harshly those companies that gorged themselves on debt in the aftermath of the financial crisis and are now suffering from overcapacity and softening demand.

Heavy industrial companies beset by overcapacity and a collapse in pricing power — such as iron ore mines, steel mills and some real estate developers — are in genuine distress. Shi Zhenglei, iron ore analyst at consultancy Mysteel, estimates that about half of China’s 1,500 iron ore mines will be forced to close this year.

In the three industrialised northeastern provinces of Liaoning, Heilongjiang and Jilin, the debt burden was a big factor behind a 32 per cent year-on-year decline in industrial profits in the first quarter of the year, compared with a 0.1 per cent fall in other regions. This, in turn, has triggered an 18.7 per cent tumble in manufacturing investment in the northeast during the first quarter.

Andy Rothman, strategist at Matthews Asia, a fund management company, sees two debt “hotspots” — state-owned enterprises and real estate developers. By far the most indebted sector is real estate and construction, with a debt to equity ratio of more than 250 per cent, while state-owned enterprises are significantly more leveraged on average than their private counterparts (see chart).

There are some compensations, though. The lower leverage ratios of private companies present a relatively encouraging sign, said Mr Rothman, because privately owned small and medium-sized enterprises account for more than 80 per cent of China’s employment and almost all of its job creation, as well as most of its investment.

Mr Rothman added: “The medicine for this problem will be another round of serious state-owned enterprise reform — including closing the least efficient, dirtiest and most indebted state firms in sectors such as steel and cement . . . leaving healthier, private firms room to grow.”

But before that time comes, gathering deflationary pressures and rising real interest rates are expected to inflict a good deal more pain upon the most vulnerable strata in China’s economy — property and construction companies, state-owned enterprises and the old industrial heartland of the northeast.

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This article has been amended to reflect the fact that the average debt to equity ratio (not debt to asset ratio) of real estate and construction sectors is running at more than 250 per cent.