China is taking steps to address its debt problem

Sometime in the coming months, China Huarong Asset Management, which was set up in 1999 to deal with the bad debts of Industrial & Commercial Bank of China before its listing, will go public, following the example set in 2013 by rival China Cinda, the corresponding bad debt arm of China Construction Bank.

At the Boao Forum in China at the end of March, Lai Xiaomin, its head, described Huarong as "the unsung hero" of the financial system, helping to stabilise banks' balance sheets by taking their troubled exposures.

But Huarong is much more than just the carp of the Chinese financial landscape, taking bites of all the garbage that comes its way. Today, it is a conglomerate with banks, a securities business, and various other arms.

As a prelude to becoming a public company, some months ago Huarong sold stakes to a mix of international and domestic financial firms, with the blessing of the Ministry of Finance, still the biggest shareholder.

Not long ago, it would have seemed that the timing for Huarong - and all financial institutions - could not have been more auspicious. But now investors are focused on the growing risks in China's financial system.

There is concern about the bad debts in the banking system and a corporate sector that has borrowed way too much money, some of it in cheap dollars that no longer appear quite the bargain they were at the time.

Local government debt now accounts for 40 per cent of GDP, or about Rmb15tn, an amount that "is so large, the stability of the financial system is at stake", analysts at CICC wrote recently. The figure is up 25 per cent in a mere 18 months.

"The increase in China's debt over the past five years (a total of nearly 70 per cent as a share of GDP) is the largest that any major developing country has seen in post-WWII history, with the bulk of the increase in the corporate sector, (or 200 per cent of GDP)," says Ruchir Sharma of Morgan Stanley Investment Management.

The macro backdrop is sobering. The mainland economy is slowing dramatically; growth came in at a six-year low for the first quarter, exports have plunged and producer price deflation in China, part of the landscape for more than three years, is deepening. That deflationary pressure underscores the extent of excess capacity and the lack of pricing power for most of corporate China.

Banks are considered the best way to play the prospect of economic growth in any country, which is why slow growth is leading the markets to anticipate a surge in bad debts and the need for the central government to both recapitalise the banks and reduce Beijing's ownership.

In fact though, the concerns may reflect a trend that has already reversed. Most mainland companies and their bankers are beginning to deal with their debt problems. "Banks are the most defensive asset class in China. China banks have so far been strong on funding and profitability but weaker on capital allocation and asset quality," Morgan Stanley analysts noted.

Now, however, "banks are slowing asset growth, especially off-balance sheet growth. They are starting to recognise NPLs [non performing loans] and differentiating between stronger and weaker borrowers."

Moreover, China's cash strapped borrowers (and hence their lenders) will probably soon get some help from the central bank in the form of two expected interest rates cuts some time in the second quarter. They will also benefit from Monday's 1 percentage point cut in the reserve requirement ratio, the biggest reduction since 2008. Indeed, such easing is one reason the stock market, which has always been more about liquidity and easy money than about macro fundamentals, has been on such a tear.

In addition, China is taking steps to reduce the dependence on a bank-led financial system by developing its capital markets. For example, the new municipal bond market is a mechanism to restructure the debt of local governments, making it due in 10 years rather than two.

On balance, the rise in reported bad debts is actually a positive rather than an alarming trend: it means transparency is improving. True, some of the capital raisings the Ministry of Finance orchestrates appear to be just shuffling assets between different government entities. And some participants will come in to the Huarong placing precisely as a way to bet on the growth of distress in China.

China will never be entirely market driven, but it continues to take small steps in the right direction.

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