Wednesday, July 1, 2015

Accounts Receivables, China's Other Credit Problem.

There are two major types of corporate debt:  Bank lending and bond issuance.  As China's economy slows and more bankruptcies are allowed, these two debt markets are receiving much more attention.  However, this attention is misplaced.

During China's experiment with the command economy, the banking system simply distributed funding from the central government to state-owned enterprises.  After Reform and Opening, this type of direct funding was transitioned to bank loans, although the precedent was set early on that non-performing loans would simply be rolled over by the state-owned banks.  This problem was never really solved.  Either the entities that could not repay loans were bailed out, or the non-performing loans themselves were rolled up into other assets, such as the four asset management companies established in the early 2000s.  Since the corporate bond market re-appeared on the Chinese mainland in the 1980s, a bond issuer had never been allowed to miss a payment until Chaori Solar defaulted on interest payments in March 2014.  A year later, Cloud Live defaulted on principle and interest.  That same month, Baoding Tianwei was the first state-owned enterprise to default on interest payments.  In May 2015, Zhuhai Zhongfu was the fourth Chinese company to default on onshore debt, but also the second private-sector company to default on principle and interest.

By the time a firm is late to repay a bank loan or defaults on a corporate bond, the root cause had already been forming for years.  A better credit instrument to judge the health of the Chinese economy is accounts receivable.  It is China's other credit problem.

The first time accounts receivable was specifically mentioned as an issue for Chinese companies was back in 2009. The Economic Observer ran an article titled “Chinese Coal Production and Sales Continue to Grow, but Company’s Accounts Receivables Increase.” It quoted the China Coal Industry Association:
[Translation: Between January and November of this year [2009], national coal sales reached 2.51 billion tons, up 0.13 billion, or 5.5%, over the same period last year. Even as production and sales increase at a steady pace, coal enterprises’ accounts receivables are on the rise. According to statistics from the Chinese Coal Industry Association, between January and November, the accounts receivables of large-scale coal enterprises increased ¥86.3 billion, up ¥5.9 billion, or 7.4%, over the same period last year.]
Despite accounts receivables growing faster than revenues, companies still funded additional projects to expand capacity. According to the same article, the coal mining industry invested in fixed assets to bring on an additional one billion tons of capacity between 2006 and November 2009, and another 300 million tons of capacity planned for the next year. The reason for the increase in capacity was a basket of economic stimulus policies increasing the demand for coal.

In 2011, accounts receivables became a noteworthy issue for another company: China Southern Railway. In the middle of 2011, it announced revenues of ¥40.1 billion, up 42.39% over the same period a year earlier. However, accounts receivables increased to ¥26.6 billion, up 138.17%. Its main customer at the time was the Ministry of Railways. The Economic Observer had this to say about the issue:
[Translation: Relatively high accounts receivables and continuously increasing payment cycles put pressure on China Southern Railway’s liquidity. However, considering the fact that the company’s main customer is the Ministry of Railways, which has excellent credit, the risk of not collecting on receivables is extremely low.]
A rational person might make the observation that an entity with excellent credit should not have trouble paying its bills—or, put another way: An entity that has trouble paying its bills should not have excellent credit. Obviously, that person does not understand the Chinese economy.

According to China Daily, in October of that year, China Southern Railways and China Northern Railways were paid ¥6.0 billion and ¥4.5 billion, respectively, by the Ministry of Railways. Eventually, the Wall Street Journal reported that the Ministry of Railway’s debt became so large that the State Council had to create China Railway Corporation to take over the ¥2.66 trillion in debt owned by the ministry.

The issue of accounts receivables as a systemic issue has begun to receive limited coverage from international media since that time. In 2012, the Financial Times reported on the issue.
A Financial Times analysis revealed that 66 per cent of listed Chinese companies that have reported third-quarter results showed a year-on-year increase in such unpaid bills – called accounts receivable in accounting – as a proportion of sales, according to the S&P Capital IQ database. … Sany Heavy, the world’s ninth-largest machinery maker by sales, reported that accounts receivables were up 83 per cent year to date at the end of the third quarter, hitting Rmb21bn. … Other machinery companies reported similar problems: at Shanghai-listed First Tractor, accounts receivable rose 169 per cent from the beginning of the year. … At Zoomlion, a leading Chinese machinery maker, accounts receivable at the end of the third quarter were up 69 per cent from the beginning of the year, according to earnings released on Tuesday. … At Baosteel and Jiangxi Copper, the biggest listed producers of steel and copper, unpaid bills rose 52 per cent and 66 per cent, respectively, since the beginning of the year.
In 2013, the Wall Street Journal ran an article on the growing business of factoring, which is when companies sell their accounts receivables to banks.
China's banking regulator has instructed banks to better monitor a type of lending particularly popular with small firms as demand burgeons and banks relax their oversight standards. … Shanghai Pudong Development Bank Co. has said that it did 130 billion yuan ($21 billion) worth of factoring business in the first half of the year, up 51% from the same period last year. That is equivalent to about 8% of the new loans it made between January and June. … China Merchants Bank Co. said it earned 562 million yuan in income from its factoring business in the first half, an increase of almost 150% over a year earlier. … Bank of Communications Co. and Agricultural Bank of China Ltd. both said in their half-year earnings reports that their factoring business expanded rapidly.
In 2014, Reuters ran an article on the rising levels of accounts receivables and collection times.
A Thomson Reuters survey of data on China's more than 2,300 stock market-listed firms illustrates the impact on corporate payments, with company receivables - the accounting term for money owed by customers - on average reaching $160.49 million at the end of last year, more than double the $65.9 million average at the end of 2009. … Over the same period, the median collection time for billings crawled up from 71.4 days to 90.42 days. It was the first time China's market-listed firms averaged more than 90 days in a decade.
In addition to increased accounts receivables, there is another trend that will have systemic ramifications: Cross-ownership. Many of the companies involved in the capital goods sector own their suppliers and customers either partially or outright. Many companies are engaging in entrusted loans with owners or subsidiaries, allowing them to pay accounts receivables on time, but then have the same issues repaying the entrusted loans later down the line. According to the same Reuters article as quoted above, “Chinese companies granted a net 2.55 trillion yuan ($411 billion) in so-called entrusted loans in 2013, nearly double the 1.28 trillion yuan total in 2012.”

The current issues that affect the bank lending and corporate bond markets have formed over the last few years, many of them starting with accounts receivables. Understanding future issues that will soon impact those two markets will most likely come from understanding the accounts receivables issues of today.