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China, the Trade War and Capital Misallocation

By Motley Fool Staff – Updated Aug 19, 2019 at 10:34AM

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Private companies in China rarely get the loans they need. But what does that mean for the Chinese economy?

With countless daily headlines pouring out about the trade tension between The United States and China, it can be hard to sort out exactly what outcome both entities are vying for. But one often overlooked -- and relatively obvious -- area may be the answer to solving the exceedingly complicated situation. 

It may come as a surprise to learn that the two powers actually share a common goal: channeling more loans to China's private sector. Doing this may actually be the simplest and most direct approach to reaching a sustainable trade truce. Pushing such an initiative is not only beneficial to China (as it's a more efficient use of capital for the country), it also aligns with U.S. goals as it develops a stronger free market in the country. Let's explore the geopolitical ramifications such a shift may have.  

China's 13th National People's Congress (NPC) held in early March was centered on stability, and after posting 6.4% GDP growth in the first quarter of 2019, Beijing's efforts appear to be on track.

But as political analysts argued, Beijing's message at the NPC was that fiscal and monetary policies will remain loose, reneging on previous reform attempts that were aimed at deleveraging the economy and removing systemic risks from financial systems.

A balancing act between two superpowers

Beijing's stability pursuit may be difficult to achieve as the Trump administration pushes for unilateral penalty enforcement along with snapback options, which essentially allow the US to re-implement sanctions should a deal ultimately fall through. In such a situation, the US would play both the judge and the jury as it oversees the entire loan and reform process, removing the stability component that China desires.

It's not as if Beijing opposes supporting private companies. The country's top banking regulator recently made comments about allowing higher non-performing loans from smaller entities, indicating there's interest in bolstering private companies and helping them grow. 

Notably, private enterprises in China have an outsized impact on the overall economy. They account for about 50% of tax collected, 60% of economic activity, and 80% of new urban job creation. But despite this heft, they only rake in less than 25% of total new bank loans, according to the China Banking and Insurance Regulatory Commission.

Politics and credit don't mix well

Commercially, private companies are perceived as higher risk, since they have neither local nor national government backing. And bank lending is highly political. Helping a government-related entity normally garners favors from central authorities, providing a goodwill component that benefits financial institutions.

This practice not only crowds out more efficient investments but also spurs a moral hazard with a false sense of risks. This is evident in the current economic climate, where it takes more than six times the amount of credit to create the same unit of growth than it did a decade ago.

Beijing is its own worst enemy

Pushing more credit into China's private sectors would assuage Washington's trade concerns that subsidies are being indirectly channeled into government entities that create an unfair advantage for foreign investors. But redirecting loans counteracts other political projects in Beijing, including its Belt and Road Initiative (BRI) and Made in China 2025 campaign.

Ironically, pulling back on its BRI may prove to be ideal for Beijing, as it addresses concerns that China is using debt diplomacy to attack the sovereignty of recipient countries. This flexibility is already evident following Beijing's decision to lower the cost of the East Coast Rail Link in Malaysia by a third, from RM 66.7 billion to RM 44.0 billion.

But this is occurring simultaneously as Beijing continues to push money toward state-owned enterprises (SOEs) over private firms. In the first quarter, credit flows were dominated by SOEs and local governments. Net issuances by SOEs exceeded RMB 750 billion compared to RMB 741 billion by corporates of all types, according to data from Wind, a Chinese data provider.

Looking for efficiency

Though large private companies in China have access to foreign capital, it's not sufficient enough to sustain growth long-term, nor does it address the structural bias in the banking system. Investors should be wary of this, as much of these loans aren't able to generate tangible or productive assets that add real value to the economy.  

If these SOEs produce profits less than the amount that subsidies or cheap financing provide, this creates real economic consequences. As China's policymakers grapple with headwinds in an economy that is the second-largest in the world, it's worth investors' time to actively monitor the Hong Kong market to see where the most efficient (and productive) listed Chinese companies exist, and consider whether entanglement in an already complicated market is worth the risk.

A version of this article originally appeared on our Fool Asia site. For more coverage like this head over to Fool.hk.en.

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