Chinese State Firms' Debt Hits New All Time High, As Profits Tumble

Overnight China's finance ministry reported the latest data on state-owned firms profitability. At a cumulative CNY 2.04 trillion (or $316 billion) for the January-November period, this was another nearly double digit decline, or -9.5% from the year ago period, following a -9.8% drop for the 10 month period the month before.

State-backed financial companies, which in China is redundant as all financial companies are state-backed, were responsible for roughly a third of the cumulative profit decline: excluding financial firms, combined revenues of state-owned firms fell 6.1% in the first 11 months from a year earlier to 40.7 trillion yuan, the ministry said.

According to Reuters, companies in transportation, chemical and power sectors reported a rise in profit in the January-November period, while firms in oil, petrochemicals and building materials - or a vast majority of them - saw a drop in earnings. Firms in steel, coal and non-ferrous metal sectors continued to suffer losses.

"The downward pressure on economic operations remains relatively big, although there are signs of warming up in some indicators," the ministry said.

This optimism is, however, entirely baseless and we are confident that Chinese corporate profitability is set to go from bad to even worse. The reason for that is that at current commodity prices and production, virtually all of China's steel industry is loss-making, while over half of commodity companies with debt do not have the funds to make even one coupon payment.

While the logical response to plunging profits would be for the government to enforce a strict discipline for excess capacity reduction, Beijing has been unwilling to do this, afraid of the outcome from the resulting surge in corporate defaults.

As Credit Suisse notes, "although we have seen more default announcements since (including three SOEs) [the March 2014 first ever corporate default of Chaorisolar], both the number and magnitude of Chinese defaults are lower than one would expect (only seven this year) given the size of the corporate sector, Chinese debt market and scale of uneconomic production, particularly in basic material industries. Of 17 bond defaults since then, only four involved SOEs. In fact we only find three unresolved defaults (Tianwei, Yingli and Sinosteel), and of these only one (Tianwei) resulted in a closure of capacity."

CS' conclusion is that China, like Japan back during its peak bubble days, is operating a policy of employment maximisation at the expense of profit maximisation, and therefore appears unwilling to shut down excess capacity. This assures a continued decline in profits.

Meanwhile, as SOE profits continue to deteriorate at the expense of maximizing jobs and employment (recall the biggest threat facing China is a working class insurrection, or simply said, "lower and middle-class revolution") debt at these same SOEs just hit a new record high: according to the same FinMin numbers, total SOE debt rose by CNY393 billion to CNY78.3 trillion, or over $12 trillion - well above 100% of total Chinese GDP.

While hardly as dramatic as the unprecedented CNY5.9 trillion surge in September (duly noted in "Did Something Just Snap In China: Total SOE Debt Rises By $1 Trillion In One Month"), the trend of declining profits (and cash flows) coupled with debt rising to new record highs month after month, assures a head-on collision with financial reality which will leave many debtor and creditor casualties, both metaphorically and literally.

The question, just like the main question involving the US stock market, is how much longer can this unsustainable divergence continue?