China Economy

All signs are pointing to a 'tough year' for Chinese businesses

Key Points
  • Thomas Gatley, corporate analyst at Gavekal in Beijing, says there aren't many bright spots in his analysis of the latest Chinese earnings reports.
  • One of Beijing's strategies for boosting growth is increasing the availability of financing to privately run companies. 
  • However, opening the financing spigots — whether from banks or private firms — doesn't necessarily translate into a sustainable turnaround in growth since it is difficult to determine which companies have a viable business structure.
Factories in China's Shandong province.
Zhang Peng | LightRocket | Getty Images

Judging by the latest reports from Chinese companies, the world's second-largest economy still has a challenging stretch ahead.

Take earnings reports in the last few weeks from the country's technology giants:

Then on Monday, China's National Bureau of Statistics said industrial profits fell 3.4% in the first four months of this year.

"There's not a lot of stuff that looks particularly bright, frankly," Thomas Gatley, corporate analyst at investment research firm Gavekal in Beijing, said in an interview last week about his review of the latest earnings season. "It's going to be a tough year."

Since last summer, the Chinese government has announced a slew of measures to stimulate growth. While those have kept the situation from getting much worse, it's not clear whether they've been enough to spur the economy in a major way. The country faces a host of unresolved internal problems — not to mention growing pressure from its largest trade partner, the U.S.

In Morgan Stanley's assessment of companies in the MSCI China index, analysts said earlier this month that some quarterly results did beat expectations for the first time in at least 12 months. But they were cautious about the road ahead, "given the reescalation of trade tension between the U.S. and China, together with the recent macro weakness reflected by the April data."

Challenges for privately run companies

One of Beijing's strategies for boosting growth is increasing the availability of financing to privately run companies.

Private businesses are key to the economic and social well being of China since they contribute to 90% of new jobs and 70% of technological innovation and new products, according to state news agency Xinhua. And for a country controlled by a single party, maintaining social stability is key.

Since China's largest banks are owned by the state, they prefer to lend to other state-owned companies. That leaves most private businesses with less-transparent channels of financing. Beijing cracked down on that financing early last year as part of an attempt to rein in ballooning untracked debt.

Even before then, smaller companies had a tough time. Small and medium-sized enterprises in China have an average lifespan of 2.9 years, versus seven years in the U.S. and 12 years in Japan, according to a report from The Boston Consulting Group.

China's government may play a 'balancing game' going forward: Analyst
China's government may play a 'balancing game' going forward: Analyst

Gatley also pointed out that a greater percentage of publicly listed not-state-owned companies in China derive their profits from overseas, making them more vulnerable to rising trade tensions with the U.S.

As growth slowed, the government announced major cuts in taxes and fees, and directed banks multiple times to lend more to private enterprises, especially small businesses.

Some of those efforts have paid off. Analysis from Gavekal showed cash flows from financing for private firms picked up in the first quarter of this year after nearing zero in the fourth quarter of last year.

However, opening the financing spigots — whether from banks or private firms — doesn't necessarily translate into a sustainable turnaround in growth.

Given a lack of reliable credit information, financial institutions still have a difficult time determining which businesses are worth lending to, said Duo Yuan, founder of Beijing-based Bluestone Asset Management.

"China's credit market is far from mature, and some private enterprises, after getting capital from the private funds, play tricks and try not to pay their debts to investors, even when they have the money," he said in an English-language statement. "And due to the absence of legislation in this area, these companies are not even fined or punished. The consequence is that fewer financial institutions dare to buy bonds issued from private enterprises."

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Incidents involving two companies in the last several weeks have highlighted the shortcomings of Chinese governance.

In late April, drugmaker Kangmei Pharmaceutical said an "accounting error" resulted in an overstatement of cash in 2017 by 29.94 billion yuan ($4.4 billion). On May 20, the company also disclosed it transferred nearly 8.9 billion yuan to related entities to trade its own shares. Kangmei is a member of MSCI's China Index, as of last summer's review. It's yet to be seen what punitive action regulators might take beyond delisting the stock.

Also in late April, Kangde Xin Composite Material Group said in its first quarter report there was no trace of 12.21 billion yuan the company claimed to hold in a bank deposit. Earlier in the year, the company missed interests payments and defaulted on debt. Local police have taken action against the company's controller, Caixin reported in mid-May, citing a vaguely worded post on Weibo, China's version of Twitter.

Bluestone's Duo noted that longstanding concerns about the ability of investors to recover their money from private enterprises based in northeastern China — so much so that there is a saying in Chinese that "investments must not go beyond Shanhaiguan." The phrase refers to a major Great Wall pass east of Beijing.

Last week, the Shenzhen Stock Exchange disclosed on its website that its department overseeing small and medium-sized listings issued an inquiry into the 2018 annual report of Zhangzidao, a fishery company located in the northeastern city of Dalian.

The company has raised eyebrows in the last few years for blaming massive financial losses on missing or dead scallops. Zhangzidao has until Wednesday to respond, according to the filing. Company representatives did not immediately respond to a CNBC request for comment.

"The fraud risk remains huge in the Chinese market," Gatley said. "(There's) outright criminality at one end, and then firms doing things that don't seem to be business."

"There are large and very difficult vulnerabilities beneath the surface," he added.

On the side of the banks, government requirements for lending to private enterprises could also introduce more risk into the system.

"I actually think banks shouldn't be told to lend to a particular sector, private or (state-owned enterprises)," Weijian Shan, CEO and managing partner at investment firm PAG, said in an email. "Banks should make their own credit decisions based on the creditworthiness of the borrowers. With the risk management systems in place in Chinese banks since the banking reform of early 2000s, they aren't likely to meet policy targets designed to support borrowers of weak credit anyway, which isn't a bad thing."

Shan added that he expects if a company has a reasonable credit record, it shouldn't have trouble obtaining financing.

China is still one of the fastest-growing economies in the world, and analysts see opportunities in areas such as the country's smaller cities. China's official (although frequently doubted) gross domestic product grew by 6.4% in the first quarter, unchanged from the prior quarter but down from 6.8% a year ago. Authorities project slower growth of 6% to 6.5% this year.

With a state-controlled economy like China's, authorities have shown they can engineer a recovery. The question, for Gatley, is: "After the immediate crisis is past, how (long does Beijing) keep the pressure up?"