Two phenomena have recently occurred in China's capital market. First, despite five successive interest rate cuts between 2014 and 2015, funds have remained in capital markets, rather than moving to the real economy. This is despite a drastic fall in return on investment. Second, the new third board market, an over-the-counter equity exchange, has been extremely popular. As of November 6, 2015, 3,982 enterprises were listed on the platform. It is estimated this figure could rise to 10,000 as the market continues to develop.
These phenomena demonstrate two things: first, financing difficulties in the real economy persist; second, enterprises still need capital, not through debt financing but through equity financing instead.
Three reasons behind the two phenomena
First, enterprises are having difficulty financing themselves through direct channels, as financial institutions are proving inadequate in providing direct financing services. Direct financing accounted for merely 17.3% of all social financing in 2014 – excluding the interbank bond market where banks act as purchasers, the percentage falls to 13.1%. Though it was often stressed in the past that efforts should be made to increase the ratio of direct financing to indirect financing, we have seen little progress during the past few years in this aspect.
During the period from 2010 to 2014, China's equity financing reached 1.9 trillion yuan, only accounting for 2.52% of all social financing. Many enterprises were unable to obtain the equity financing they desired. That is why we are seeing an extended queue of companies now waiting to be listed on the main board market and the new third board market.
A second reason for the phenomena is the amount of debt held by enterprises, which totalled 94 trillion yuan at the end of 2014. The debt-to-GDP ratio was 160%. At the end of the third quarter of 2015, the debt-asset ratios of listed companies exceeded 0.6, while for many enterprises they surpassed 0.7–0.9. A ceiling should be set for such ratios; otherwise, both enterprises and banks will face substantial risks.
Third, enterprises are receiving low returns on investment. The return on equity (ROE) for non-financial listed companies in the third quarter of 2015 was 7.2%, while their average financing cost was 6.2%. With a one percentage point margin, the situation was not that bad. But even so, their profit margins were the lowest since 2007.
Meanwhile, listed companies with much lower ROEs than financing costs were pressured into a vicious cycle of paying off old debts with new debts, which poses a major risk to both enterprises and banks.
Addressing debt risks
In the next three to five years, China's economy may be at risk of a debt crisis on account of a relatively high national leverage level and even higher levels for enterprises. Should a debt crisis occur, the impact will be significant for the banking system and even the economy at large.
The government will likely need a comprehensive approach to address debt risks. One important measure is to accelerate the construction of a multi-level capital market. In doing so, China can rapidly lower the debt-asset ratios of enterprises and make them more resilient while defusing the risks in the banking system, where almost all risks of the financial sector are accumulated and concentrated.
To this end, a revision of the Securities Law should be made as soon as possible. After years of development, China has successfully established the framework for a multi-level capital market, while structural reforms that aim to adjust the ratio of direct financing to indirect financing are under way. But policy hurdles remain, and must be overcome through revising the Securities Law.
The authorities should also accelerate the development of multi-level and diverse equity financing. Regarding the main board market, the priority should be to simplify administrative authorisation procedures. Listed companies should also obtain more financing from the SME board market and the second board market. Moreover, a transferring system should be established in the new third board market and regional equity markets. This would enable enterprises listed in the new third board market to obtain financing in the SME board market and second board market, and enterprises in regional equity markets to obtain financing in the new third board market.
China should also build a healthy and sound crowdfunding system, in a timely manner, and affirm it is supportive of mass entrepreneurship. There is a need to establish a regulatory system for crowdfunding. On October 30, 2015, the US Securities and Exchange Commission approved a system for equity crowdfunding, with explicit access provisions on the investees and investors. China has no such provisions and rules, which stands as a colossal obstacle to mass innovation.
Another crucial reform concerns the regulatory system. At present, the China Banking Regulatory Commission, China Securities Regulatory Commission and China Insurance Regulatory Commission share responsibility for supervising and regulating Chinese financial markets. However, this approach has to be changed, because the fluctuations of the capital markets in July 2015 were mainly caused by over-the-counter financing, which was not subject to oversight by any of the three Commissions.