(Bloomberg Opinion) -- Even the savviest of investors were caught off-guard by the speed of China Evergrande Group’s unraveling. They shouldn’t have been: Trouble has long been brewing at China Inc., where balance sheets are weakening in the face of a rocky economic recovery. This could be Beijing’s worst blind spot yet.
At over 1,100 listed companies in China’s industrial and manufacturing sectors, receivables are piling up; cash conversion cycles are getting longer (that is, the time it takes to turn inventory investments into cash); and net short-term debt levels are becoming increasingly volatile, a Bloomberg Opinion analysis shows.
The pandemic has been a challenge, no doubt. Officials deployed hefty stimulus measures to keep the lights on and production lines running for China Inc. Yet for the roughly 40 million small and medium-size enterprises, it’s been even tougher. Their struggles, including poor access to cash and strained working capital, predate Covid-19. What’s worrying is how mainland companies got into this compromised position in the first place.
Chinese suppliers wait a long time to get paid by their customers, which squeezes their working capital. Even in the pre-pandemic good times of 2019, it took almost 92 days on average, compared with 51 in the U.S. To bridge that funding gap, companies increasingly have turned to supply chain financing — instead of waiting to get paid, firms go to a third party that hands over cash sooner. A big benefit is that companies struggling to borrow can use their assets as collateral, which helps break the vicious cycle of weak creditworthiness.
But the moment repayment becomes an issue, credit tightens. Cracks quickly appear up and down the supply chain. (Think: the Greensill Capital debacle.)
That’s what eventually caught up with Evergrande. Inventory makes up a big portion of its working capital, and as that deteriorated, bills piled up. (According to the New York Times, the real-estate developer’s funding squeeze hit as early as April.) In addition to the debt the company took out from mainstream financing channels, Evergrande leaned on vendors and other parts of its supply chain — apartment buyers and customers. It even roped in its employees, who were told to invest in the company’s wealth products. In an interview cited by the Times, management said the employee investments were part of “supply chain financing” and would allow Evergrande to make payments to its suppliers.
Companies across China’s industrial landscape have turned to similar arrangements to alleviate their funding troubles. Supply chain financing has exploded over the past few years, ballooning to 17.4 trillion yuan ($2.69 trillion) by 2019, at a compounded annual growth rate of 10.6% since 2015. Banks, along with trust companies, insurance firms and other non-bank financial institutions, play an active role.
This growth happened, in part, because regulators encouraged it. Policy makers put out guidance promoting supply chain finance as early as 2017. When Beijing was cracking down on shadow financing, firms turned to their suppliers and customers. Between 2015 and 2019, the total amount of accounts payable for China’s stronger companies rose to 30.2 trillion from 17 trillion yuan, with an average of 5 billion yuan to 6.7 billion yuan per enterprise, according to China Insights Consultancy. Beijing’s own fiscal constraints and attempts at a more disciplined approach to credit only added to the push. Even for those firms that had access to capital, it was expensive.
Theoretically, this form of short-term financing has potential in China, home to some large and sturdy state firms, or prime borrowers. The practice depends on so-called anchor enterprises that offer support to distributors and suppliers lower down the chain. But the market has started to look large and unwieldy. Last year regulators issued a directive to step up scrutiny. In June, state-media said China would “promote the standardized development of supply chain finance” to broaden channels for SMEs “and ensure more funds flow to the real economy,” citing the central bank.
Set against this backdrop, manufacturers are in for a squeeze, though perhaps not at Evergrande’s scale. But even if just half of China’s SMEs have working capital issues that hit their supply chain financing, Beijing could end up facing a solvency crisis. Repayment ultimately depends on the health of companies’ sales: Falling demand and slowing industrial profits don’t bode well.
Untangling these challenges and shoring up balance sheets isn’t front-of-mind for Beijing yet. When they do get around to drawing up a solution, pumping in credit won't be an option — that’s what officials have been doing for years, and it never fills the right holes. Firms have to do their part, too.
If there’s one lesson from Evergrande, it’s that, more than China’s inflated debt levels, working capital is becoming a bigger, more opaque risk.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Anjani Trivedi is a Bloomberg Opinion columnist covering industrial companies in Asia. She previously worked for the Wall Street Journal.
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