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China Credit Crunch Squeezes Small and Mid-Sized Firms

Easy credit is drying up in China, according to a host of recent media reports. China’s government is cracking down on shadow banking, and China’s broadest measure of new credit has fallen to a 21-month low in July. Reducing credit may make it tough to achieve economic growth targets, but the government does not want to tip over into a debt crisis.

Retail sales growth in China slipped in July, and has declined year over year. Sales growth was 13.5 percent – enviable by any standard, but lower than expected. Consumer prices were up 2.7 percent in July, year over year, below the government target of 3.5 percent. Producer prices were down 2.3 percent.

For apparel and garment manufacturers, slowing growth could mean lower input prices and manufacturing costs, and it will likely become easier for makers to book factory space. A credit squeeze, however, could put many suppliers out of business.

Thousands of businesses, ranging from car dealerships to luxury retailers, have already closed and protests are breaking out in the streets of many Chinese cities. Western fashion retailers have been particularly hard hit.

The economic crisis in China, sparked by the credit crunch, is starting at the margins of the Chinese economy, in small and medium sized cities. It’s driven by rising defaults on “shadow banking” loans, overcapacity in the construction industry, and a sharp fall in the prices of assets that were used to underwrite expansion.

As industries have started to fail and borrows have begun defaulting, interest rates for the informal sector have risen from 25 to 40 percent a year to as high as 125 percent a year. This has left many owners unable to repay their debts or finance expansion. Building projects are being halted.

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Some changes have been introduced to encourage state banks to lend to small and medium sized enterprises, but for now the main recipients of funds are large, government owned companies. Much of the financing for export markets comes from international banks, but export firms often have yuan denominated debts as well, making them vulnerable to the credit crunch.

GDP expansion remains at around 7.5 percent per year, but that number doesn’t mater much for companies sales and profits. The so-called nominal growth rate, which is GDP growth plus inflation, has to exceed the interest rates on their loans in order for credit to flow and debts to be repaid. That rate was high for much of the last decade, between 16 and 23 percent on average. This allowed firms to borrow at double-digit interest rates. Now it has fallen to around 8.8 percent, making it difficult for firms to pay back debts borrowed in boom times.

Standard & Poor’s analysts recently released a report showing that the creditworthiness of China’s biggest companies will likely deteriorate in the coming year, and saying that the corporate sector has “a large debt hangover.” S&P’s downside scenario has overall GDP growth falling as low as 5% by 2014.

Large firms are vulnerable because of their high debt loads.