Private credit in an economy in transition
ShoreVest’s private credit strategy comes down to three interrelated sub-strategies: asset-backed lending, asset restructuring, and debt resolutions or investing in distressed debt, such as non-performing loans. From a macro perspective, when the economy is deleveraging, in transition, or trying to stabilize, such opportunities appear in significant volume.
Where the economy is in transition from old economic drivers to new, more advanced drivers, it often produces asset-restructuring opportunities because bad balance sheets need to be cleaned up and good assets need to be repurposed. For instance, in early 2015, ShoreVest bought a portfolio of non-performing loans in Shanghai, many of which were first-lien loans collateralized by warehouses owned by defunct steel-industry borrowers. To monetize these loans and collateral, ShoreVest found new economically viable homes for the warehouses with buyers in the e-commerce industry who were short on logistics assets.
One of the biggest economic challenges facing China at the moment, and one that will require significant transition, is overcapacity. It is responsible for entrenched producer-price deflation, has eroded corporate profits, and has resulted in falling tax revenue for the government.
Consequently, in recent months, tackling overcapacity has moved to the top of Beijing’s list of priorities. Efforts have only just begun in earnest, and key questions, such as who should bear the cost of factory closures, how quickly excess capacity should be shuttered, and how assets might be repurposed, remain unanswered. We are likely witnessing the start of a years-long transition that will require creative financing solutions and create new opportunities for private credit, particularly in asset restructurings.
Sunset and sunrise industries
Overcapacity refers to when an industry is capable of producing far more goods than the market demands. It is not a technical term, and identifying when an industry is suffering from overcapacity is more art than science. Still, a broad swathe of Chinese industries are in a state of overcapacity. Those industries can broadly be divided into two categories: sunset and sunrise.
Sunset industries are typically those whose fortunes were linked to the housing sector, such as steel, flat glass, cement, home appliances, and construction machinery. Demand in these industries will never again be as strong as it was prior to the housing market’s peak in 2021. Many have ramped up exports to make up for the collapse in domestic demand, but have done so by cutting prices, thereby exacerbating trade tensions.
Sunrise industries are innovative sectors that Beijing is trying to encourage, such as electric vehicles, batteries, and solar panels. Overcapacity has emerged in these industries for two main reasons. First, local governments have blindly encouraged their development, helping keep alive firms that would otherwise have collapsed without support. Second, firms are striving to maximize market share rather than profit in the hope that they can drive competitors out of business. With local governments keeping underperforming firms alive, that process is taking far longer than it should.
Overcapacity is evident in other industries as well, including coal and petrochemicals, largely because of overinvestment encouraged by local authorities. But it is most concentrated in sunrise and sunset industries.
From policy concern to enforcement
Overcapacity periodically afflicts China’s economy. The last state crackdown lasted from 2015 to 2019. This time, Beijing identified overcapacity as a concern in December 2023, when the Central Economic Work Conference labelled overcapacity in some industries as a major challenge for the year ahead.
Authorities initially did little to tackle the problem, leaving it to market participants. However, problems persisted and worsened. As of August, producer prices had declined for three consecutive years.
The first sign that Beijing intended to take a more hands-on approach came on June 30, when the People’s Daily ran a front-page editorial blaming local governments for the emergence of overcapacity in key cleantech industries. It criticized misaligned local priorities, blind capacity expansion, duplicative projects, subsidy arms races, excessive preferential policies, and local intervention that stalled the exit of inefficient capacity.
The following day, Qiushi, the Party’s top journal, argued that local-government overreach, flawed performance metrics, local protectionism, market fragmentation, weaknesses in bankruptcy and restructuring, and interference with failing firms had delayed consolidation and created zombie companies.
On July 2, the Central Commission for Financial and Economic Affairs, the Party’s top policymaking body for economic issues, said it wanted the government to rein in industry price wars and support the orderly exit of outdated capacity. Xi Jinping also made clear that local officials would be held responsible for illegal investment-promotion behavior and local protectionism.
- People’s Daily: local subsidy races and duplicative investment distorted resource allocation.
- Qiushi: local protectionism and weak exit mechanisms prevented timely consolidation.
- The Central Commission for Financial and Economic Affairs: price wars should be restrained and outdated capacity should exit in an orderly way.
Early effects and the cost of capacity exit
Beijing’s efforts are already having an effect. In August, fixed-asset investment dropped sharply across industries where Beijing is targeting overcapacity.
However, while the decline in investment will limit the problem from worsening, closing down existing production facilities is likely to prove far more difficult. The biggest challenge will be deciding who bears the cost. The burden could fall on local governments, shareholders, creditors, workers, or some combination of all of them. In the polysilicon sector, the costs look set to fall upon industry leaders.
- Investment in metal smelting and pressing facilities fell 16.7% year over year.
- Investment in electrical-equipment manufacturing, including solar panels and batteries, dropped 9.5%.
- Investment in chemical processing and manufacturing fell 8.7%.
The polysilicon test case
Polysilicon is the raw material used in solar components, and the industry’s efforts to deal with overcapacity are more advanced than those of any other sector. Since May, China’s biggest polysilicon firms have been in talks to jointly establish a RMB 50 billion fund that would acquire outdated production facilities from small domestic firms and shut them down.
The goal is to reduce annual production capacity from 3 to 3.2 million metric tons to approximately 2 million tons. That would still be well above projected 2025 market demand of 1.4 to 1.6 million tons, but could be enough to boost prices, which have collapsed in recent years.
The challenge for participants, most of which are private-sector firms, is agreeing on how much each company should contribute to the fund and what the fund should pay for outdated plants. An agreement was originally hoped for in the third quarter, but no longer seems likely before 2026.
A drawn-out restructuring cycle
It is also unclear how quickly Beijing wants to reduce capacity. The issue is unquestionably urgent. Without an end to overcapacity, deflation will persist and dampen domestic demand. However, a rapid adjustment could be traumatic for the economy, particularly if it results in layoffs, bankruptcies, and further financial stress for local governments.
Petrochemical giant Rongsheng Petrochemical recently disclosed that it expects Beijing to close 10% of its industry’s installed capacity and that the process will take three to five years. That suggests Beijing hopes to limit disruption by drawing out the process over a relatively long period. The last campaign to rein in overcapacity, beginning in 2015, also lasted about five years.
What is clear is that the process will require mergers and acquisitions, corporate restructuring, and the disposal of distressed assets. While banks will undoubtedly play a role, this activity falls outside their typical operations and often requires an experienced credit-solution provider able to identify which collateral assets might be repurposed for more forward-looking uses.
We have written previously about how overinvestment in renewable energy and cleantech will create opportunities for private credit providers such as ShoreVest. As Beijing pursues an even broader campaign to rein in overcapacity throughout the economy, the opportunities may extend well beyond green industries.