In case you missed it, I had a piece on FT Alphaville about the amount of bad loans in the Chinese banking system. The key take away is that banks are recording 3.7 times the amount of revenue that firms report paying in interest.
One astute reader pointed out some of the discrepancy could stem from the capitalization of interest in large investment projects specifically in the real estate industry. This is a reasonable and valid question but one that does not impact the results.
- Firms can capitalize interest and count it as the cost of goods sold in certain cases. However, the cases are limited to cases where there is an extended construction or manufacturing period. Let me give you a couple of examples. If a real estate developer is building an apartment building for two years and they will sell the apartments in the third year, while the building is under construction for the first two years they count the accruing interest into the cost of the building. However, during the third year after the building is complete they must count any additional interest accrual is a financial cost. Another example, a steel mill decides to build a new plant and it takes two years to build. During the two year construction phase, they can capitalize the interest charging it to the cost of the building. A key point here is that when they move in and begin production they have to count the loan for the building as a financial cost. If the firm uses or holds the asset they should charge interest as a financial cost. One final example, a t-shirt manufacturer takes out a line of credit on Monday manufacturers t-shirts all week and sells them on Friday and pays of the line of credit. The t-shirt manufacturer cannot capitalize the interest expense and count that under the cost of goods sold. This should be a relatively limited exception.
- The data that I have covered here both in listed and unlisted firms goes well beyond real estate. From the listed firm data, the real estate sector comprises 15% of total liabilities and the industrial dataset covering nearly 378,000 firms does not even cover the real estate sector. This covers lots of in garment, chemicals, tobacco, and publishing but not the real estate sector. What is notable about this is that most firms across sectors demonstrate a similar pattern. Publishing, printing, and media topped out at 2.6% financial cost as a percentage of liabilities for the full year ending 2014. 7% for textile and garment firms. 2.4% for pharmaceutical manufacturing. 1.9% for liquor beverages and tea. In other words, this pattern is not in any way unique to capital intensive firms. These are firms that should not be capitalizing interest and should be recording higher financial expenses.
- Let’s take it one step further. Even if every new loan was 100% capitalized for three years because it’s a big new construction project, that would still imply that the bank was receiving 5.5% in interest payments and capitalizing 2.3%. for the total 7.8% that they report. That still leaves a significant discrepancy between the 2.1% firms report paying and the 5.5% they would be paying. In other words, even if every new loan is capitalized for three years more than enough for the vast majority of projects, that would leave a very sizeable discrepancy between what firms should be paying and what they report paying.
- With all of that said, I actually believe most firms with bank agreement are capitalizing the interest costs adding to the principal balance. However, that is not a good thing. Basically, they are building up the amount of money that they must pay but can’t because they simply aren’t generating the cash flow necessary to pay the balance. I believe this actually partially explains why the bank reported interest income as a percentage of loans outstanding is a relatively high almost 8%. The base corporate lending rate in China should be lower but if interest is being capitalized into the principal, recorded as revenue, this would explain part of that amount.
- Even if interest is be capitalized increasing the loan balance, this is simply rolling over the debt into more unsustainable levels. It goes against all accounting principles that this much debt should be counted under the cost of goods sold. Neither scenario is positive.