Assessing China’s “new normal”

A group headed by Standard & Poor's chief economist explains the ramifications for corporates as China taps the breaks and reforms kick in.

Assessing China’s “new normal”

Q: Do you expect China’s GDP growth to fall further this year?

A: We would not be surprised to see a below 7% GDP growth outturn this year. We lowered our GDP growth forecasts for China to 6.8% this year and 6.6% in 2016. Growth momentum in Q1 was below target, providing a soft base for the rest of the year. Moreover, the authorities have ruled out aggressive policy action, except in a bad scenario, saying some pain will be involved in putting growth on a more sustainable path. And perhaps most important, one of the main reasons for requiring a high GDP growth in the past -- the need to absorb new entrants into the labor force -- has diminished because the 20- to 39-year-old age group is now shrinking.

China still has to create urban and manufacturing employment for those being "released" from the agricultural sector, but the GDP growth rate needed to achieve that social stability objective will be much lower than the 7%-8% targets over the recent past.

Q: How does financial sector reform fit into the macro view?

A: Financial sector reform -- in particular the role of government guarantees -- is a key component of the drive for higher quality growth. One of the consequences of explicit as well as perceived widespread government guarantees has been the mis-pricing and mis-allocation of credit. In short, too much credit was going to too many firms in key sectors, causing an oversupply problem. This has resulted in disinflationary pressure and potential impaired assets for creditors – in banks and non-banks.

The challenge was laid out clearly in the policy statement coming out of the Third Plenum released in late 2013: To move to a model where the market plays a decisive role in resource allocation. This means that the government needs to make clear what is guaranteed or not (for example via deposit insurance) and, more importantly, to let weak firms fail, which will help instill a stronger credit culture and improve the efficiency of the financial sector, as well as the economy overall.

Q: How would China’s “New Normal” affect profitability of Chinese banks?

A: Economic slowdown, interest-rate liberalization, and stiff competition will likely lower the profitability of Chinese banks is in 2015. We expect the lower growth to affect business confidence and investment plans of companies, particularly in industries with overcapacity. This could push up credit losses and lower the profitability for banks.

The second wave of credit losses for Chinese banks from midsize and large manufacturers is firming up as overcapacity in certain industries is getting worse and implicit government support for large firms is waning. The nonperforming loan ratio of the banking sector is likely to remain manageable at below 3% in 2015, but with some acceleration in write-offs and sales of bad loans.

Q: Will banks’ funding costs go up with the introduction of deposit insurance scheme? 

A: We expect the gap in effective funding costs to widen further following China's plan to introduce a formal deposit insurance scheme in May 2015. According to the rules on the bank deposit insurance scheme issued at the end of March 2015, the insured amount for a depositor's qualified bank accounts with a bank will be capped at RMB500,000. Wealth management products and interbank borrowings are not insured. Therefore, corporate depositors and other financial institutions may demand additional yields for added risks. While this scheme would seemingly level the playing field for acquiring household deposits, midsize banks may still suffer because of their greater reliance on wealth management products for funding than mega banks and grassroots banks. At this stage, it is not clear how significant the difference in deposit insurance premiums would be. But it is unlikely to favor most small banks.

Q: With the recent default of Cloud Live Technology, do you expect more to come for the China corporate space for the rest of this year?

A: Persistent overcapacity crimps the profitability and cash flow of corporates, which will likely cause more corporate defaults this year. With a slower growth in China, financing for small and midsized companies in the private sector remains challenging despite easing monetary conditions as lenders scrutinize credit risks.

The recent default of Cloud Live Technology Group put China’s commitment to market discipline to test. Any bail-out could undermine the central government's attempts to instill greater market discipline in the bond market. Differentiation in credit risks and pricing are likely to remain quite limited until more genuine defaults are allowed to happen.

Q: What about property developers? 

A: More Chinese developers could default in 2015 as the earnings and profitability deteriorate further. The slack operating performance in recent months has weakened the credit profiles of many Chinese developers.  Continuous slower sales growth and swelling leverage could lead to further negative rating actions over the next 12 months.

We expect developers with operations in smaller cities to face more difficultly in destocking and improving profitability this year. Sales in these cities have not picked up markedly despite price cuts owing to severe competition and a pile-up of inventory. Liquidity remains a key risk for Chinese developers, and has worsened for a number of already-weak companies. Lower cash balances paired with increased short-term maturities have heightened refinancing risks, particularly for developers carrying high-cost alternative financing.

The Chinese government and the central bank's recent measures aimed at boosting market sentiment should help release pent-up demand. However, the positive impact will likely take time to materialize; more likely toward the second half of 2015.

Q: 2014 was a remarkable year for China’s securitization market in terms of issuance, do you expect the trend to continue this year? 

A: We expect to see securitization being utilized even more as a funding channel for a greater variety of assets and market participants. Process efficiency, coupled with refined governance and reporting, is likely to be the next step now that market players have gained more experience with live transactions.

More issuers and investors are likely to join the market in 2015. As regulations now allow more issuers and asset types to be part of the securitization scheme, we expect smaller banks, auto finance companies, leasing companies, and some nonfinancial institutions to join the major banks in exploring securitization as a funding option. A need for wider funding sources, better capital management, and direct access to capital markets are driving factors, as seen in more developed markets.

Enhanced operational processes are also developing since the introduction of more self-management initiatives in the securitization market at the end of 2014.  New processes include the registration of intended issuance and transaction structures rather than the approval of individual transactions, and the inclusion of industry associations to coordinate issuance-eligibility reviews. In our opinion, these initiatives indicate domestic players' growing sophistication and regulators' increasing confidence. Self-management practices are likely to expand to areas such as investment guidelines, independent risk analyses, and more standardized servicing benchmarks.

The article is co-authored by:

Paul Gruenwald, Asia-Pacific Chief Economist, Standard & Poor’s
Christopher Lee, Managing Director, Corporate Ratings, Standard & Poor’s
Qiang Liao, Senior Director, Financial Institutions Ratings, Standard & Poor’s
Christopher Yip, Director, Corporate Ratings, Standard & Poor’s
Aaron Lei, Director, Structured Finance Ratings, Taiwan Ratings Corp.

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