China risks rise as economy rebalances

Standard & Poor's Ratings Services believes that credit risks are rising for key sectors of China's economy but says the authorities can avoid a hard landing.

China risks rise as economy rebalances

The Chinese economy is in a tight spot, with a slowing economy accompanied by volatility in the equity market and the Chinese renminbi exchange rate. Standard & Poor's Ratings Services believes that credit risks are rising for key sectors, but says the authorities can avoid a hard landing. Here we answer some of the key queries we've received from investors regarding our views on the Chinese economy, sovereign, financial institutions, and companies.

What are some of the "big policy mistakes" that could spook the markets?

The track record of Chinese authorities and macro policies has been pretty good over the past few decades. The recent communication issue over the stock market and foreign exchange market is an exception. That's what spooks the market.

China still has a lot of cushions to manage and stabilize the economy and its markets. This makes China different from other emerging markets, making it less vulnerable to shocks and crises. The Chinese economy is largely self-funded. The Chinese fiscal balance sheet is still in good shape. We acknowledge that the fiscal deficit is higher than in the recent past, but the all-in government's debt to GDP ratio is still about 60%. So, there is some fiscal space to counter the economic slowdown. With the Latin America and Southeast Asian crisis, the "late-mover advantage" allows China to understand macroeconomic vulnerabilities and minimize them.

Are the large capital outflows driving the depreciation of the renminbi?

Yes. The renminbi depreciation has been partly driven by capital outflows. However, there have also been some "non-inflows". Many Chinese exporters are keeping their U.S. dollar export proceeds offshore, not bringing them onshore and converting them into yuan, unless they absolutely need to.

For the foreseeable future, we will continue to see this combination: China running large current account surpluses (that reached US$595 billion in 2015) and at the same time losing some foreign currency reserves, which suggests substantial capital outflows. It's a major switch in market perception about the renminbi: From being a one-way bet on the strong side to being a one-way bet on the weak side.

What are the triggers for negative rating actions on China?

We could lower the ratings on (AA-/Stable ) if we expect weak economic or financial sector trends to materially increase the government's contingent fiscal liabilities. Such a scenario is likely if we assess economic rebalancing to be progressing slowly and if economic growth slows gradually even as investment spending maintains its outsized role as a source of growth.

We could also lower the sovereign ratings if China expands credit to fund investment spending to maintain strong economic growth. While such an approach could boost near-term economic performance, it could postpone inevitable economic rebalancing and rapidly raise leverage from an already elevated level. Such a scenario would increase the risks to stability in the financial sector and could trigger a sharp economic correction.

So would the government stimulate the economy while the debt is still high?

We believe that the government will implement policies to keep economic growth close to its target level or range. It is likely to increase public investment in lesser developed regions of the country. However, given the changes in the fiscal framework in the past two years, we expect much of the funding to come from bond issuances by provincial governments. The Chinese central government appears to have appreciated the increased risks in the financial system arising from strong credit growth since 2008. Consequently, it has been wary of relying on bank lending to finance very strong stimulus spending to stabilize growth.

Are China's diminishing foreign exchange reserves putting pressure on the sovereign ratings?

Not yet. Despite Chinese foreign currency reserves falling to US$3.2 trillion at the end of January, they are more than twice the total foreign debt that all its residents owe. Financial institutions in China hold a further US$640 billion in foreign assets. Even if the foreign exchange reserves continue to decline at the rate of the past year or so, China's external balance sheet will remain one of the strongest support factor for the sovereign ratings, at least in the next year or two.

How will asset quality for Chinese banks evolve in the next 12-24 months?

We expect deterioration in assets quality to accelerate over the next 12 months. Asset quality for the banking sector can be better tracked by considering both the reported nonperforming loans (NPLs) and special-mention loans. While the 2015 year-end NPL and special-mention loans ratios are yet to be announced, we estimate that the NPL ratio for year-end 2015 would be about 2%. By the end of 2016, we expect this ratio to increase to 3.1%. The special-mention loan ratio stood at 3.77% for Chinese commercial banks at the end of September 2015. Our estimates consider banks' potential disposal of NPLs and some questionable loans that have been classified in the special-mention loan book. We expect banks to dispose of NPLs, given the pressure from the regulator and to appear comparable to their peers.

What's the forecast for banks' net profit growth in 2016?

Based on our views on the banking sector's credit losses and the potential hit on the net interest margin, we expect banks' net profit growth to be in low single digit in 2015. This will translate into a return on average assets of 1%-1.1%, compared with 1.2% in 2014. With mounting pressures on the banks' interest spreads and credit losses, we expect total profits of Chinese banks to fall noticeably in 2016, which would be the first time in more than a decade.

A risk for the banking sector is the depreciation in the renminbi. A weakening renminbi could dampen investors' sentiment toward Chinese assets and trigger more sizable capital outflows, leading to tighter liquidity or financing conditions. This may have a material impact on the property market, resulting in falling property prices and rising risks for the banking sector. We believe the government will strike a balance to support the economy and contain the impact of renminbi depreciation on the property market and the financial sector.

How will a weaker corporate sector affect reforms to state-owned enterprises?

The worsening performance of Chinese companies may accelerate consolidation among state-owned enterprises (SOEs) to bolster their financing standing. The government could do this by combining loss-making SOEs with more profitable ones. Such consolidation may stave off financial distress on the weak SOEs for the time being. However, it would not improve the efficiency and debt servicing capability of these entities without material capital injections or drastic restructuring and streamlining that result in closure of loss-making units and disposal of assets.

What's the default risk of local government financing vehicles (LGFVs)?

The risk varies. In the past 12 months, we have rated LGFVs from various levels of governments. The ratings range from investment grade to non-investment grade. This reflects the differences in stand-alone credit profiles of the LGFV, the local government credit ratings, and our assessment of extraordinary government support. The credit profiles of LGFVs are anchored by the government ratings and the likelihood of extraordinary support because the stand-alone credit profiles of LGFVs are quite weak.

We believe government support for LGFVs is quite strong due the reputation risk and the need for local governments to use LGFVs to access the offshore bond market to fund infrastructure projects. However, the role of LGFVs to the local governments could diminish over time as the funding role of these entities for the government has been curtailed and their stock of government debt is gradually refinanced. This could result in a reassessment of the level of government support.

How would lower oil prices affect Chinese companies?

Lower oil prices would have divergent impact on various sectors. For the oil and gas sector, lower oil prices would mean lower earnings and cash flows, which would put pressure on the sector's financial strength. We have recently downgraded a number of oil and gas companies in China reflecting our assumption of lower oil prices for 2016 and 2017.

Sectors that would benefit from lower oil prices are consumer and manufacturing. Lower oil price is a windfall for consumers as they can spend savings from lower fuel cost on other products and services. Manufacturers should benefit from lower fuel costs but they may have to pass through lower costs to consumers because many sectors are very competitive and fragmented. This is reflected in the continued negative producer price trends for the past two years due to a slump in commodity prices. The net beneficiaries of lower oil prices may be exporters with reasonable pricing power, especially those selling into the recovering U.S. market.

The article is co-authored by the following from Standard & Poor’s Ratings Services:

Paul Gruenwald, Asia-Pacific Chief Economist

Kim Eng Tan, Senior Director for Sovereign Ratings

Qiang Liao, Senior Director for Financial Institutions Ratings

Christopher Lee, Managing Director for Corporate Ratings 

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