Why are China's corporates finding it harder to service debt?
The debt-servicing capability of China's top corporates continues to weaken. Standard & Poor’s Ratings Services’ survey of China’s largest 200 companies shows that weaker revenue growth and margins have offset moderating capital expenditure (capex). Unfettered investments — much of it debt-funded — have led to chronic overcapacity, low profitability and rising leverage across many industries.
Profitability — a major measure of cash flow and debt-servicing capability — is likely to continue to deteriorate, based on current trends (see chart 1), amid a slower growth environment.
Higher borrowings have not translated into higher profitability. Average Ebitda margins declined to 14% in 2013, from about 19% in 2007. The credit stimulus in 2008-2009 had a short-term effect in boosting revenue and earnings growth in 2010; however, in the following years, annual debt growth surpassed both revenue and earnings growth.
Although the financial strength of China's corporate sector continues to deteriorate, the pace of deterioration is slowing. This is mainly reflected in the limited increase in capex over 2011-2013, compared with 2008-2009. As a percentage of sales, capex has fallen to about 13%, from more than 20% in 2009. Even so, we expect capex to remain high, as companies invest to protect their market share, upgrade technology, and improve efficiency.
How sensitive are China’s top companies to an economic downturn?
They are quite sensitive. China's top corporates face two key problems: weaker cash flow, due to slower growth and margin pressure; and a high debt load, which crimps profitability and debt-servicing.
China’s GDP growth will likely slow as the government rebalances its economy towards higher consumption. We forecast that the Chinese economy will continue to grow at a healthy pace, but consolidate at about 7% for 2015-2016. In a downside case, GDP growth could fall to 6%.
The impact of lower economic growth will impede many companies' ability to reduce debt, particularly for those that have taken on unprofitable or uneconomic projects and expansion. Some companies will experience considerable pain, with some possibly facing consolidation or default.
Which sectors are more vulnerable to a sharp economic downturn?
The slowdown in investments will affect those sectors that are cyclical, face large overcapacity, and depend on investment demand. Heavy industries and asset-heavy sectors, such as the metals and mining, are particularly vulnerable because they have high operating leverage and are also fairly indebted. Asset-light sectors, such as engineering and construction, will still suffer as their order books will shrink.
In a downside scenario of 6% GDP growth, the credit profiles of companies in the capital goods, real estate, building materials and metals sectors could drop by one notch. The most affected sectors will be mining, transport, engineering and construction, which could see their credit profiles decline by one-to-two notches. Sectors with solid financial strength will be relatively unscathed.
Where are the bright spots among the sectors in your study?
The credit risks of the 18 sectors covered in the survey are polarized, with some sectors showing diverging trends. Compared with 2007, the financial leverage and profitability of almost all sectors have materially deteriorated. Debt is largely concentrated in sectors such as railway/metro and utilities, which are closely tied to the central government's economic and energy policies.
Some sectors that have seen consolidation, such as the cement industry, are benefiting from improving profitability. The technology sector continues to be a beacon of innovation in China, with some technology companies having both a good reputation and market presence globally.
Also, pricing reform has benefited power generators, which have been battling low profitability. Private companies generally are stronger financially and more competitive than their state-owned counterparts.
What’s your view on the financial conditions of state-owned enterprises (SOEs)?
In this year's survey of China's top 200 corporates, private companies account for 29% of the sample pool, but their contribution to the sample's aggregate debt and earnings is about 6% and 10%, respectively.
SOEs dominate the sample, as they do China's economy. Their impact on China's corporate credit profiles is disproportionate, and any improvement cannot be achieved unless SOEs take measures to control leverage, instill greater investment discipline, and improve profitability and capital efficiency.
In our study, the financial deterioration of SOEs is very telling. From 2007 through 2013, SOEs' debt-to-Ebitda ratios have deteriorated twice as much as that for private companies. SOEs' profitability, as measured by a return on capital, is also nearly half that for private companies. For the latter, the deterioration in capital efficiency is more moderate compared with that for SOEs, but it still reflects a weaker business environment.
One strength of SOEs is their significant cash buffer. At 24% of total borrowings, the cash buffer provides solid financial flexibility. However, the large cash pile also reduces their capital efficiency. Many corporates have stockpiled cash because banks' preference to lend to SOEs often means corporates borrow, even when they don't need to in order to maintain a good banking relationship.
How do you evaluate SOE reforms and their role in the government's reform program?
SOEs continue to dominate China's corporate sector and are the largest sources of investment in China. Policymakers have recognised that SOEs have a critical role to play in improving efficiency.
The central government's reform program for SOEs is far-reaching in scope. Initiatives include increasing the securitisation of state assets (ie increasing the liquidity of these assets through public listings) and appointing professional managers.
Improving the governance and management incentives to perform could help some state sectors and the wider economy. But it would require broader reforms that reduce moral hazards, raise credit risk pricing and ensure strong implementation through government agencies. These ambitious measures will need to overcome vested interests and thorny implementation issues.
Since early 2014, a number of SOEs have announced reform plans, and a few have made progress. Through asset sales and equity raising, these SOEs have improved their financial ratios and flexibility to increase spending.
However, many SOEs are still tentative about their reform plans. Asset sales and privatisation are unlikely to occur on a large scale, given that many companies may be unwilling to dispose of their core and profitable assets.
What’s your credit outlook for China’s property sector?
In our view, the property sector in China will continue to face tough operating conditions due to moderating GDP growth over the next 12 months.
Although polarisation in credit profiles will continue, we expect market sentiment to recover somewhat in 2015 due to the government's policy loosening, especially on the mortgage side. The recent interest rate cut — which will lower funding costs and eases interest burdens — is also a welcome relief for property developers.
Weaker speculative-grade Chinese developers are likely to be hit by slower sales and weakening margins, leading to increasing leverage, deterioration in liquidity and rising refinancing risk.
Although large Chinese developers face similar challenges, a range of factors will generally help them weather the market correction more effectively: stronger balance sheets, access to financing, and geographic diversification. Nevertheless, we may see further rating downgrades, and even defaults, at the lower end of our rating spectrum.
The author of this article is Christopher Lee, Managing Director of Corporate Ratings at Standard & Poor’s Ratings Services.