China defaults are unnerving bond markets

In view of recent corporate defaults in China, Standard & Poor’s discusses what lies ahead for the country's credit market.

Why was Chaori’s default a landmark event for China’s bond market?
For a long time there has been a market perception of implicit Chinese government support for companies, especially issuers of onshore bonds. That perception may be changing. Indeed, Chaori’s recent default signals greater government willingness to let borrowers be subjected to market discipline. It is clear that the Chinese government is beginning to address this difficult moral hazard and the issue surrounding an implicit state guarantee of financially weak and commercially unviable borrowers. However, we are unlikely to see support for state-owned enterprises and local government financing platforms being reduced soon.

Are some sectors in China more vulnerable to defaults?
China's corporate sector debt has doubled over the past five years, reaching about US$12 trillion at the end of 2013, only behind the US. We estimate China's corporate debt could hit US$13.8 trillion in 2014, surpassing the US as the world's largest. The easy credit growth in the past few years has led to over-investment, often in sectors that already face severe overcapacity. The rapid accumulation of debt has led to many companies being over-leveraged and weakened debt servicing capability. This, in combination with a weaker growth outlook and tighter funding cost, could tip over many weak corporates into distress. 

Companies operating in competitive and cyclical industries with overcapacity are particularly vulnerable: shipbuilding, metals and mining (steel, coal, and aluminum), building materials (cement and glass), and solar equipment. Some weaker borrowers in the property sector who have higher exposure to trust funding are also vulnerable, given lenders are becoming more selective. With onshore funding conditions deteriorating for weaker borrowers, we may see more Chinese corporates trying to tap offshore bond markets. Even though funding costs would be considerably higher, offshore markets can become a critically important source of liquidity for these borrowers. 

We expect the number of defaults to increase in 2014 compared with 2013. We have downgraded a number of issuers to the ‘CCC’ category in the past 12 months. These include property developer Renhe Commercial Holdings, coal logistics provider Winsway Coking Coal Holdings, and coal miner Hidili Industry International Development. Credit quality for China issuers is trending downward as the economic outlook weakens and funding conditions tighten.

Are property developers also at risk of default?
The credit environment for small developers is deteriorating amid uncertain sales prospects and intensifying competition. The recent case involving Chinese developer Zhejiang Xinrun is merely one example of many distressed small developers in China. These developers often have a small number of projects and struggle to replace their land reserves as land prices have escalated . Also, many small developers struggle to meet their financial obligations as property sales prospects weaken and lenders turn cautious on high risk credits.

Despite challenging operational and financing conditions, we expect most of the developers Standard & Poor’s rate to be able to weather the current turmoil. We consider most of the rated Chinese developers to be medium-to-large scale in China's context. What’s more, these rated entities are typically listed and have reasonably good bank relationships and capital market standings. Many have lowered their exposure to trust financing over the past two years. Nevertheless, funding costs are likely to increase, which will weaken their profitability and cash flows. In our view, developers rated in the 'B' category or below in Standard & Poor’s global rating scale are particularly vulnerable.

So what lies ahead for China’s bond market?
With the Chinese government signaling a greater willingness to subject borrowers to market discipline, we expect a greater differentiation of credit risks. This, in turn, is likely to lead to more limited funding, at a higher cost, for weaker companies. The re-opening of the domestic bond market may not help these companies as only the largest, typically state-owned enterprises, can access the bond market. Together with tough operating conditions in some industries, the tightening funding conditions could lead to more defaults among weaker borrowers.

The Chinese government has realised that capital market reform needs to coincide with economic restructuring in order to allocate capital more efficiently and curb wayward debt growth. The current Chinese leadership's broader strategy is to increase the role of the market in allocating financial capital resources.

Although Chaori's default is a small test case for the authorities to signal an end to long-standing implicit government support, we do not think this in itself will create systemic risks for the financial sector. Chaori’s outstanding debt is small given the scale of the China’s domestic bond market.

On the positive side, we believe Chaori’s default will increase transparency in the bankruptcy and liquidation process for lenders and investors. There is no precedent for default resolution of a domestic bond issuer. So investors and lenders are eager to see how the process will play out and what they can expect from the recovery of their investments and loans. China’s bankruptcy regime is currently untested and bankruptcy proceedings are unclear.

Do you expect more wealth-management or trust products to be under stress?
We believe more trust products could come under stress this year as the economy slows. The underlying risks to the assets of wealth-management products and trust loans have yet to decline. This reflects the tough operating conditions for some of the assets that are pledged as security for the products or loans. Early this year, investors in a sizable collective trust program in China that had been under stress were spared losses. But we see this as a temporary reprieve for China's shadow-banking segment.

What are the implications of shadow banking?
The rise of the shadow banking sector in China highlights leverage in the economy and the issue of capital allocation — both of which are among the key long-term determinants of the Chinese banking sector's credit performance. Shadow banking can be conducive to China’s economy. For example, internet finance, based on massive transactional data of small business and individuals, may have a competitive edge over banks’ traditional SME and consumer lending in terms of credit assessment and cost efficiency. But we do not think it will develop into mainstream corporate finance.

However, we believe that China's shadow banking system poses more risks than potential benefits. This is because the already-high debt levels of corporate China leave little room for a further rise in leverage, particularly given the slower economic growth scenario and  a significant proportion of shadow banking credits flows to uneconomic investment projects.

Would shadow banking activities lead to systemic risk for the banking sector?
We continue to view China's shadow banking more as a symptom than a cause of some emerging systemic risks to the banking sector and the wider economy. Chinese banks have already accumulated high credit risks on their balance sheets. But distorted growth in shadow banking could lead to a further unintended build-up of credit risks that banks may not fully appreciate. Certain parts of the shadow banking sector, notably trust companies, may prove to be the weak link of China's financial system.

Is China heading for its own “Lehman moment”?
We do not foresee a liquidity-triggered banking crisis in China. China has many levers in its economy that can protect it from having such a crisis. Chinese banks are predominantly funded with retail and business deposits, with limited reliance on wholesale funding. The banking sector’s loan-to-deposit ratio is very low compared to global norms, while sizeable reserves (over 20% of deposits for major banks) placed with the People’s Bank of China can be used as a stopper in any credit event.

We can't rule out financial distress and severe credit losses for Chinese banks over the next two to three years. But we believe a prolonged crisis is unlikely for Chinese banks. And we believe China's economy has sufficiently robust growth potential for its banks to ride out any credit crunch. China's US$3.8 trillion in foreign reserves are the largest in the world and constitute over 40% of GDP. This makes an external crisis and an approach to the IMF extremely unlikely.

China also has a strong public sector balance sheet. Even with the recent recognition of local government debt, the public debt to GDP ratio stands at 36%, relatively low compared with China's peer group. This means that in a "credit event", the public balance sheet has room to absorb substantial losses in public entities, such as banks and other financial firms.

The authors of this article are Standard & Poor’s credit analysts: Christopher Lee ,managing director of corporate ratings, and Qiang Liao, senior director of financial institutions ratings.

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