Following several years of strong investment and rapid debt accumulation, China's major companies are now facing a much more adverse operating environment. Christopher Lee, managing director of corporate ratings for Greater China at Standard & Poor's, explains how China's economic slowdown could affect its major companies, and why some industrial sectors are more exposed than others.
Tell us about S&P’s annual survey on China's top corporates.
In this year’s survey of credit risks facing corporate China, we assessed 151 companies and increased the proportion of private enterprises in the sample to 25% from 12% in 2012. These companies were selected from a pool of the largest domestic bond issuers and biggest revenue earners, and we also included companies that we think were representative of 17 industry sectors covered in the survey.
Why are many of China's top corporates vulnerable to an economic slowdown?
China's top 151 corporates accumulated high levels of debt during the credit boom of the past five years. In the same period, the credit ratios of China top corporates have deteriorated steadily, most notably profit margins and debt-payback measures (funds-from-operations divided by debt). Most sectors have suffered, even strong sectors such as oil and gas, due to large acquisitions.
We believe the capacity of China’s top corporates to service debt has weakened compared with a year ago. Also, a sizeable minority of companies with highly leveraged balance sheets and continued high investment appetites remain particularly vulnerable in the current slowdown. To safeguard the stability of China’s financial sectors and shift the economy away from an over-reliance on investment (and towards greater consumption), China's new leadership may introduce measures that curb excessive credit growth. In our view, such measures are likely to lead to lower and more sustainable economic growth rates, as well as moderating debt growth. However, it also means that the margins and cash flow of China’s top corporates may compress further, weakening their debt-serviceability.
Which sectors are most vulnerable to the slowdown?
We regard coal, metal and mining (including steel), and transportation as those that are most vulnerable. Companies in these sectors generally carry high financial risks, and some of these sectors are struggling with sluggish demand, excess capacity, and depressed profitability. To promote consolidation in these industries, we believe the government may intervene to remove excess capacity by encouraging some state-owned enterprises to merge or acquire weaker entities.
On the other hand, we think the telecommunications, oil and gas, consumer products, and healthcare and pharmaceuticals sectors are better-placed to weather the downturn. Notably, the telecommunications and oil and gas sectors are the two strongest performers in our survey. Companies in these two sectors benefit from their oligopolistic market positions and strong financial positions.
What effect will there be on Standard & Poor’s corporate ratings?
We believe the majority of the 151 corporates analysed in the survey are likely to weather the current economic slowdown. However, a sizeable minority of the companies in our survey have "aggressive" to "highly leveraged" financial risk profiles (these are the two lowest categories in our six-point scale for financial risk). We think these corporates will be more vulnerable. The effect of the slowdown, however, will depend on its severity. For example, in a downside scenario where China’s real GDP grows by 6.5% in 2013 and 5% in 2014, we believe there is the potential for downgrades of two or more notches of companies in the coal, metal and mining, and transportation services sectors (see table), as well as some defaults among weaker entities. Our base-case expectation for China’s read GDP is 7.3% for 2013 and 2014. Given our expectation that some companies and sectors are likely to weather the downturn better than others, we think there is likely to be increased differentiation among China's top corporates' credit profiles.
Have industry sector rankings changed since your survey in 2012?
Yes, our rankings for the sectors have somewhat shifted this year due to the addition of two sectors (retail, health care and pharmaceutical), which brings the total number of sectors to 17. The strongest and weakest sectors in terms of quartile ranking are broadly similar to our survey in 2012. However, some sectors have shifted as we reassessed their business and financial risk profiles. For example, we have lowered our assessment of the business risk profile for shipping companies, which resulted in the transportation sector ranking falling to 16th (from 10th in 2012). Similarly, the downward adjustment of metal and mining companies' business risk profile due to weak profitability led to the sector rank falling to 17th (from 11th in 2012). The building materials sector rank fell to 14th (from 3rd in 2012), because the 2012 sample comprised the strongest cement producer, and the subsequent expansion of the sample to six cement companies and two glass manufacturers diluted the sector's business risk profile. Finally, the infrastructure sector moved up to 9th spot (from 15th in 2012), as the new expressways and ports companies that we have added to the 2013 sample have stronger financial profiles.
How do you assess the credit profiles of the top 151 companies as a whole?
Based on our survey, we assess the stand-alone financial risk profiles for China's largest companies as relatively weak on average. On the other hand, their business risk profiles are comparatively better. In our view, the comparative weakness of these companies' financial risk profiles reflects the substantial investments they have made in order to keep pace with or outperform China's fast-growing economy. The fact that state-owned enterprises represent about three-quarters of our survey partly explains this push. The objectives of these state-owned enterprises go well beyond profit maximization--their shareholder base and relative cost of capital both favor the use of debt, which naturally heightens their financial risks.