Onshore liquidity crunch to undermine China credit

China’s worsening borrowing conditions could prompt a rise in bond supply and corporate defaults, threatening the credit profiles of local companies, says Morgan Stanley.

The market for Chinese credits is likely to remain under pressure from rising bond supply and risk of corporate defaults. These are the side effects from the cyclical deterioration in the mainland’s borrowing conditions that result from a more constrained financial sector.

In the short term, market risks will be dominated by tighter financial conditions – reduced availability and higher cost of credit – which results in financial sector deleveraging, according to a Morgan Stanley report.

“Tighter financial conditions create two types of pressures on China credit markets: it increases refinancing risks and therefore the risk of defaults, and it increases the need for corporates to have access to alternative credit sources and creates supply overhang in bond markets,” wrote Viktor Hjort at Morgan Stanley in the report.

China credit is an asset class that is already highly sensitive to domestic credit conditions, where the liquidity cycle matters more than gross domestic product (GDP), notes the bank.

During periods of tightening it works in reverse – most notably in 2008 and 2011, when spreads widened materially or underperformed global peers.

“We are currently in a similar period but relative spreads are towards the tighter end of the historical range, hence the balance of risk is, in our view, skewed to the downside,” wrote Hjort.

Why are markets so sensitive to credit conditions?

High leverage and heavy reliance on short-term funding, modest free cashflow generation – on each measure China’s corporates have weaker credit metrics than global peers – as well as a fairly cyclical earnings profile all mean that small changes in economic growth and the credit cycle will have a big impact on Chinese credit profiles, highlights Morgan Stanley.

The risk of corporate defaults – which in any market is a function of leveraged balance sheets, sluggish growth and tighter borrowing conditions – are now present in China.

This means that idiosyncratic risks should be high now, particularly in the private sector-dominated high-yield universe, adds the bank.

Morgan Stanley is cautious on both the property and industrial sector.

High supply pressures

As traditional credit channels become increasingly constrained, Chinese corporates will need to rely on alternative sources including offshore credit markets, and as onshore funding costs rise, the incentive to go offshore increases, notes Morgan Stanley.


For the important Chinese state-owned enterprises (SOEs) for example – which dominated investment grade issuance – dollar-denominated funding is nearly 350bp more attractive than onshore loans, not accounting for cross-currency swap costs, and 200bp more competitive than the onshore bond market, says the bank.

This gap is growing as onshore debt markets come under pressure.

“This gives us some perspective on what an issuer could really be willing to pay to get dollar issues done,” wrote Hjort.

“Considering the size, debt stock and reliance on short-term funding of the SOE universe, supply pressures on credit markets should be material.”

Chinese issuers account for the majority of G3 bond issuance in Asia ex-Japan, achieving an overall market share of 31.4% with $7.9 billion worth of deals just year-to-date, according to Dealogic data.

The same goes for total 2013 issuance, where Chinese issuers accounted for nearly 40% of Asia ex-Japan G3 market, followed by the South Koreans with 16.3%.


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