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Why rising profits won’t rescue China’s riskiest companies

S&P Global Ratings expect defaults in China to rise in 2018 and predicts that 2018 may see the first LGFV default in the bond market.

How is 2018 shaping up for Chinese corporates?

Last year, profits for Chinese companies were boosted by economic reflation, strong commodity prices, and buoyant refinancing conditions. Overall operating and financing conditions should remain favorable in 2018, but last year's exceptional financial performance will be hard to match. Also, higher yields and spreads in China's domestic bond market are signaling tougher refinancing conditions for the riskiest corporate borrowers in China.

Even so, our base case assumes continued EBITDA gains on average for our rated Chinese companies. This, combined with more disciplined spending plans, will lead to further deleveraging. As such, the net outlook bias on our China portfolio is pushing towards neutral territory, compared with last year's deeply negative bias.

Do you expect corporate defaults to rise?

Yes, albeit from a low base, amid tightening credit conditions in the domestic market. Regulators are taking advantage of continued economic reflation to shut down backdoor funding channels and hold Chinese companies to more disciplined financial standards. The process could expose weaker or highly indebted borrowers. Sectors most vulnerable include producers in supply-glut industries, heavily indebted property players, and local government funding vehicles (LGFVs).

The full impact of banks' financial deleveraging and the crackdown on shadow banking has not materialized yet as this is progressing in stages. In this environment, certain types of highly indebted issuers will have less access to credit and this could tip them over. Government support for "zombies" (i.e., companies that have limited prospects of recovery) should be slim. Even with record profits, some companies in overcapacity industries such as metals and mining continue to have unsustainable debt levels.

Could we see the first LGFV default in the bond market?

Yes. These financing platforms are often able to roll over debt despite poor operating fundamentals, due to expected government support. However, the implicit support by their respective governments will be tested, given the central government's renewed efforts to reduce financial risks of runaway local government debt growth. The platforms' ability to manage rising funding costs, tightening liquidity, and tough policy restrictions on their financing channels post significant challenges to their debt refinancing. The risk of LGFVs defaulting on their bond has increased, which is why we may well see the first LGFV default in the bond market.

Will debt and leverage levels continue to rise?

We believe corporate debt growth peaked in 2017 and will fall over the next two years.  We expect a moderate improvement in debt leverage for 2018-2019, driven mainly by a continued recovery in profitability and greater discipline on capital spending. Both state-owned enterprises (SOEs) and private-sector companies are under pressure to control debt and reduce leverage. This is because enforcement and implementation of financial risk-related policies will likely be much stronger following the consolidation of Chinese leadership at the five-yearly Party Congress held in October 2017.

Are refinancing risks also changing in 2018?

Crackdowns on the informal banking sector, including interbank-lending activities, will choke off some channels for refinancing debt. Even so, many companies still turn to short-term trust financing, sometimes to bypass restrictions on credit to less-favored or more regulated sectors. However, the new rules go a step further by requiring financial institutions to move shadow-banking exposures on onto their balance sheets. We believe this will reduce banks' regulated capital adequacy ratios, likely forcing a slowdown in overall credit growth. Moreover, the new rules will provide more "see through" supervision of banks' ultimate borrowers, thus stemming demand on borrowing side as well.

We expect LGFVs, property developers, and companies in oversupplied and environmentally sensitive industries, such as metals and mining, to face greater refinancing challenges. This is because many of these companies or vehicles have often flouted official guidelines or rules on credit allocation. Companies that rely on the smaller banks for financing are also more vulnerable to tougher refinancing conditions. Small and midsized banks rely more on wholesale funding markets, and thus will be hit the hardest by crackdowns on interbank-lending activity and shadow banking funding.  

Banks provide more than 60% of corporate funding in China, so all companies will be affected by tightening conditions. Average lending rates are increasing gradually despite significantly higher wholesale funding cost in the past 12 months. Nonetheless, in our view, credit access will remain benign for most of our rated entities, which tend to be leading companies with good banking relationships. Moreover, we expect policymakers would quickly provide liquidity injections if funding costs jumped substantially.

Will offshore bond issuance increase in 2018?

Yes, this is likely, because maturities will increase significantly in 2018 and 2019 and rising onshore yields will drive weaker issuers to tap funding in the lower-cost dollar funding. New issuers come from many different sectors and are mostly privately owned, whereas a few years ago real estate developers and SOEs dominated. Last year saw record offshore bond issuance by China's companies.

Which sectors will see profitability gains?

We expect profitability improvements to be more broad-based this year. Industrial profit growth should slow this year as commodity prices stabilize, while downstream sectors will benefit from rising product prices. In early January, producers announced price increases for beer, paper and packing products, packaged food to offset rising input costs. Even airline ticket prices are trending higher.

Utilities is one sector that might not benefit from the producer-price trend. Higher coal prices have crimped profitability, but it's not certain that tariff increases will materialize this year. Regulators are balancing the need for utilities' continued large capital expenditures (capex) and deteriorating financial positions against the rising burden of debt and inflation on households.

Will appetite for expansion and capex be restrained?

We expect restraint on capital spending. Companies are not recycling profits into major new investments or capex, despite the five-year high in profitability. This is in part due to government pressure to control debt growth. SOEs companies will have to meet specific targets and measurements on deleveraging over the next three years. Private enterprises are also heeding the government's call to change their credit-dependent habits. Highly indebted property developers have vowed to reduce leverage and cut overseas investments. Companies are taking advantage of buoyant stock market conditions to raise equity capital. More broadly, investment growth is slowing as deleveraging measures take hold.

Where capex is increasing, it is in step with rising profitability such as metals and mining and oil and gas producers. As a share of revenue, capex will modestly decline for 2018-2019, with the exceptions of utilities and transportation infrastructure. However, should China's global "Belt and Road" infrastructure initiative accelerate, then we would expect more leveraged investment and M&A activities by Chinese companies chasing global infrastructure projects.

(For more S&P Global Ratings research and multimedia on Chinese issuers and markets, please visit this webpage:

The article is co-authored by Christopher Lee and Gloria Lu, credit analysts at S&P Global Ratings

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