Credit FAQ:

China Walks Policy Tightrope In The Midst Of Rising Financial Pressure

Chief Economist, Asia-Pacific: Paul F Gruenwald, Singapore (65) 6216 1084; paul.gruenwald@standardandpoors.com Primary Credit Analysts: Christopher Lee, Hong Kong (852) 2533-3562; christopher.k.lee@standardandpoors.com Ryan Tsang, CFA, Hong Kong (852) 2533-3532; ryan.tsang@standardandpoors.com

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Frequently Asked Questions Related Research

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Credit FAQ:

China Walks Policy Tightrope In The Midst Of Rising Financial Pressure

Given China's recent bond defaults, failures in wealth management products, and slowing property sales, investors are knitting their brows and wondering what to make of the cracks in the financial system and its economy. Is the country nearing the tipping point? China has now seen its first public onshore bond default, a solar equipment company. Soon after that, a few Chinese property, building materials, and steel companies defaulted in bank loans. Standard & Poor's Ratings Services forecasts China's GDP growth at 7.4% this year, easing to 7.2% in 2015. A slowing economy combined with tough operating conditions in certain industries facing cyclical downturns, overcapacity, and high leverage tend to lead to more companies missing payments, including debt payments. Standard & Poor's recently held investor teleconferences to discuss the growing pressures in China. Participants had the opportunity to ask our panel speakers some questions. Here are some of the issues discussed.

Frequently Asked Questions

How big is China's shadow banking system? What is the risk from this?
We estimate assets in the shadow banking system at the end of 2013 was about US$30 trillion. We use the Financial Stability Board's definition for shadow banking, which is "credit intermediation involving entities and activities outside the regular banking system." Our view on the risk from this system is different from a common perception that all shadow-banking exposures are risky. We believe about one-third of the products are more risky and are likely to pose some problems for the systems. Wealth management products form a significant part of shadow banking. As product distributors, commercial banks are not liable to compensate investors for their investment losses. Although banks, in some cases, may choose to buy back the product or offer some compensation, in our view, the long-term trend is the banks, as distributors, will not continue to bear the investment risks of these investment products. Investors will have to bear the risk.

Will the defaults hinder the growth of the bond market? If not, how will it further develop?
We think bond defaults will affect the development of China's bond market to some degree, but the market will benefit in the long term. The Chinese onshore bond market has grown very quickly in the past decade. As the market develops and credit risk is repriced, we can expect turbulence. In the offshore bond market, credit risk differentiation is more pronounced; yields on bonds issued by state-owned enterprises (SOEs) are significantly lower than those issued by private enterprises. In the onshore market, the Chinese government is encouraging greater development of the capital markets. Bond yields and spreads have risen since 2013. We believe differentiation in credit risks will improve in China--between strong and weak companies, private versus government-owned enterprises. China's bond market needs more transparency, and stronger credit culture.

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Credit FAQ: China Walks Policy Tightrope In The Midst Of Rising Financial Pressure

Do you expect the Chinese government to allow smaller banks with liquidity problems to fail or will the government bail them out?
We believe the government will continue to be very supportive of the financial system, especially the banking sector, until it sets up an infrastructure to administer orderly closures of troubled financial institutions. This is to avoid a crisis of confidence. In our view, deposit insurance and a resolution framework for stressed financial institutions and other tools are important for the government to build a stronger financial system. After those tools are in place and the public has built up its confidence in the system, we believe the government may allow the smaller banks to go through a resolution process.

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 U.S. We estimate China's corporate debt could hit US$13.8 trillion in 2014, surpassing the U.S. as the world's largest. The easy credit growth in the past few years has led to overinvestment often in sectors that already face severe overcapacity and weak prospects for earning a reasonable return. 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 Co. Ltd., coal logistics provider Winsway Coking Coal Holdings Ltd., and coal miner Hidili Industry International Development Ltd. Credit quality for China issuers is trending downward as the economic outlook weakens and funding conditions tighten.

How will Internet finance operators affect banks?

The direct impact from China's online finance industry is on funding costs for banks. Some banks have responded with similar products to defend market share. Banks have also imposed limits on how much their customers can transfer to online finance services. We believe the authorities eventually will have more clarity on the boundaries for the online finance industry and regulate their activities. The growth of Internet finance has been phenomenal. Money raised by these asset management companies through online channels has been invested in money market funds. This money has been withdrawn by retail depositors only to be placed mainly back into the banking system. The difference is the banks have to pay a higher cost for the same money.

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Credit FAQ: China Walks Policy Tightrope In The Midst Of Rising Financial Pressure

Do we differentiate the level of government support in evaluating default risk?

Yes. The support from the central government is strong. Local government support varies from strong to weak as it depends on the government's financial position. Nevertheless, our baseline scenario is that all levels of government have strong incentives to support and prevent their government-owned companies from default. These companies play an important role in the local economy, providing employment and often fulfilling government socio-political objectives. In our view, the local governments, even if they are financially weak, can help SOEs to repay their debt through asset swaps, such as selling land owned by SOEs to repay debt, or the governments can provide financial support through their own funding. But we believe all parties (including banks) will have to bear some losses if the government has to do debt-for-land swaps.

Does rising labor cost in China pose a problem?

Rising wages in China are good for two reasons. First, they reflect rising productivity. China has been moving up the value chain in its exports. The lower value products are moving inland or to countries such as Vietnam and Bangladesh. Two, rising wages is also necessary for rebalancing China's economy, if the government wants to boost the consumption-to-GDP ratio. Robust wage growth backed by rising productivity spurs consumption.

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 norm, 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's public sector also has a strong balance sheet. Even with the recent recognition of local government debt, the ratio of public debt to GDP 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. Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.

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Credit FAQ: China Walks Policy Tightrope In The Midst Of Rising Financial Pressure

Related Research
A Slowdown Is Manageable For China's Major Banks, Says S&P, April 2, 2014 Credit FAQ: Chinese Steelmaker's Default Highlights Troubles In Sector, Could Benefit Larger Players, March 31, 2014 Economic Research: Despite Our Steady Growth Forecasts In Asia-Pacific, China's Financial Risks May Be A Wrench In The Works, March 26, 2014 Credit Conditions: Largely Stable In Asia-Pacific, With A Dash Of Negative And A Focus On China's Financial Sector Risks, March 26, 2014 Chaori's Default Highlights The Need For Institutional Framework Improvements In China's Debt Capital Market, March 25, 2014 Simmering Situation For Small Chinese Developers May Be Starting To Boil, March 18, 2014 Cracks in the Fortress? Challenges Rise Within China's Financial Sector, March 3, 2014

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