China's ongoing rebalancing poses near-term economic and credit risk across many sectors in the Mainland and could increase the number of defaults among small private companies, says Moody's Investors Service.
However, the rating agency believes that most of the Chinese entities it rates, including the national government, exhibit characteristics that should mitigate the resulting credit stresses and make them resilient to such challenges.
"The Chinese authorities have embarked on a path of rebalancing the economy, defined by a reorientation away from an export- and investment-led development model towards a model where consumptiongradually becomes a more important growth driver," says Michael Taylor, Moody's Chief Credit Officer for Asia Pacific.
"Although such rebalancing is positive for China's long-term macroeconomic stability, over the near term, tighter credit conditions and decelerating economic growth are creating significant financial stress for many sectors, and especially for smaller, privately owned corporations," adds Taylor.
Importantly, Moody's notes, many of the corporates it rates in China are investment grade, state-owned, and are leading firms in their industries.
These characteristics mean that they are relatively well positioned to manage the challenges in their respective sectors, notwithstanding the negative trends they may face. For example, they are likely to maintain ready access to funding markets, even as credit conditions tighten more broadly.
And, significantly, for many of these entities, Moody's believes that, as state-owned enterprises, extraordinary government support would likely be made available if they experienced significant financial distress.
"The situation in the steel industry is a good example, where default risk among small, privately owned companies may be rising, but the largest players are state owned, like Baosteel Group Corporation (rated A3 stable)," says Taylor. "As a result, we believe Baosteel, and others like it, will gain further market share and benefit from the consolidation trends likely to emerge in that sector."
"Similarly, the banking sector's asset quality is expected to weaken in line with the credit tightening and economic slowdown currently evident on the Mainland," says Taylor.
"However, the big five Chinese banks have characteristics that should make them resilient to the economy's deleveraging and deceleration. They have robust capital adequacy and liquidity metrics and, perhaps more importantly, they are likely to be the beneficiaries of government support in distress, as they have in the past," says Taylor.
At the same time, Moody's does expect further defaults, primarily among unrated companies and in sectors such as steel, mining and property, where negative trends are more pronounced.
The new Moody's report notes that recent episodes of financial distress, most notably the landmark onshore bond default seen in March, are the result of company-specific weaknesses, shifting policy priorities and softening economic activity. As such, Moody's does not expect these episodes to give rise to systemic risk.
"In this case, as an example, with the property sector, we note that developers are facing increasing credit challenges in the face of shrinking sales, rising inventory levels, and weakening liquidity," says Taylor.
"In this instance, a large percentage of the rated portfolio is also speculative grade, reflecting the challenges that these companies face when operating in a cyclical industry now facing another downturn. However, many have taken advantage of their ongoing access to offshore bond markets so that we are not seeing any material deterioration in their balance-sheet liquidity, a situation which well positions many of them for the downturn," says Taylor.
More generally, while Moody's baseline assumption is that the risks arising from the process of economic rebalancing in China will remain contained, a more disorderly process is also possible.
"Tighter credit conditions have the potential to bring about larger economic effects than currently anticipated. Such a downside scenario would be characterized by a liquidity crunch in China's credit markets, as the contagion effects from defaults and restructuring both trigger volatility," says Taylor.
Such adverse developments would produce a much deeper downturn in Chinese economic growth than is currently factored into Moody's baseline.
"In this context, we believe that if a disorderly rebalancing scenario were to unfold, the Chinese government's own creditworthiness would exhibit substantial resilience since it has the fiscal space to absorb the considerable amount of additional debt that might be needed if its contingent liabilities in support of local governments, state-ownedenterprises and large banks were to crystallize," adds Taylor.