China's reform of state-owned enterprises (SOEs) will continue at a gradual pace, given the need to balance the central governments' multiple commitments and other reform objectives, says a Moody's Investors Service report.
While this gradual pace of reform has supported the credit quality of rated SOEs in recent months, the measures will have mixed credit implications in the longer term for the sovereign, banks and corporates.
"The authorities have issued implementation directives at a faster pace recently, but we expect them to remain cautious in adopting reforms," says Lillian Li, a Moody's Vice President and Senior Analyst. "This is because progress on implementation of SOE reform is subject to the central government's other reform objectives, such as maintaining a moderately high level of GDP growth and the stability of the social and financial systems."
"By adopting a gradual pace of reform, the authorities have so far avoided the widespread corporate and banking system distress that would be associated with radical deleveraging," adds Li.
Support will diverge
Moody's report points out that government support will diverge according to each SOE's strategic importance, resulting in a mixed impact on individual SOEs' credit profiles.
In particular, Moody's expects effective reform would help improve the credit profiles of SOEs with leading positions in their respective industries, but also accelerate defaults for weak SOEs.
In the banking sector, Moody's expects SOE reform will have a mildly negative impact in the short term, irrespective of its pace.
SOE reform is credit negative for the banks in the short term because highly indebted SOEs will continue to weaken banks' balance sheets, but the relatively small scale of the defaults will limit near-term pressure.
However, if a rapid and widespread reduction of government support results in the bankruptcy or restructuring of financially weaker SOEs on a large scale, the negative impact on banks' balance sheets would be more immediate and direct.
The credit implications for the sovereign remain as yet uncertain, says Moody's. While the current gradual pace of reform reduces the likelihood of a near-term crystallization of significant contingent liabilities, it has a cost in terms of a continued increase in economy-wide leverage and the contingent liability that SOE debt represents for the sovereign, a credit negative development.
Moreover, higher leverage would reduce the effectiveness of policy support.
However, gradual reforms would be positive for the sovereign if they resulted in a shift in credit allocation towards higher productivity sectors.
China is in the midst of a multi-year effort to rebalance its economy away from its past reliance on investment, particularly infrastructure investment, towards a greater role for domestic consumption and services.
SOEs were largely responsible for administering the post-global financial crisis stimulus package of infrastructure investment.
In consequence, their indirect role in implementing and transmitting government policies remains instrumental in shaping China's economic outcomes.