Many sovereigns, including China, are exposed to contingent liability risks from the banking system and state-owned enterprise (SOE) debt, according to Moody’s Investors Service in a report. Moody's incorporates these contingent liabilities into its analysis of sovereign credit profiles, basing its assessment of the risk they pose on their nature, source and size.
Across all sectors, debt in China (Aa3 negative) has increased to around 280% of GDP. Meanwhile, liabilities equal to about 115% of GDP are owed by SOEs. In the event that some entities faced difficulties in honoring their obligations, the government could become responsible for some of the related contingent liabilities.
The Moody's report notes that experience from other countries shows that only a fraction of SOE-related contingent liabilities typically crystallize.
In the case of China, Moody's estimates that the portion of SOE liabilities that could potentially require restructuring amounts to 20-25% of GDP; with this estimate representing the cost of equity injections to lower the leverage of the 10% most leveraged SOEs to the median leverage ratio for all SOEs.
Moody's estimate of the size of potential contingent liability risk represents only a fraction of total SOE liabilities in China, reflecting the sound financial health evident in parts of the sector. However, the amount is still sizeable.
Moody's further believes that this cost of restructuring SOE liabilities may be shared across sectors. Restructuring would likely involve mergers between SOEs; forbearance and other measures involving banks; the downsizing of some SOEs; as well as equity injections and other forms of government support.
The report notes that while such burden sharing may lower SOE debt, banking-related contingent risks would continue. For example, measures such as debt-to-equity swaps would reduce the contingent liabilities posed by SOEs because they would lower corporate leverage.
However, debt-to-equity swaps alone would not address the issue of falling returns on assets. Therefore, a parallel increase in risk for the banks involved in these swaps could occur, raising in turn the risks to the government from contingent liabilities related to the banking sector.