As China pushes forward with "supply side" economic reforms, Chinese financial institutions may face heightened risks from the property and corporate bond markets due to eroding asset values and investor confidence.
What policymaking risks could affect China's financial sector?
The government is adopting a so-called "bottom-line mindset," which we view as a form of crisis management. Policymakers are willing to press ahead with reform measures on a trial-and-error basis as long as they don't trigger a financial crisis or social instability.
If something doesn't seem to be working, the government can simply reverse the measures again. That exposes the financial sector to significant costs associated with reform measures and suggests elevated policy risks for financial institutions. We've seen the impact of this in the heightened volatility in China's equity and currency markets since mid-2015.
What could go wrong with China's "supply-side" economic reforms?
China's key economic challenges go way beyond slowing growth. Entangled issues range from supply gluts in various industries and the property market to excessive debt overhangs in the corporate sector and among local governments. The policymakers' "supply-side" reforms are aimed at addressing the structural issues, but there are side effects. The impact on the asset quality and profitability of overcapacity industries and the financial sector could dampen investor confidence in Chinese assets.
A resulting slide in asset valuation could develop into a self-fulfilling vicious circle that would destabilize the economy and the financial sector unless proper measures are in place to anchor investor confidence.
Which key sectors could destabilize the economy and the financial sector through a loss of investor confidence?
We see two areas where this could happen. First, the property market. With significant supply gluts, China's property market appears to be in a precarious state in a vast number of small cities. Should property prices decline in a disorderly manner, the falling value of properties will at least partially undo the ongoing corporate deleveraging efforts. Such a decline would also undermine corporate refinancing capabilities because property is currently used as collateral for 30%-40% of corporate borrowings from Chinese banks. The dual effects may eventually weaken the creditworthiness of banks, which in turn could further undermine the property market.
Second, the rapidly growing corporate bond market. Currently, the China All Bond Index stands at an all-time high after soaring for the past two years. This market matters because it affects corporates' funding costs, and more importantly, banks have a lot of indirect exposure to corporate bonds via the sale of wealth management products to retail investors.
Should the corporate bond market experience a chaotic risk repricing due to some unexpected credit defaults, we believe banks would suffer substantial mark-to-market losses from these "deposit-like" wealth management products. For some nonbanking financial institutions, such exposure is even more significant than for banks because of their leveraged bond investment positions. Nobody really knows who has financed these leveraged positions or by how much since funding arrangements are complicated. Contagion risks for the financial sector could therefore be high.
Are risks fully factored into corporate bond pricing?
Corporate bond yields are decided by both the risk-free rate and risk premium. The consensus is that the risk free rate will continue to decline as China continues its easing measures. However, the risk premium is determined by market participants' risk perception, and that is out of the government's control. The problem now is that market participants anchor the risk perception by second guessing or perceiving the government's comfort level. This creates circularity, and could cause disorderly mispricing if any shocks affect the market.
How will the recent stock market volatility affect the financial sector?
Compared with the property and corporate bond markets, heightened volatility in China's stock markets will have less of an impact. Indeed, the recent correction in the equity market was something of a side issue for banks and even the broader financial sector because they have limited exposure to the market. Where they do, the exposure is mainly in the form of limited holdings of listed shares relative to their capital base and conservatively equity-backed lending. Due to regulatory restrictions, banks don't directly engage in margin lending; that's reserved for securities firms.
Prolonged volatility in the stock market may also hamper equity financing, constrain the reduction in corporate leverage, and dampen investor confidence in China assets. Equity market volatility could also add to the pressure on the securities firms' income statements as they may suffer from decreasing brokerage and underwriting income.
What about renminbi depreciation?
A weakening renminbi could be neutral to positive for China's export segment and the banking sector. We base our view on the significant contribution that depreciation would make to the orderly consolidation of China's sizable export segment, where profit margins for many exporters have been unsustainably thin. Banks may also benefit from their net long positions in U.S. dollars, growing fee income from clients' currency hedging transactions, and improving forex-denominated funding and liquidity profiles.
The central bank has many tools at its disposal to replenish interbank liquidity if the currency depreciation leads to capital outflows. But the liquidity drain is likely to be uneven across banks, sectors and regions. That could lead to unintended credit tightening, particularly for small and midsize enterprises. More importantly, it could shake public confidence in the property sector, which would have knock-on effects for industries.
In our view, Chinese policymakers appear to be more concerned about the negative effects of depreciation on the property and financial markets than its possible supportive effects for the export segment. We believe the government sees an emerging risk that expectations of renminbi depreciation will be self-fulfilling.
Why do you expect the banks to be hit even if the government smoothly pushes ahead with supply-side reforms?
First, it's about credit losses. On a stand-alone basis, the three most vulnerable sectors are manufacturing, local government financial vehicles (LGFVs), and property developers, in our view. However, LGFVs are receiving extensive government support as their debts are refinanced with proceeds from long-dated provincial government bonds.
For the property sector, the government has also taken various measures to boost property demand and substantially mitigate the developers' refinancing risks. These efforts leave the overcapacity issues in the manufacturing sector as the remaining major weak spot.
While nonbank financial institutions have sizable exposure to LGFVs and property developers, the banks still dominate the supply of credit to manufacturers. We believe overcapacity industries may contribute the most to nonperforming loans this year, particularly when the government has decided to step up efforts to eliminate supply gluts.
Secondly, it's about net interest margins. We've seen consecutive cuts in policy interest rates, the government's debt-swap program for LGFVs, and soaring growth in the corporate bond market, which was policy-induced. These factors will further squeeze the banks' interest spreads. Indeed, we believe the targeted reduction in corporate borrowing costs will come at the cost of the banks' profitability.
The author is Qiang Liao, Senior Director for Financial Institutions Ratings at Standard & Poor's Ratings Services.
