Asia Pacific's credit conditions may improve in the third quarter of 2017, thanks to improving macroeconomic and borrowing trends, according to S&P Global Ratings. Nevertheless, tail risks remain for the region's credit markets, with the potential impact of higher interest rates back as Asia-Pacific's top credit risk.
Risk #1: Higher interest costs and volatile foreign exchange
Although domestic interest rates have not substantially increased over the past few months, regional issuers' recent return to the markets, including tapping in foreign currency, has convinced us that this risk should return to number one. A steady pipeline of issuances continues, implying that the risk is trend is increasing.
Rate rises by the US Fed could affect more highly indebted borrowers. Furthermore, capital flight risks may also occur in emerging markets as investors are lured back to the US. As such, the spectre of investors chasing a stronger US dollar and higher yields and selling down emerging market currencies may occur.
Our stress scenario analysis conducted in December 2016 showed the sensitivity of Asia-Pacific issuers to interest rate hikes. In the scenario, we increased credit yields by more than one-third from 2015 levels to the global financial crisis levels in 2008-2009 for a two-year period on a global pool of rated nonfinancial corporate issuers.
Our study found that the sensitivity of borrower pools to an interest rate shock is correlated to the issuers' debt maturity profile and floating versus fixed interest rate mix. Not surprisingly, hardest hit under the scenario were companies in the Asia-Pacific and Latin America--primarily because borrowers in these regions have proportionally more debt coming due sooner than companies in Europe and North America. In addition, a bigger proportion of their debt comprises floating-rate interest payments.
Risk #2: Market reaction to political events
The risk of market reaction to political events includes the imposition of country-directed trade tariffs (for example, US government's tax proposals) and geopolitical confrontations (for example, political conflicts in the Korean peninsula, South China Sea), and rise of populist or extremist movements (for example, Southeast Asia). This risk is somewhat indirect in that it is the market reaction (or overreaction) to an event, rather than necessarily the event itself, that could undermine relatively benign credit conditions.
At the start of 2017, the new US administration was inclined to adopting protectionist trade policies as part of its wider economic and tax agenda. However, in recent months, a more measured attitude in approaching this matter is appearing. Among the major Asia-Pacific economies, China, Taiwan, Korea, India, and Japan may be most sensitive economies from the perspective of net exports-to-GDP (i.e. net exporter's national GDP) should the US impose tariffs or border taxes against exporting countries. While Singapore and Hong Kong are net importers from the US, their economies would also be affected, given their high reliance on the trade flow of exports and imports, particularly if non-US countries engage in a tit-for-tat tariff war.
Growing political tensions, threats of a trade war, and terrorism are just a few areas of concern causing occasional market volatility. Strained relationships between trading countries, for example by disputes over territory in the South China Sea, could lead to trade disruption. The implied threat posed by missile testing by North Korea is raising alarm bells in Northeast Asia. The Asia-Pacific region is also not immune from the rise of pockets of populism and extremism (for example, Southeast Asia), which could affect investor sentiment, government policies, and business operating environments. While such risks are of low-to-very low likelihood, the impact from such events could be significant.
Risk #3: Property market adjustment
Despite various attempts to cool down property markets in Asia-Pacific cities, property price growth continues to be a key factor. With household debt growth continuing to outpace household income growth and frothy property prices, we view the risk trend of a property market adjustment as increasing. We anticipate that slower market activity, coupled with the impending interest rate hikes by the Federal Reserve, could dampen real estate demand. Should banks pass through interest costs, highly leveraged investors relying on the low interest rate operating environment may feel the brunt of the impact.
In the current low interest rate and low-yield environment, property appears to be a favorable alternative investment for many investors (both domestic and foreign) chasing not only yield, but also seeking stability. If we consider rental as a more realistic reflection of property demand from the household level, the gap between ownership and rental is significant. This implies a demand and supply distortion due to a large capital injection into the property market.
China is a key player in the property investment and development arena, both domestically and internationally. The continued economic slowdown, combined with recent capital flow restrictions, is having a spillover effect in some key cities. Currently, this is most notable in Sydney and Melbourne residential apartments, where some investors are abandoning their investments due to their inability to meet repayments or settle.
Other countries in the region that have been fueled by an investor buying spree--including Hong Kong, Malaysia, and New Zealand--may also see a pullback in housing demand. It should be noted that Hong Kong is characterized by strong fundamental imbalances that will continue to make the city a target for investors and speculators—further increasing property prices. However, it is more susceptible to external economic shocks due to its close ties with economics giants, China and the US The last property price correction occurred during the global financial crisis.
Risk #4: China debt overhang
A disorderly deleveraging of China's outsized and growing debt burden (particularly corporate), as China's economy rebalances away from being overly investment dependent, would undermine market confidence, loan performance, and asset and commodity prices. Such a scenario would increase volatility and liquidity stresses in financial markets, particularly those in emerging markets.
The ever-increasing level of corporate debt in China is intensifying risks because of weakening borrower credit quality. The still-high growth rate of debt could lead to potential losses over the next year or two; however, we believe China's banks have sufficient financial strength to absorb the potential losses that could arise.
Risk #5: Corporate refinancing challenge
Our fifth and final top risk remains corporate refinancing, which is partly tied to the preceding four risks.
China has a relatively high degree of bonds maturing in 2017, which poses some refinancing risk. That said, the bulk of China's bonds are domestically sourced, mitigating some of the risk for the country.
The article is authored by Terry Chan, Managing Director, at S&P Global Ratings
