More corporate defaults ahead For China

Tough financial conditions continue to test corporate China. Following a record number of defaults in 2015, S&P Ratings believes that default risks will continue to rise in 2016.

Which Chinese corporate issuers defaulted in 2015?

Six offshore issuers that Standard & Poor’s rates have defaulted since early 2015 (see table). Defaults in these industries – mining, building materials, and real estate – had been widely anticipated, due to the sharp drop in commodity prices and the correction in the real estate market. All except one issuer, Renhe Commercial Holdings Co. Ltd., defaulted because of missed payments on interest or principal amounts. Renhe restructured, which we assessed as a distressed exchange.

In the onshore market, more than eight issuers missed payments on bond obligations. The defaulters came from diverse sectors and issued varying types of bonds, including medium-term notes, commercial paper, and corporate bonds. Defaulters also included state-owned enterprises (SOEs), an unthinkable development a year ago because lenders and investors expected implicit support from the government. 

China corporate defaults for 2015

Source: Standard & Poor's

Why does the central government tolerate greater defaults? 

The government wants to instill greater market discipline and credit risk pricing in the bond market. Until recently, defaults in the public bond market were rare. Shanghai Chaori Solar Energy Science & Technology Co. Ltd. was the first public bond defaulter in 2014. Allowing the market to price credit risks would entail removing implicit guarantees and ending bail-outs of defaulted borrowers. We have seen some progress on the latter when the state did not rescue the SOE Baoding Tianwei Group Co. Ltd. in September 2015.

As the credit quality of corporates weakens to a critical level, the burden on the government has risen substantially. There is a limit to the support that can be reasonably extended to bond issuers, especially those in old industrial sectors that are struggling with overcapacity, such as steel, coal mining, cement, aluminium smelting, shipbuilding, and solar equipment.

Why do you forecast more corporate defaults in 2016?

We expect defaults to increase in 2016 due to downside risks associated with lower economic growth, weak external demand, and potentially volatile credit markets as the US raises interest rates. Corporate sector leverage has increased substantially in the past five years due to large debt-funded investments that have gone into sectors with low returns. As a result, the debt-servicing capacity of the corporate sector has deteriorated. The burden of servicing debt becomes tougher as demand weakens. And sectors struggling with overcapacity feel the pinch more acutely.

Our expectations for corporate defaults to increase are aligned with our forecast of a rising credit cost for banks. Standard & Poor's believes the reported ratio of nonperforming loans in China could increase to 2.3% in 2016 and to 3.1% in 2017, from 1.7% in 2015.

However, we believe that the risk is manageable from a systemic perspective. State ownership of a large swathe of these troubled sectors means that any restructuring and removal of overcapacity will be orderly to minimize the impact on unemployment and tax revenues for local governments. In 2016, China's corporate sector will aim to rebalance their financial risk profiles. As economic growth slows and lenders turn cautious due to elevated financial risks, disciplined financial management -- including controlling debt leverage and strengthening debt servicing -- will become more important for Chinese companies.

Do you expect any changes to the central government position regarding bailouts?

We believe the government’s support for SOEs will vary, and possible bailouts will be more selective than in the past.

SOE reform will clarify the role and function of SOEs into either a public welfare or commercial role, based on their chosen core business. This will lead to greater differentiation among SOEs by lenders and investors, including their importance to – and possible bailout by – the government. Combating excess capacity is a major economic objective for 2016. In our view, that means the government will be prepared to merge and consolidate those SOEs that could be salvaged and letting go of the weakest players.  

Do you expect Chinese companies’ credit metrics to stabilize in 2016?

We see a low likelihood that corporates' credit metrics will stabilize over the next 12 months, due to the downside risk to investment demand. Companies are under increased pressure to preserve cash flow and restore financial strength because of sluggish demand. This will force many corporates to cut costs and capital spending, which will have a knock-on effect on aggregate demand and continue to strain corporates' cash flow. Based on our estimate, the top 200 corporates in China will see their debt-to-EBITDA ratio rising to about 5x by the end of 2015 from about 4.5x at the end of 2014. We expect this ratio to continue to deteriorate in 2016.

What is the central government doing to stave off financial distress? 

The government has cut interest rates and reduced banks' reserve requirements to boost liquidity in the credit market and support debt-servicing. This should alleviate debt-servicing pressure by refinancing debt at lower cost for corporates. However, high debt leverage and low profitability curtail corporates' room to further increase leverage. Stabilizing the financial risk of corporates would require more fundamental reform and structural change, such as shutting down obsolete capacity and allowing highly indebted corporates with limited turnaround prospects to default.

What sectors are vulnerable?

The sectors most at risk have high operating leverage, high debts, and overcapacity, such as metals and mining, real estate developers, transport, and building materials. There is meaningful downside to our base-case projections for top-line growth and profitability as corporates rationalize their costs and capital spending. If investments decline and property construction remains weak, heavy industries and asset-heavy sectors will be the most affected. We could downgrade issuers in these sectors by up to two notches if GDP growth decreases to about 5% instead of between 6% and 6.5% for the next two years.

How does the weakening of the renminbi affect offshore bond issuance?

The depreciation of the renminbi has curtailed U.S. dollar (USD) bond issuance by Chinese issuers. Expectations of further weakness in the renminbi will likely suppress issuers’ appetite for USD issuance again in 2016. However, some issuers will continue to seek USD bond funding as they need hard currency for expansions overseas. More opportunistic issuers such as property developers will likely continue to tap onshore bond market for funding. Domestic bond funding costs have declined materially below the cost of offshore bond for speculative grade issuers. This will allow some issuers to swap their higher cost offshore bond to reduce average funding costs and extend debt maturities.

The author is Christopher Lee, Managing Director for Corporate Ratings at Standard & Poor's Ratings Services.