Economic Analysis - Credit Risks To Increase As Regulatory Tightening Continues - 15 MAY 2017


BMI View: A ny policy missteps by the Chinese government in curbing leverage could lead to continued onshore bond sell-off and potentially spill over to the US dollar bond market, considering the dominance of Chinese investors in the offshore market. Additionally, we expect the number of defaults to rise in the coming months due to increasing refinancing needs coupled with rising borrowing costs and slower profit growth for industrial enterprises.

Regulatory crackdown on leverage has led to a sell-off in the bond market and pushed corporate bond yields to the highest levels in two years. The change in market dynamics also constrained onshore issuance and fuelled offshore issuance by Chinese corporates. We highlight that any policy missteps by the Chinese government in curbing leverage could lead to continued onshore bond sell-off and potentially spill over to the offshore US dollar bond market, considering the dominance of Chinese investors in the market. Additionally, we expect the number of defaults to rise in the coming months due to increasing refinancing needs coupled with rising borrowing costs and slower profit growth for industrial enterprises.

China's banking regulator has shown a strong determination to curb leverage in the interbank market and step up efforts to regulate banks' off-balance-sheet investments, after Guo Shuqing started the role as chairman of the Banking Regulatory Commission in February. The move was supported by President Xi Jinping, with him reemphasising the importance of maintaining financial security during the Politburo meeting of the Communist Party on April 25, following the issuance of a series of new regulations by the banking regulator in early April. The renewed drive to curb leverage, coupled with gradually tightening monetary policy since end-2016, have lead to a liquidity squeeze in the money market.

Liquidity Squeeze
China - 7-day Repo & Overnight SHIBOR, %
Source: Bloomberg, BMI

Yields To Rise Further Amid Government's Deleverage Push

Corporate bond yields will come under pressure and rise further due to tightened liquidity in the country's money market. According to data from ChinaBond, the average yield-to-maturity (YTM) of domestically 'AAA' - rated corporate bonds rose by 109bps from the start of December 2016 to early May. For 'AA' - rated bonds, YTM rose by 116bps during the same time period. The recovery of the Chinese economy has provided room for policymakers to attempt to contain financial risks in 2017, and we expect China to remain on the tightening track over the rest of 2017 in order to curb leverage in the corporate and interbank sector (see ' Gradually Tightening Path As Financial Risks Come Under Scrutiny ' , May 2) .

Bond Yields On The Rise
China - 5-Year Corporate Bond Yield & Government Bond Yield, %
Source: ChinaBond, Bloomberg, BMI

Offshore Issuance Surges, But Dominance By Domestic Investors Poses Risks

The rising domestic bond yields and tighter rules for issuing exchange-traded bonds for corporates in the property, coal, and steel sectors have constrained domestic issuance and instead fuelled offshore issuance to meet their financing needs. In the first four months of 2017, onshore bond issuance slumped to USD132bn from USD796bn a year ago, based on calculations from Thomson Reuters. In comparison, Chinese corporates issued US dollar-denominated bonds worth a total of USD55bn in the year to date, which exceeded half of last year's total. Noticeably, the yield spreads of offshore high-yield bonds over corresponding onshore bonds continued to narrow. For example, the spread of Times Property Holdings Ltd's offshore bonds over onshore bonds tightened by about 30bps from December 2016 to February, according to data from Fitch Ratings. This implies that the offshore cost of bond financing for high-yield issuers has decreased on a comparative basis.

Given that the offshore bond market is dominated by Chinese domestic investors (mostly state -owned or holding asset managers), the onshore bond sell-off could spill over to the US dollar bond market. According to Bloomberg, US-based money managers only have access to 7% of the deals in the year to date, down from 46% in 2014. In the worst case scenario, a broad sell-off in the onshore market due to a regulatory crackdown on wealth management products and entrusted investment could force domestic asset managers to offload offshore holdings and invest onshore instead to support the bond market.

Defaults To Increase If Liquidity Remains Tight

In our view, the number of credit events will likely rise over the coming quarters, given that large amount of debt will mature in 2017 and our expectation is for growth in the industrial sector to slow from current peak levels. Based on the data we compiled, nine companies defaulted on a total of 11 onshore bonds from January to April, compared to 11 defaults during the same period in the prior year.

Defaults On The Onshore Bond Market
Issuer Default Date Default Type Amount Defaulted (CNYmn) Sector
Source: Shanghai Clearing House, China Central Depository & Clearing Co, Ltd., Bloomberg, BMI
Evergreen Holdings Group Co Ltd 24-Apr-17 Interest 42 Transportation
Inner Mongolia Huolinhe Coal Industry Group Co Ltd 12-Apr-17 - - Coal
Zhuhai Zhongfu Enterprise Co. 28-Mar-17 Principal+Interest 590+39 Containers & Packaging
Huasheng Jiangquan Group Co Ltd 14-Mar-17 Principal 800 Industrial
China City Construction Holding Group Co 1-Mar-17 Interest 1800 Industrial
Shandong Shanshui Cement Group Limited 27-Feb-17 Principal+Interest 200+16 Construction Materials
Dalian Machine Tool Group Corporation 13-Feb-17 Principal+Interest 500+30 Industrial Machinery
7-Feb-17 Principal+Interest 500+30
16-Jan-17 Interest 28
Inner Mongolia Berun Group Co, Ltd. 3-Feb-17 Principal+Interest 800+53 Commodity Chemicals
Donbei Special Steel Group Co, Ltd. 16-Jan-17 Interest 85 Steel

The aforementioned deleveraging push by the government has ramped up corporate borrowing costs and forced many companies to wait for a better issuing window. For example, Guizhou Guilong Industrial Group issued a CNY500mn five-year domestically 'AA' - rated corporate bond at 7.8% on April 27; however, the average YTM of bonds with the same rating is priced at about 5.3%. The real cost of borrowing will increase if inflationary pressures wane in the coming months. In fact, the producer purchase index (PPI) expanded at a slower pace at 7.6% y-o-y in March, compared to 7.8% in the prior month. Our commodities team expects a further moderation of commodity prices especially industrial metals such as crude oil, copper, and iron ore in the rest of 2017, which will put PPI under pressure. In addition, companies in distressed sectors have failed to sell bonds in the capital market, which adds pressure on their cash flows. According to Wind, the number of bonds being delayed or cancelled increased to 285 in the first four months of 2017 from 201 in the prior year, marking a 41.8% y-o-y increase. At least CNY243.8bn onshore bonds and other fixed income issuance were delayed or cancelled in the first four months of 2017, compared to CNY252.9bn during the same period of 2016.

Industrial Sector Growth Has Peaked
China - Industrial Profits, PPI, % chg y-o-y & PMI
Source: Bloomberg, BMI

Furthermore, with about USD1.5trn onshore debt maturing in 2017, refinancing risks are mounting among Chinese corporates. This is compounded by the fact that growth in the industrial sector is showing signs of losing momentum, which will result in waning investor demand for these securities. The growth of industrial profits, which has been driven by the recovery of commodity prices, slowed to 28.3% y-o-y in Q117 from 31.5% in the first two months of 2017. Meanwhile, manufacturing purchasing managers' index (PMI) is expanding at a slower pace at 51.2 in April, compared to 51.8 in March. The new-orders sub-index dropped to 52.3 in April from 53.3 in March. As we expect Beijing to gradually pull back from the extensive fiscal support over the coming months, the industrial sector will be under pressure to service their debt.