Even after the current bout of Chinese money market volatility subsides, credit conditions are likely to remain tighter than they used to be in the country. Market professionals believe that regulation will create tighter borrowing conditions in the coming six to nine months.
For a corporate market that has seen a rapid build-up of leverage and is by now also quite geared by global standards, this could represent the first step towards more sustainable balance sheets in China. Over time, that will be good for the economy and the health of the corporate sector, but there are near-term downside risks for credit investors, according to a Morgan Stanley report published on June 28.
“China credit performance has always been highly sensitive to ebbs and flows in domestic credit – this now means a big tailwind for the past eighteen months turns into a headwind,” wrote Viktor Hjort, credit analyst at Morgan Stanley, in the report. “Corporate leverage is higher today than either 2008 or 2011, the two most recent periods of tight credit in China and slowing economic growth will likely add further pressure on credit profiles.”
Policy and liquidity impacts borrowing conditions and, as these deteriorate, credit risk increases because a worsening of conditions for refinancing. This is made more prominent given that leverage is high in corporate China and the sector is still largely bank-funded – which implies relatively short maturity profiles, notes Morgan Stanley.
Additionally, the bank highlights that supply risk in offshore corporate bond markets increases as bank credit availability shrinks and becomes costlier.
“As policy tightening accelerated in 2011 and bank lending slowed, offshore bond issuance from corporate China reached record levels,” Hjort wrote.
Even if money market rates normalise in the coming weeks, regulations forcing banks to bring off-balance sheet assets back on balance sheet mean that credit conditions are unlikely to return to what they have been in the past year, said Morgan Stanley.
Assuming no additional government stimulus, the firm's base case is that the one-month repo rate is likely to be at 5%-6%, having averaged 4% in the past twelve months. Additionally, onshore corporate bond yields have also increased by 60 basis points (bp) since the money market stresses began in June.
Credit risks amplified
Higher funding rates and slower credit growth make the current outlook similar to the two most recent periods of tight credit in China — in 2008 and 2011. But the risks associated with such tightening are arguably higher now because corporate leverage is higher today than at the start of either of those periods, the report said.
“China is not unique in having experienced rising corporate leverage in recent years – the same can be seen in other parts of Asia as well as both the US and EM [emerging markets] – but the pace and magnitude make China stands out,” said Hjort.
Bottom-up corporate data suggest that the leverage increase has been driven by the state-owned enterprise (SOE) sector, which on average has tripled leverage in the past five years. The sector's gross leverage of 4.6 times is higher than, for instance, US sub-investment grade companies, the report said.
Not reflected in valuations
The increasing downside risks created by Chinese deleveraging are not yet reflected in valuations, the analysts argued.
US high yield spreads are 100bp wider and US Treasury yields are 30bp higher since chairman of the Federal Reserve (Fed) Ben Bernanke said in May that the US hoped to begin reducing its quantitative easing programme later this year if economic conditions allowed. Chinese high yield spreads are 280bp wider, but Morgan Stanley noted that in past periods of tight credit, China high yield has moved far more than that.
“China credit has so far traded as a derivative of the Fed and we would argue has yet to evolve as a story in its own right driven by China-specific factors,” said Hjort.