Tag: China

Fitch Ratings says the recent pattern of trade flows in Asia suggests that the sharp decline in world trade growth in the second half of 2018 was primarily due to the slowdown in domestic demand in China rather than the direct impact of tariffs associated with increased US-China trade tensions.

Fitch Ratings latest chart of the month shows that exports to China from a selection of other large economies in Asia have slowed much more sharply than their overall exports. Since intra-Asian trade flows are much less likely to have been affected by the tariff measures imposed by the US and China, this points to weakening domestic demand in China as a key driver of the slowdown. China’s year-on-year import growth (in nominal US dollar terms) turned negative at the end of 2018, despite rising import prices. This was the first decline since 2016 and reflects a slowdown in domestic investment and private consumption.

The US and the Eurozone have also seen their export growth to China falling more rapidly than total exports. Germany in particular has been hit hard by declining auto sales in China, although, for the Eurozone as a whole, exports have also been affected by declining sales in the UK and Turkey. US exports to China have fallen very sharply in recent months but these bilateral flows have been distorted by tariff measures, including possible front-loading of trade flows in mid-2018 ahead of anticipated further tariff hikes and the subsequent payback. The evidence from Asia suggests the outlook for Chinese domestic demand will be a key driver of global trade in 2019.

Three defaults in recent months have highlighted the risk of broader disclosure and governance problems among Chinese corporates, as well as the variable quality of local auditing, says Fitch Ratings. Shandong SNTON Group Co. (Snton, RD), Reward Science and Technology Industry Group Co. (Reward, RD) and Kangde Xin Composite Material Group Co. (KDX, WD) all defaulted on moderate amounts relative to their reported cash holdings.

Corporate defaults are usually driven by insufficient liquidity, but these companies’ stated cash balances cannot explain the non-payments. Snton was sued by the Hebei Bank Qingdao Branch on 25 September for CNY139 million, which included defaulted principal of two drawn facilities. It had a reported cash balance of CNY4 billion at end-June, of which we estimate roughly half was unrestricted, which should have provided a significant buffer against default. It was also able to raise CNY400 million through domestic bond issuance in 1H18, suggesting normal access to the domestic funding market, despite generally tight credit conditions.

Reward failed to repay CNY300 million of commercial paper on 6 December, despite having CNY4.9 billion in cash – just CNY548 million of which was restricted – at end-June 2018, and CNY4.2 billion at end-September, according to its management accounts. KDX failed to repay CNY1 billion of commercial paper on 15 January. It had reported available cash of CNY15 billion and a net cash position in September.

These companies did not show other typical signs of distress prior to the defaults. The rise in Snton’s leverage in 2017 was above Fitch’s expectations and drove our downgrade of the company’s rating in May 2018, but its FFO net leverage of around 3.5x at end-June 2018 did not indicate an unsustainable capital structure. Reward’s FFO interest coverage was over 3.5x in 9M18, while KDX was around 5x in 1H18.

The defaults call into question the actual availability and amounts of reported cash balances. The three companies reported their restricted cash balances in line with Chinese accounting standards – China GAAP – which mandate similar disclosures on cash encumbrances to international standards. It is unclear if there were less formal restrictions in place, such as agreements with lending institutions to keep sums in designated accounts to support facility access. In any case, Reward and KDX confirmed to Fitch shortly before their commercial paper due dates that their holdings of realisable cash were sufficient to meet obligations.

Uncertainty over the accuracy of the companies’ books and disclosure of pertinent information is ultimately related to governance and accounting quality. Governance issues – often challenging to uncover – have been a factor in Fitch’s ratings on Reward and KDX. Reward’s ratings have been constrained by its low transparency as a private unlisted company with concentrated share ownership. The company changed auditor and re-issued its 2017 accounts due to disclosure and accounting problems flagged by the regulator.

KDX is listed on the Shenzhen Stock Exchange (SSE), but an apparent problem with its disclosure of concerted party arrangements at shareholder level prompted an SSE investigation, which hampered access to funding and prompted our downgrade in December. Snton’s case demonstrates unpredictable financial management. It failed to repay domestic bank loans, but has continued to service onshore bonds.

All three companies are audited by domestic accounting firms. International bond investors have become more receptive of Chinese issuers choosing not to hire one of the “Big Four” international accounting firms over the past decade. However, the quality of domestic auditing is variable. It is not unprecedented for domestic audit firms to be reprimanded for shortcomings. The auditors of Snton, Reward and KDX have previously received reprimands, albeit not for their work on these companies.

China’s recent measures to support the economy mark a shift in the policy stance towards easing and away from the previous singular focus on addressing financial risks, says Fitch Ratings. Easing is likely to stop short of the type of credit stimulus that could add significantly to economic imbalances, but this remains a risk that could have negative implications for the sovereign rating.

A series of loosening measures have been announced over recent months in response to signs that previous tightening has had an overly blunt effect on the economy, exacerbated by risks from trade tensions with the US. Easing measures have included reserve-requirement ratio cuts, liquidity injections, dilution of some recent macro-prudential tightening measures, and circulars that call for more accommodative fiscal policy and other forms of support to the real economy.

The authorities appear eager to avoid another large-scale stimulus, reflecting the sheer scale of the economy’s indebtedness, the prominence of the deleveraging drive and the designation of financial de-risking as one of three “critical policy battles”. Moreover, our baseline scenario is that an aggressive policy response is unlikely to be necessary to meet the authorities’ stated growth objectives, with growth forecast to slow only gradually – to 6.6% in 2018 and 6.3% in 2019 from 6.9% in 2017.

However, the continuing importance of medium-term growth targets suggests that a significant loosening of policy cannot be ruled out in the event of a macroeconomic shock or a slowdown that is sharper than we expect. Rising trade tensions raise the likelihood of such a policy response. We do not see the US tariffs already imposed on USD50 billion of Chinese goods as large enough to revise our China growth forecasts, but the imposition of a further round of US tariffs on USD200 billion in goods, as threatened by the US administration, could have a material effect.

The deleveraging campaign had succeeded in essentially stabilising macro-leverage ratios, with a particularly strong impact on riskier, less transparent lending within the shadow-banking sector. Downward pressure on the rating could emerge over time if we were to assess that a reversal of policy settings could result in a further build-up of the economy’s vulnerabilities. Policy easing is only at a nascent stage, and we last affirmed China’s ‘A+’/Stable sovereign rating in March 2018. The policy stance is among the key sensitivities that we will continue to monitor.

China’s two recent reserve requirement ratio (RRR) cuts amid slowing economic growth and rising trade risks have prompted market speculation that a new cycle of monetary easing is underway, but Fitch Ratings believes it is too early to conclude recent policy actions mark a clear reversion in stance.

A return to policy settings that add to the economy’s imbalances and vulnerabilities, such as credit stimulus, nevertheless remains a risk and could put downward pressure on China’s sovereign rating, as Fitch has previously stated.

The decision by the People’s Bank of China over the weekend to implement another 50bp RRR cut across much of the banking sector follows a targeted 100bp cut in April. The latest cut will release around CNY700 billion in reserves, effective on 5 July, bringing the combined net reserve injection to CNY1.1 trillion this year. The government has stressed that funds released by the latest cut should be used to support implementation of the debt-to-equity swap programme and small and micro-sized enterprise lending.

Fitch believes that the recent RRR cuts should be viewed in the context of liquidity management measures to ensure interbank funding conditions remain stable amid the ongoing crackdown on shadow banking. The authorities have previously relied on liquidity tools such as the medium-term lending facility, the pledged supplementary lending facility and the standing lending facility to provide liquidity in the face of weak base money growth, but an RRR cut should provide more permanent (and lower-cost) support. This should reduce liquidity risks for smaller banks, in particular, which are net liquidity takers and generally more reliant on shadow financing.

RRR cuts have previously coincided with policy loosening, but periods of clear easing (2008-2009, 2011-2012 and 2015) have also been marked by cuts to benchmark interest rates and a sustained decline in interbank rates, which have so far been absent (see chart). Meanwhile, the authorities continue to maintain a tighter bias towards macro-prudential policies and other financial regulations that aim to close regulatory loopholes, many of which are unlikely to be unwound at this stage, given the prominence the deleveraging campaign has taken at major policy meetings.

For now, Fitch’s expectation is that regulatory tightening will have a more powerful impact on credit growth than the additional liquidity generated by recent RRR cuts. Additionally, while further cuts are still possible, Fitch does not believe banks have sufficient capital to support aggressive asset expansion. That said, these adjustments do suggest that the authorities’ deleveraging drive has likely moved past its apex, and the swift deceleration in credit growth over the past year or so should soon begin to moderate.

Our baseline forecast is that GDP growth will slow during the second half of this year, due to deceleration in credit growth and a softening in the property market. Trade tensions with the US have not so far had a noticeable impact on exports, but could soon become a key policy consideration, given that a buoyant external environment has been an important contributor to China’s strong growth over the past year. If this dissipates, the authorities could be tempted to fall back on domestic stimulus to meet growth targets.

The authorities do have other policy tools beyond credit stimulus to shore up growth. Other forms of stimulus, including an on-balance-sheet fiscal stimulus, would not necessarily be ratings negative. Fitch estimates gross general government debt at less than 50% of GDP, in line with ‘A’ rated peers, which provides some room for fiscal easing. A recent State Council decision to lower taxes, which included a cut to value-added-tax rates, and plans to increase personal income tax deductions perhaps signal an initial step in that direction.

Fitch Ratings says that China’s tightened regulatory stance has slowed the build-up in financial-sector risks and should help improve the financial system’s overall stability. However, Fitch Ratings does not believe these measures have reduced risks meaningfully enough to warrant the type of sector-wide bank rating upgrades recently made by Moody’s. The authorities have also not been tested in their resolve to tackle financial risks if economic growth slowed beyond tolerance levels.

The result of Moody’s approach is rating compression between policy banks and large state banks (and mid-tier banks to some extent), which creates potential for higher rating volatility. Fitch has adopted a ‘through-the-cycle’ approach and differentiates more between institutions that we believe are likely to receive a high level of state support and those for which support is less certain.

Regulatory tightening has slowed credit growth over the last year, particularly shadow-bank activities although they have not declined. Interconnectedness in the financial system has also fallen, as shown by a drop in interbank wealth-management-product investment in 2017 and lower sequential growth in bank claims on non-bank financial institutions since 2H17. The credit-to-GDP growth gap has narrowed, but we still expect our Fitch-Adjusted Total Social Financing to reach around 273% of GDP by end-2018F (269% at end-2017). A change in the outlook on China’s operating environment, currently ‘bb+’/negative, would hinge on continued deceleration in credit growth, with deleveraging reducing contagion risks and improving transparency and governance.

The largest state banks are likely to be less affected by tighter regulation (which could increase asset impairments), given their stronger capital positions and loss-absorption buffers, as well as superior liquidity (and geographical diversification for BOC). These factors underpinned our decision last month to upgrade the Viability Ratings of BOC, CCB and ICBC to ‘bb+’ from ‘bb’.

However, mid-tier banks are more exposed, due to weaker funding and liquidity profiles, larger off-balance-sheet activities, and lower loss-absorption capacity. Moody’s upgraded almost all banks in its ratings portfolio, including some mid-sized ones, noting that they are “managing the transition well by virtue of their capital strength, liability franchise and/or relatively modest involvement in shadow banking activities”. Fitch disagrees with Moody’s view that the mid-sized banks’ involvement in shadow activities is “modest”. We also view their capital as overstated if taking into account off-balance-sheet exposures. Any upgrades to bank Viability Ratings would likely require sustainable improvements in capital buffers commensurate with risk appetite.

Our approach to support ratings for Chinese banks also differs. Fitch does not, for example, factor institutional support into the ratings of Ping An Bank or China Guangfa Bank (both BB+/Stable/b), as their largest shareholders are insurers that are subject to sector-specific regulation and would be similarly affected as the banks in a stress scenario, given the nature of their investments. These two banks represent over half of their largest shareholders’ assets, which raises doubts over their parents’ ability to provide support.

Fitch believes the state’s propensity to support different tiers of banks will vary under a stress scenario, with mid-tier banks unlikely to receive the same level of sovereign support as larger banks. Moody’s gives a three-notch uplift for many mid-tier banks, which is equivalent to the uplift that it gives for BOC, CCB and ICBC. Moody’s also now equalises its ratings of almost all state banks with the policy banks and the sovereign, which means it gives a higher support uplift, of four notches, to ABC and BOCOM than to the largest state banks.

Fitch will continue to focus on differentiating the potential for support in its rating analysis and research. In addition, Fitch’s ‘through-the-cycle’ approach aims to minimise ratings volatility.