Moody's: China State Council multi-pronged guidelines indicate credit positive willingness to address the risks posed by high corporate debt

Moody's Investors Service says that guidelines issued by China's State Council earlier this month indicate a credit-positive willingness to address the risks posed by high corporate leverage. How the guidelines are implemented will determine their credit implications across sectors.

Moody's conclusions were contained in a just-released report, "China credit - State Council Guidelines Indicate Credit-Positive Willingness to Address Risks Posed by High Corporate Debt".

China's State Council published two guidelines on 10 October. The measures outlined in the guidelines include mergers and acquisitions, revitalization of stock assets, securitization of performing and nonperforming assets, optimization of debt structures, debt-equity swaps, developments of equity financing, regulation of the bankruptcy process, and strengthening of corporate governance.

Moody's sees two potential challenges to their implementation. First, in the near term, the deleveraging that these measures seek could lower GDP growth. However, Moody's expects that the current context of proactive fiscal policy and prudent monetary policy, which the guidelines re-assert, will mitigate this near-term effect.

The second set of challenges is related to the absence of a deep and liquid equity market, a pricing framework for equity in the debt swaps, or relevant legal framework (including a transparent and predictable bankruptcy process).

The market-oriented principles emphasized in the guidelines, if thoroughly implemented, will introduce safeguards to reduce the risk of banks swapping non-viable companies' debt for equity at a price that would leave them exposed to sharp falls in valuations. Meanwhile, the asset management companies may need new equity injections, particularly if book values are broadly retained.

The report says that it is likely that, through some of the measures envisaged, some of the leverage currently on corporate balance sheets is shifted to other parts of the economy, including the banks and asset management companies. Moreover, the government and the public sector in general would also take some of the costs, either directly or indirectly through the provision of policy support.

The credit implications for the sovereign will depend on whether the measures effectively reduce the economy-wide contingent liability risks for the government posed by state-owned enterprises, banks and asset management companies.