Moody's: More corporate defaults in China to come, but mitigated by policy support

Moody's Investors Service says that the number of companies in China (Aa3 stable) in financial distress will rise as slower domestic economic growth and the government's reform agenda, intended to allow markets to play a "decisive" role, expose overstretched balance sheets in the corporate sector.

But policy easing and government support will prevent rising corporate distress from escalating to a level that would cause systemic risk to the onshore and offshore markets.

"The increased number of onshore corporate defaults in 2015 -- which already exceeds the total number for last year -- breaks the myth of the 'automatic bailout' in China's onshore market, which had led some investors to ignore credit fundamentals in the expectation that all debt would ultimately be underwritten by the state," says Kai Hu, a Moody's Vice President and Senior Credit Officer.

"The perceived reduction of such implicit guarantees will result in greater differentiation in the onshore bond market, which will in turn enhance risk-based pricing of debt," adds Hu.

Moody's conclusions are contained in its just-released report entitled "China Credit: Corporate Distress Is Rising, but Policy Support Will Prevent Systemic Risk".

Moody's report highlights that corporate revenues at Chinese corporates have weakened in lockstep with nominal GDP growth, with the latter decelerating to 5.8% year-on-year during Q1, the slowest pace since the height of the global financial crisis in Q1 2009.

Such weaker revenues have increased system-wide corporate leverage, which stood at around 150% of nominal GDP in Q3 2014, according to Moody's estimations, a 34-percentage-point rise over the past five years.

Moody's highlights that high-yield private companies in sectors with excess capacity, such as steel, mining, solar, commodities trading and shipbuilding, are most exposed because their financial profiles are relatively weak and their access to funding is limited.

While corporate defaults in China are thus likely to increase in frequency, Moody's expects policy easing and government support will prevent an escalation of corporate defaults and systemic risk to the onshore and offshore markets.

"The authorities are demonstrating a renewed bias towards policy easing and flexibility towards structural reform in other sectors in order to engineer a soft landing," says Rahul Ghosh, a Moody's Vice President and Senior Research Analyst.

Moody's points out the high-profile property sector has been one of the first recipients of policy support. This led to market conditions stabilizing during January-April, leading to expectations of a modest recovery in sales volumes for 2015, in sharp contrast to the fall evident in 2014.

Looking ahead, Moody's says the central government has adequate fiscal and monetary headroom and exerts sufficient control over the economy to avoid widespread corporate failure and support the banking system.

Room is also available for a further loosening of monetary policy should macroeconomic conditions continue to deteriorate, given that real lending rates and the reserve requirement ratio remain high by historical standards.