Understanding a Seismic Shift in Credit Quality in China

A crackdown on the use of leverage by retail investors in China; a potential slowdown in China’s economic growth; a decrease in imports into China; and a collapse in oil prices have all weighed on market sentiment in China and in its main trading partners in Asia.[1] Over the past six months, our PD (Probability of Default) Market Signals[2] indicated a credit risk of: 6.60% in China (with a PD implied credit score of “b-”); 3.62% in Hong Kong (“b+”); and 1.34% in South Korea (“bb”) and 1.10% Taiwan (“bb”)[3] as of September 15, 2015.

Not surprisingly, a correction in China’s equity markets would not only imply higher market signal PDs across the board over the same period, this flight to quality naturally favored defensive sectors over cyclicals. Consequently, PD market signals for the S&P China Broad Market Index® (comprising of ~700 stocks traded in China with minimum free float market cap of USD100mn) reflected the largest increases in default risks for cyclicals such as Materials (increase of 9.0% to mapped credit score “ccc+”) and Energy (an increase of 6.0% to “b-”). On the other hand, PD for Information Technology only rose by 1.1% to “bb-”.

Market and Fundamental Based Probability of Defaults for CSI 300 and S&P China BMI Indices

How much of this increase in PD is a bursting of a market bubble, and how much of this reflects a seismic shift in credit fundamentals? Some of this appears to be caused by a major sell-off from domestic retail investors. The CSI 300 Index, which measures the returns of 300 companies trading in China’s domestic “A” share market, doubled in value from June 2014 to May 2015 (implied score of “bbb”), before falling by 34.8% (implied score is now “b+”).

Similarly, the S&P China Broad Market Index (S&P China BMI) had also returned +20.0% from March to May 2015, before the market correction from June 2015 to September 2015 erased 28.8% of its value. This maps to a deterioration in market signal PDs for the S&P China BMI index from 0.49% (“bbb-“) in March 2015 to 3.77% in September 2015 (“b”), with the sharpest increase from June 2015 onward. The difference in credit risk between the narrow and broad market indicators shows that credit risk increased by even more for smaller companies.

However, some of this market correction could also reflect a “wake up call” of market participants to a weaker earnings outlook in China. The fundamental PD of the CSI 300 Index, which forecasts default risks using the companies’ latest reported earnings, was 0.52% (implied score of “bbb-”) vs. 2.7% (implied score of “b+”) for the broader S&P China BMI index.

In terms of earnings trends, equity analysts have trimmed their FY1 consensus earnings of both indices an average of 5–7% over the last six months; and Standard & Poor’s credit ratings analysts have anticipated a declining profitability in China as far back as in 2012 (see “Shanghai Share Market Correction Isn’t Surprising Given the Declining Profitability of China’s Corporates”, RatingsDirect, August 26, 2015).

Whilst market signals are reflecting fundamental credit views of the S&P China BMI (with market and fundamental credit indicators at “b” and “b+”, respectively), the forecasted earnings and credit fundamentals could not fully explain the large increase in market signal PDs from “bbb-“ to “b+” for the larger-cap CSI 300 index in the span of six months.

How can investors and risk managers calibrate a logical response to the recent stock market volatility in China? Whilst some of this increase in equity market signal PDs may well be explained by excess market volatility, as the China story plays out in the coming months, a closer surveillance on credit risks of (i) Chinese entities; (ii) Energy companies; and (iii) China’s trading counterparties is now warranted.

This blog is an excerpt from the October issue of Credit Market Pulse, a publication for the credit risk industry which provides a holistic overview of the credit health of global capital markets. 

To read our full analysis of the mounting credit risk in China, download this month’s issue today. If you haven’t subscribed and would like to receive this report direct to your inbox every other month, register your interest at here.

[1] “The China Story Continues to Unfold onto Asia-Pacific’s Credit Conditions,” RatingsDirect® September 10, 2015; “Asia-Pacific Credit Outlook 4Q 2015: China Slowdown Concerns Spill Over Into The Region’s Industries,” RatingsDirect®, September 9, 2015.

[2] PDs are produced by S&P Capital IQ Probability of Default Market Signals model. PD Market signals is a quantitative equity-based model that is completely independent from Standard & Poor’s Rating Services. The quantitative scores derived from this model are represented throughout the report in lower case letter grade to differentiate these from Standard & Poor’s Rating Services credit ratings.

[3] Lowercase nomenclature is used to differentiate S&P Capital IQ PD credit model scores from the ratings issued by Standard & Poor’s Ratings Services, which is analytically and editorially independent from S&P Capital IQ.

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