Domestic factors drive China’s credit outlook amid heightened uncertainty
On February 24, Russian forces launched a military attack on parts of Ukraine. Since then, numerous Western nations have responded by imposing a range of sanctions on Russia.¹ We assess the event’s impact on China’s credit markets and outline why we believe that the effect on investment-grade credits is currently limited and that domestic factors are largely driving the outlook for the high-yield segment.
Although the Russia-Ukraine military conflict has sent tremors throughout global markets, the impact so far on China credit has remained minimal.
Geopolitical events such as war are extremely fluid, with broad and rapidly shifting implications for economies and markets. The most immediate impact of the ongoing conflict and associated sanctions against Russia is the fear regarding supply shortages of energy, grain, and metals globally. The absence of the Russian supply of fertilizers may result in a long-term decline in the supply of agricultural products, or a food crisis. High—and rising—commodity and food prices could push the global economy further into stagflation territory and weaken the recovery from the pandemic.
China, as a voting member of the United Nations Security Council and its closer diplomatic relationship with Russia, will inevitably be affected by recent developments. Chinese companies may be directly affected by rising volatility and prices in the commodity markets as Russia is a key producer and exporter of energy and rare earth metals. In addition, offshore funding could be hindered as capital markets are disrupted by geopolitical events; however, economies such as China—with stronger balance of payments, robust current account surplus, and foreign currency reserves—may prove to be particularly resilient against these potential shocks.
Investment-grade credits: sectors to watch
Overall, based on the current situation and number of sanctions imposed on Russia, we don’t yet see a negative impact on segments of China’s credit market, although this assessment could change. In our view, investors should keep their eyes on two important sectors in the investment-grade space: financials and energy.
Financials: China’s financials sector has limited direct exposure to the Russian economy, or to financial counterparties in Europe, which may experience a weakening in their capitalization and liquidity position. The decision to remove Russian banks from the SWIFT financial messaging network doesn’t affect China directly, and domestic financial institutions may undertake efforts to develop an alternative system with Russian institutions, while strictly adhering to the current sanctions regime.
Energy: China has broader energy ties with Russia, including a recently signed 30-year agreement for natural gas delivery. Some state-owned firms also have minority stakes in Russian liquid natural gas projects.2; however, the country isn’t overdependent on Russian energy imports and still has a diversified energy base and rich domestic coal deposits.
Since energy isn’t currently included in broader sanctions (although the United States has banned Russian oil, liquid natural gas, and coal exports), we believe the exposure of Chinese energy companies is limited. Furthermore, capital raising activities aren’t likely to be adversely affected as several prominent state-owned companies are already on U.S. sanction lists.
Latest assessment of China high-yield market
The outlook for the high-yield space remains challenging due to the country’s real estate sector. Although some high-profile large developers defaulted in December 2021, the amplified financial distress caused by those events has led to weaker sentiment and reduced liquidity, judging from the several distress cases in January and the latest February contracted sales data.
This, in turn, has negatively affected stronger and higher-quality developers (from “BB” to “B” rated) that previously were thought by investors to be less risky. This phenomenon is also starting to seep into the stronger onshore credit market, leading to more volatility. We believe more defaults of high-profile names could materialize soon.
These developments broadly align with our original thesis that the rebound of the real estate sector will be gradual. The sector will take several years to deleverage and transform into a right-sized, more financially stable and commercially viable industry.
Domestic factors drive China’s high-yield market outlook
In the meantime, we’ve seen some positive developments since our last update in government policies, although more support might be needed. The People’s Bank of China adopted a more accommodative monetary policy stance since December 2021, having lowered the one-year loan prime rate by five basis points (from 4.65% to 4.60%) as well as the mortgage reference rate. Locally, mortgage rates in nearly 90 cities have been reduced to help cushion the downside and several cities have relaxed down payment rules to boost affordability for home buyers.
Moving forward, we believe investors should pay attention to three key catalysts in the short to medium term:
- Trajectory of contracted sales and consumer confidence—This metric represents the number of sales for developers and serves as a rough proxy for consumer confidence and the health of the industry. While we haven’t seen a turnaround yet, this can be a leading indicator that should show improvement when it comes.
- Continued government policy support—Although central and local governments have begun to provide policy support, we believe further targeted backstop measures could be unveiled in the coming months to improve liquidity and incentivize consumers to purchase real estate.
- Restructuring of existing defaults/distress—Although numerous property developers are already in technical default, or on the precipice of defaulting, there’s still limited visibility on the haircut that creditors will ultimately take. We expect the restructuring discussion to take longer than a year, but note that the size of the potential haircut could serve as an indicator for sentiment to recover, particularly if it’s smaller than currently expected. And as the restructuring process progresses and these uncertainties are addressed, we expect more market participants to enter the market to acquire assets.
The importance of robust credit selection in volatile markets
As the speed and volatility of recent geopolitical events illustrate, we believe robust research and due diligence is paramount in credit selection. Many of the risks in the current environment are due to economic linkages that may not be apparent from cursory analysis. Indeed, our bottom-up credit research includes careful examination of company fundamentals, including customer concentration and cash flow sources as well as stress tests of potential punitive actions, which carefully inform our investment decisions.
1 A raft of sanctions, including on the Central Bank of Russia and other Russian banks, as well as access to global payments systems and high-tech equipment exports. 2 Bloomberg, March 12, 2022.
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