Credit implications of China's corporate deleveraging mixed: Moody's

Onshore defaults likely to escalate.

Moody's Investors Service says that the Chinese government's deleveraging measures are broadly credit positive for the country's corporates. However, the credit implications will be mixed for the sovereign, banks and among individual corporates.

"The proposed deleveraging measures, if implemented effectively, will help lower leverage in the corporate sector, and will in particular benefit commercially viable companies with strong business profiles, as reflected by leading market positions and technologies," says Kai Hu, a Moody's Senior Vice President.

"However, fundamentally unviable companies will be cut off from credit supply and be forced to shut down, resulting in a spike in onshore defaults in the short term," adds Hu.

In the banking sector, Moody's expects the rise in corporate defaults will increase non-performing loans in the short term. In addition, the banks may lose their seniority in any claim on company assets if they had swapped debt for equity in nonviable firms.

In the long run, however, Moody's expects the banks will benefit from improving corporate fundamentals and profitability, provided the measures are carried out in a market-based manner.

Moody's report further highlights that economy-wide leverage is unlikely to decline significantly in the short run.

Instead, leverage and credit risk are likely to shift to financial institutions, the government, or to the public via funds that are set up by financial institutions for debt restructuring.

For example, reducing overcapacity will shift part of the burden to the central, regional and local governments, which need to increase spending to provide for laid-off workers and affected local economies.

Further, Moody's points out that the implementation of the government's deleveraging plans involves several challenges and hurdles. Debt-equity swaps, for example, need carefully designed rules and market oversight to be effective. And public-private partnerships, which support infrastructure investment, have attracted limited private investment owing to the lack in clarity over the sector's legal and accountability framework.

Other hurdles include misaligned objectives and interests among different tiers of governments, investor and stakeholders.

Amid China's softening economic growth and weakening corporate profitability, reducing high corporate debt levels has become one of the government's key policy targets, and on 10 October 2016, the State Council of China published guidelines on a series of measures to promote corporate deleveraging.

The country's total debt stock climbed to 255% of GDP in the first quarter of 2016, from 147% in 2008, largely driven by the corporate sector. Corporate sector leverage rose to 169% of GDP in Q1 2016 from 97% in 2008, and contributed to about two-thirds of China's total debt growth during this period.