Rating China’s Economy

The CEO of Moody’s discusses China’s evolving credit system, economic performance, and liberalization of the country’s financial services sector.Moody’s Corp.—a global provider of credit ratings, research, tools, and analysis of financial markets—rates and tracks debt covering more than 110 countries. Moody’s opened its first office in greater China in Hong Kong in 1994, but its China-related business dates back to May 1988, when the firm’s rating agency assigned China an A3 sovereign credit rating. It is now three notches higher at Aa3 with a positive outlook, making China one of Moody’s highest rated sovereigns. In 2001, Moody’s opened a representative office in Beijing. That office became a wholly owned subsidiary in 2003. Moody’s operates two main divisions in China—Moody’s Investor Service and Moody’s Analytics—and has offices in Beijing, Hong Kong, Shanghai, and Shenzhen.

Moody’s President and Chief Executive Officer Raymond W. McDaniel Jr. joined Moody’s in 1987 and has served as CEO since April 2005. He agreed to an interview over email with CBR Editor Christina Nelson about China’s credit market, financial services sector, and investment environment.

What services does Moody’s provide in China?

McDaniel: China’s domestic capital market is large, and the country is taking an increasingly weighty role among the community of nations. China has an important role in the broader global economy with increasing influence and reach. As a multinational institution, we are committed to providing the types of services and products that China would find useful on its path to growth, and we have adjusted to account for it.

Through Moody’s Investors Service (MIS) we publish credit ratings and research on cross-border Chinese bond issuers. In practical terms, this means that the MIS Beijing office focuses its analytical activities on issuers offering bonds in overseas markets. In addition, in 2006, Moody’s invested in one of China’s leading domestic ratings agencies, China Chengxin International Credit Rating Co. Ltd. (CCXI), which focuses its work on companies issuing in China’s domestic bond market.

Through Moody’s Analytics (MA) we offer a broad suite of qualitative and quantitative solutions to help Chinese institutions manage risk. Our MA products include research, economics information, risk software, professional services, consulting, and training.

Moody’s has recently made a number of investments which bolster our suite of China-related products and services. These include an investment in ChinaScope Financial, an integrated provider of China-focused analytics and business intelligence; CSI Global, a provider of financial training and certifications to global customers, including Chinese managers and executives from leading Chinese financial services institutions; and Copal Partners, a leading provider of outsourced research and analytical services.

Most people think of credit ratings when they think of Moody’s. Indeed, rating the credit worthiness of issuers and debt securities is a significant part of our business, both within China and globally. But we also have extensive experience in economic analysis, research services, financial services training, and risk management.

For example, typical projects with China-based or China-focused clients include providing financial services training, enterprise risk management, and solutions for compliance with Basel III [international capital requirement] regulations, as well as assisting organizations with building their own risk management systems. Moody’s also offers China custom research services through our Copal business, which provides “deep dive” research services, such as macroeconomic studies, market surveys, industry reports, company reviews, and financial analysis, including forensic examinations. These capabilities are used by supply chain managers, credit analysts, and bankers to help analyze customers, suppliers, and partners.

What changes have you seen in China’s financial services and credit market over the last decade?

McDaniel: This question could be an entire interview in itself because so much has changed. Over the past decade, credit performance in the corporate sector has been very good. And, during and after the global financial crisis, China’s economy demonstrated good recovery despite some weakness in residential real estate.

Since 2005, when the People’s Bank of China (PBOC) introduced China’s first-ever true credit-based short-term commercial paper programs, China has rapidly developed its credit market. The domestic market has become a very important funding channel for Chinese companies and financial institutions, and facilitates more transparent and more cost-effective public bond issuances. China’s bond market is now the third largest in the world. Domestic bond issuances reached a record ¥7.8 trillion ($1.2 trillion) in 2011, and outstanding bond balances amounted to ¥22.1 trillion ($3.5 trillion) by the end of 2011. For perspective, the US outstanding bond market debt is about 10 times larger at $37 trillion.

What are the most common questions you get about China and its credit system?

McDaniel: Common questions revolve around China’s potential approaches to credit policy. For example: “To what degree will credit in China evolve towards a managed or free market?” Or, even more specifically: “Will bond defaults be permitted?”

There are several possible approaches that China could take with regard to credit policy. First, China could follow a managed pathway similar to Japan with banks and government entities extending support to effectively insolvent companies. Or, second, China could follow a more free market approach, similar to credit in the United States, where insolvent companies generally declare bankruptcy and either liquidate or reorganize with debt repayment plans. Some would argue that there is a third, a purely Chinese model which takes a bit of both. That’s essentially what the policy makers are trying to do.

Currently, there are indications that China is following a managed credit path, analogous to Japan. Based on news reports, some companies have defaulted on their bank loans, but local governments and banks then provided support to avoid public bond defaults, using public funds not only for state-owned enterprises (SOEs), but also private companies. This managed approach to credit may support social policies, but may not be ideal for a healthy bond market. Only time will tell whether a managed approach to credit becomes an enduring feature of China’s capital market.

What is China doing to create a credit system?

McDaniel: The development of credit systems pose something of a chicken and an egg problem. What comes first, a liquid debt capital market or transparent information? Liquidity creates more information, and transparent information supports more liquid markets.

In China, both of these components are, I think, developing in tandem, but are not yet fully mature. Importantly, the government is supporting the development of a credit system with an encouraging series of regulations and policies. For example, the Qualified Foreign Institutional Investor scheme was recently revised to permit international investors to buy bonds on the interbank market.

The other major opportunity is the sheer pace of change in China. China has a rapidly expanding middle- and upper-income population, and we need to serve every consumer, from the individuals that live on just a few dollars a day to the super rich and everyone in between.

While there are many other opportunities, I want to focus on one final area and that is protection of intellectual property rights. This remains problematic for both Chinese as well as multinational companies, and the Chinese government continues to work hard at addressing this major issue. We look forward to continuing that work and that dialogue so we can make further progress.

How do investors and analysts research companies in China, and how is that different than what you would do in the United States?

McDaniel: Moody’s recently surveyed 100 asset managers, hedge funds, private equity firms, and wealth managers in North America to understand how they research Chinese companies. The survey identified a couple of interesting differences. First, we learned that roughly 40 percent of investors here leverage their firm’s research teams in Asia, suggesting that local knowledge contributes to a competitive advantage. Second, we learned that investors’ top challenge is data quality, indicating a different stage of information maturity. Right now, investors are assuming that the credit risk of specific companies is linked to the credit risk of China itself.

How do you rate an SOE versus a private company in China?

McDaniel: Moody’s ratings on China’s SOEs have two key elements: their standalone credit fundamentals and the expected governmental support in a stress scenario. In assessing the stand-alone credit fundamentals of an SOE, we apply the relevant industry methodology, similar to a private company. However, we also assess the management oversight of the SOE by the government through its agents, SASAC [State-owned Assets Supervision and Administration Commission] and the National Audit Office. The government’s oversight provides checks and balances and partially mitigates our concerns on corporate governance, an issue faced by a number of private companies in China.

SOEs also have good access to domestic bank and capital markets because of their ownership by the government, which provides them with an edge over many private companies in China.

Moody’s also considers a rating uplift in view of the expected governmental support for SOEs. In assessing the support level for an SOE, we consider its strategic importance to the Chinese economy, its policy role, reputational risk to the government, and the government’s track record of providing support to the SOE. This could end up with multiple notches of a rating uplift.

As a result, in Moody’s rated universe, the majority of Chinese SOEs and their subsidiaries are rated at investment grade, while most of the country’s private companies are rated below investment grade.

What are investors in China most worried or most enthusiastic about?

McDaniel: One top question in our customers’ minds is: “Will China face a hard landing?” Obviously there is a wide range of definitions of a hard landing. At Moody’s, we define it as a permanent halving of the past decade’s trend annual real growth rate within the near term; in the case of China, from 10 percent to 5 percent. The latter would, however, still be above the global growth rate. We don’t believe such a scenario will materialize, and forecast growth for the next two years at 7.5 percent per year.

China’s economic growth is healthy, but the economy is moving from double-digit to single-digit growth rates as the country approaches middle-income levels. This appears to be a natural economic development and is similar to Japan from 1966 to 1970 and Korea from 1986 to 1990. As with the rest of the world, the European situation is a negative drag on growth, and investors are concerned that China is the most exposed among major economies to the European slowdown.

Over the longer term, our sovereign team at MIS believes China continues to have upside potential. Once the private sector plays a larger role in the financial system, the prime engine for exports and investment in the economy would receive a big boost.

Also, the inevitable internationalization of the renminbi (RMB) and potential acceleration of financial liberalization after this fall’s leadership transition creates numerous long-term opportunities.

How long could it take for the RMB to be truly an international currency? And what makes you say the potential is high for financial liberalization after the leadership transition?

McDaniel: I believe that it is likely that the RMB will trade internationally in the next 10 or 20 years. Potentially, to counteract negative public perception in the wake of recent political challenges, new leadership may be inclined to move quickly with policy reforms to demonstrate unity.

How big of a risk is China’s shadow banking sector to the stability of the banking sector?

McDaniel: There are funding activities in which banks are heavily involved for facilitating certain transactions, and so they assume direct and indirect exposures. Examples are entrusted loans, bank bill acceptances, trust products, and underground lending. We estimate the size of the non-bank credit market to be about 20 percent of total bank assets, which is significant, but not high.

The non-bank funding channel grew rapidly in 2010 and the first half of 2011, but has since slowed as the authorities have stepped up oversight of the sector. We estimate that the growth of this exposure slowed to 25 percent in 2011 from 45 percent in 2010.

Nonetheless, the slowdown in economic growth has caused more borrowers in the shadow banking sector to default, based on media reports, as these borrowers had leveraged themselves up excessively and had to pay interest rates much higher than those on bank loans. Some borrowers also have bank loans.

It is difficult to quantify the risk that China’s shadow banking sector poses to the stability of the banking sector due to the lack of disclosure. But based on Moody’s analysis, if problem loan ratios increase to high single digits from current level of around 1 percent, the capital adequacy of most banks would still be able to meet regulatory requirements. Our analysis shows that Chinese banks are well capitalized and have a good level of cushion.

However, should problem loans increase to more than 10 percent of total loans, most of our rated banks would need to raise significant amounts of capital to meet regulatory requirements.

What other important issues is Moody’s following in China?

McDaniel: Interest rate liberalization is very important for the further development of the domestic bond market and internationalization of the RMB. The PBOC released a report in February calling for significant capital account liberalization steps over the next three to five years. The governor of the PBOC, Zhou Xiaochuan, recently wrote in an article that conditions are “basically ripe” for interest rate liberalization.

We believe that interest rate liberalization will also enhance economic efficiency. China’s economy has become immensely more complex in the past three decades of rapid, double-digit growth. The economy needs price signals, rather than administrative and political decisions, to ensure a more market-based and efficient allocation of capital.

Interest rate liberalization is also a key precondition for the further development of a domestic bond market and internationalization of the RMB. With liberalized interest rates, China could develop a municipal bond market. As in the United States, it would enhance the sustainability of government finances, if a diversified investor base is developed and transparency is promoted. Ultimately, it would lead to greater fiscal discipline on the part of local governments.