One of the most significant global credit events took place two months ago. On September 21, 2017, S&P Global Ratings downgraded China’s sovereign credit rating from AA- to A+,^[1] citing risks from soaring debt. The following day, the ratings analysts lowered China’s Banking Industry Country Risk Assessment to reflect heightened concerns, as well as China’s Big Four Banks Stand-Alone Credit Profile.^[2] Investors might be wondering if they could have foreseen these developments and taken steps to protect their portfolios.

Tools to better assess credit risk

Research has shown that the stock market can anticipate a company’s future operating performance.^[3] Our Probability of Default Model Market Signals (PDMS) builds on this theory using a cutting-edge statistical framework to provide a point-in-time view of credit risk for public corporations that acts as a potential early-warning signal of default. PDMS, updated daily and expressed as a percentage, capture market signals reflecting the volatility of stock prices (market cap volatility), with smoothing techniques used to reduce any excess volatility.

Applying PDMS to China’s situation

We utilized PDMS to examine whether China’s sovereign downgrade could have been recognized in advance by zeroing in on developments in the country’s banking sector. Why the banking sector?

• The market capitalization of the financial sector in China to total market capitalization is over 20%,^[4] making it the most important sector in the country’s stock market.
• Approximately 75%^[5] of China’s financial system comes from bank financing. Commercial banks play a very important role in supporting the transformation and upgrade of China’s real economy, promoting regional economic development, backing the RMB internationalization strategy, and helping Chinese companies “go global”.

Taking the daily stock price of 14 of China’s largest banks^[6] from the S&P Capital IQ platform, we calculated their PDMS derived scores. Considering that the stock market contains information on the unique risk factors of each bank, we choose the median PDMS derived scores as an approximation of the overall credit risk movement. As shown in Figure 1, the median score of China’s banking sector deteriorated to ‘bbb+’^[7] at the end of March 2017, from ‘a-’ at the end of September 2016, providing an early-warning signal ahead of the sovereign credit deterioration.

Figure 1: China’s PDMS One-Year Standalone Score (Median Value)

^{Source: S&P Global Market Intelligence, Credit Analytics [data as of October 30, 2017]}

We also analyzed the asset quality and debt leverage of China’s banking sector over the past few years using our RatingsDirect® product,^[8] along with market data. As shown in Figure 2, the net customer loans to deposits ratio, and problem loans to gross customer loans, were 77.11% and 1.51%, respectively, by the end of 2016. This was up from 71.51% and 0.83%, respectively, in 2012.

Figure 2: Net Customer Loans to Deposits and Problem Loans to Gross Customer Loans

^{Source: S&P Global Market Intelligence [data as of October 30, 2017]}

S&P Global Ratings estimated that China’s reported private sector credit by banks to GDP ratio jumped to 116.6% by the end of 2016, from 69.4% in 2012,^[9] presenting challenges for all financial institutions operating in the country. Rapid domestic credit expansion through regular and shadow banking has even pushed up China’s debt leverage over the past few years.

Enhance your decision making with PDMS

Since the stock market is a barometer of a real economy, and market capitalization and equity volatility are the main inputs of PDMS, this tool can provide important forward-looking views on credit risk. The model can also produce a term-structure of one to five-year PDs, opening the door for enhanced and more robust measurements of credit risk.

[1] S&P Global Ratings, “People's Republic Of China Ratings Lowered To 'A+/A-1'; Outlook Stable”, September 21, 2017
[2] S&P Global Ratings, “Actions Taken on China’s Big 4 Banks Following Our Updated Banking IndustryCountry Risk Assessment, Sovereign Downgrade”, September 22, 2017
[3] Rezaul Kabir and Peter Roosenboom, “Can the stock market anticipate future operating performance? Evidence from equity rights issues”, Journal of Corporate Finance, 2003, vol.9, issue 1, 93-113
[4] Data source: Wind
[5] Data source: Wind
[6] This included: Industrial and Commercial Bank of China Ltd., China Construction Bank Corp., Agricultural Bank of China Ltd., Bank of China Ltd., Bank of Communications Co., Ltd., China Merchants Bank Co., Ltd., China CITIC Bank Corp. Ltd., China Minsheng Banking Corp. Ltd., Shanghai Pudong Development Bank Co., Ltd., Bank of Beijing Co., Ltd., China Everbright Bank Co. Ltd., Ping An Bank Co., Ltd., and Hua Xia Bank Co., Ltd.
[7] S&P Global Ratings does not contribute to or participate in the creation of credit scores generated by S&P Global Market Intelligence. Lowercase nomenclature is used to differentiate S&P Global Market Intelligence PD credit model scores from the credit ratings issued by S&P Global Ratings.
[8] The official desktop source for credit ratings and research from S&P Global Ratings, combined with additional market intelligence and risk indicators.
[9] S&P Global Ratings, “Banking Industry Country Risk Assessment: China”, September 22, 2017.