Chinese reforms are having a profound impact on the country's securitization industry, which we project to grow 6% in 2019 to US$310 billion in issuance. However, S&P Global Ratings expects institutions will find their underwriting standards tested as the industry ventures into new territories involving new originators.

Regulators are approving more transactions, while an economic rebalancing to domestic consumption and China's deleveraging are pushing more institutions to consider securitization. We see this market as going through a kind of adolescence with lots of growth and potential. But there's also experimentation with new practices that could expose the industry to greater risk.

We discuss how China's policy decisions will affect the dynamics of two primary types of securitization: the auto loan asset-backed securities (auto loan ABS) and residential mortgage backed securities (RMBS). We also examine key trends, such as Chinese issuers' interest in reaching offshore investors, and how foreign funds are tapping the market through Bond Connect, a mutual access scheme connecting Hong Kong with mainland China.

China's Household Leverage Rising Rapidly

China's household leverage, measured by the ratio of household debt to GDP, is moderate compared with peer countries (see chart 1). But the pace of increase is noteworthy. According to the Bank for International Settlements, China's household debt-to-GDP ratio in 2018 was 52.6%, at a similar level to that of Singapore, slightly lower than that of Japan and the eurozone, and much lower than markets such as the U.S., Korea, and Australia.

China's household debt-to-GDP ratio increased by 19.5 percentage points from 33.1% in 2013--the fastest growth among these markets.

Chart 1

Less financial flexibility suggests more financial vulnerability

If we delve into the composition of China's household debt, the portion of mid-to-long-term loans has increased to 72% as of June 2019, from 65% at the end of 2014. This is mainly driven by the increase in long-term consumption loans--predominantly residential mortgage loans.

In our view, such a structural shift in household debt does not suggest imminent risk. However, the reduced financial flexibility stemming from to 20-to-30 years of payment obligations increases system-wide vulnerability, particularly if the economy slows significantly for a prolonged period.

Chart 2

Sector-Specific Factors May Affect China's Auto ABS and RMBS

The performance of China's auto ABS and RMBS sectors have so far been stable amid rising household leverage. However, each sector has its own looming uncertainties.

One of the uncertainties hanging over the auto loan ABS market relates to finance companies' push into lower-tier cities. This is a less-familiar area from a credit-risk perspective to the auto finance companies (AFC) compared with top-tier cities, where most AFCs have well established operations.

In the RMBS sector, more small and midsized banks have filed RMBS issuance plans and issued RMBS over the past year. Based on our analysis, RMBS performance could show more variance than before, given the possibility of more divergent underwriting practices among originators.

Furthermore, the rise of small and midsized banks in RMBS issuance suggests greater economic-concentration risk that may affect the long-term performance of RMBS.

Auto ABS

The performance of auto loan ABS in China was stable in the second quarter of 2019. The cumulative default rate remained low, largely below 1%.

Chart 3

However, we think the sluggish auto sales since 2018 may have implications for the quality of loans supporting auto loan ABS to be issued in next year or two, should moderating factors--such as institutions' risk management--fail to work.

In 2018, passenger vehicle sales dropped for the first time in more than 20 years. The passenger vehicle sales during the first half of 2019 dropped by 14% compared with the same period in 2018. Macro and industrial factors, such as reduced benefits from tax cuts and slowing economic growth, depressed vehicle consumption.

S&P Global Ratings expects passenger vehicle sales in China to recover gradually in the second half of the year with the rollout of more stimulus. As such, we estimate the year-over-year decline to be around 2%-3% in 2019.

In light of weak vehicle sales, most AFCs are supporting their associated automakers to push into China's tier three to five cities (China's tiering system is not official but widely followed--generally, the larger the number, the smaller, poorer, and more politically peripheral the city). Compared with their expertise accumulated from increased penetration in top-tier cities, lower-tier cities are less familiar to the AFCs from a credit-risk perspective.

We believe this expansion into tier three to five cities will strain AFCs' underwriting standards, and their ability to maintain portfolio asset quality. Lower-tier cities in China tend to have more concentrated industries and economies. When rising leverage is matched with macro stresses, an individual's ability to service debt may be tested in profound ways.

A few factors may moderate such risk. For instance, all the AFCs that we reviewed have processes to monitor loan portfolios on a regular basis, identify key factors if portfolios deteriorate, and take prompt action to tighten underwriting.

It typically takes AFCs a few months to ramp up assets to a meaningful level. Moreover, auto loans typically sit on an AFC's balance sheet for six to nine months before being securitized. We therefore expect ABS with a meaningful portion of auto loans from lower-tier cities will only come to market in a year or so, at the earliest.

RMBS

We project China's RMBS sector to continue the stable performance it has recorded in the past two years or so. The cumulative default rate of RMBS transactions in China by annual vintage was around 0.3% or below--except 2015 vintage, where the cumulative default rate exceeds 0.6%. We believe long loan seasoning and low current loan-to-value ratio (the ratio of current loan balance over the initial property value) in part explains this low default rate.

The weighted average loan seasoning upon RMBS issuance is around three years, while the current loan-to-value ratio is around 50%. The higher cumulative default rate of 2015 vintage was in part to do with some small-bank issuers and low transaction volumes in that year.

The cumulative default rate of annual vintages (except 2015 vintage) should remain below 0.6% in the next 12-24 months, barring any shocks.

Chart 4

We believe the variance of underwriting skills will likely impact the performance of the RMBS sector over the next one to three years. We also consider what we call regionality risk, which looks at the breadth of an RMBS sponsor's operating base, and the location of this base.

Generally, an operating base with little geographic breadth and a homogenous economy is more risky than a more diversified base.

RMBS issuance sponsored by small and midsized banks has increased, and this trend could remain. In the first half of 2019, small and midsized banks issued RMBS accounting for nearly 20% of the total, from less than 10% in 2018.

Moreover, the performance of mortgage loans originated at small and midsized banks is diverging from that of mortgages created by the five large national banks.

The mortgage performance among the five large national banks is fairly convergent. However, if we compare the mortgage loan performance of small and midsized banks with that of China Construction Bank Corp. (CCB)--the lender being representative of the large national banks--the mortgages of the former perform erratically.

Chart 5

Chart 6

The divergence between the large national banks and the small-to-medium lenders can be traced to the widely varying resources that institutions can devote to the underwriting and servicing of their RMBS, and the regionality of the underlying loans.

We can discount other performance factors, such as loan attributes, which are largely homogeneous, and the maximum LTV ratio, which is highly regulated.

While China RMBS should be broadly stable, we expect the performance of individual transactions to vary more widely.

Securitization Market Opening Initiates Key Trends

The opening of Chinese securitization has transformed many aspects of this market, but we will focus on two frequently asked questions: the rising interest of offshore investors in Chinese securitization, and the tendency of auto loan ABS and RMBS sponsors to tap offshore investors.

Offshore investors' interest has been rising steadily

In 2018, the second year of the rollout of Bond Connect, foreign investors have held around Chinese renminbi (RMB) 12 billion (US$1.7 billion) of securitization notes, accounting for about 1% of the ABS and RMBS registered with China Central Depository & Clearing Co. Ltd. This is within our expectation given China has only recently opened credit-asset-backed ABS (including RMBS) and asset-backed notes to foreign investors.

However, over the past 18 months, we have received many more inquiries and seen much more interest in China's securitization markets. Moreover, offshore parties' participation and influence are greater than official figures suggest. Offshore participants may review the securitization transactions in China, submitted by affiliates on the ground. Such investments are booked as onshore transactions.

We expect to see a slow but continuous uptick in participation from offshore investors in the next one to three years. Meaningful market impact from offshore investors will likely only take place beyond that time.

Chart 7

Auto finance firms tap offshore investors; more RMBS originators to follow

Many auto-finance companies consider ABS as their regular funding channel. Some frequent issuers have maintained a pace of two to three ABS transactions a year, to diversify their funding sources.

Twelve auto finance companies offer ABS to offshore investors via Bond Connect, according to Wind. We believe China auto ABS issuance, especially that sold to offshore investors, will stay steady in the next year and to grow mildly over the coming two to three years.

CCB took the initiative on RMBS in 2018, issuing the first such deal that tapped offshore investors via Bond Connect. Various market participants have done much to broaden offshore investor base. The lead time to actual investment varies significantly from investor to investor.

We expect more Chinese banks to seek offshore investors via Bond Connect. The Jianyuan series RMBS, sponsored by CCB, has paved the way for domestic banks to tap offshore investors. Moreover, an industry-wide effort is likely to open the RMBS sector to offshore investors, a natural evolution seen in other developed markets, to reduce systemic risk in China.

Related Research

• China Is Shielding Its Automakers From Drastic Downturn, June 5, 2019
• China's Property Downturn Could Expose Regionality Differences And Vulnerabilities Among Developers, Jan. 29, 2019
• China RMBS: Top Originators' Mortgage Loan Performance Is Likely To Remain Consistent, Nov. 19, 2018
• Securitization's Small But Sure Role In A Deleveraging China, Oct. 11, 2017
• Securitization Performance Watch – China, published quarterly