COVID-19's latest resurgence in China came at a time when risks are rising for Chinese corporates. Higher leverage, weaker cash flows, tighter liquidity, and volatile financing conditions are biting. And all this is occurring amid unprecedented distress events and regulatory actions.

S&P Global Ratings believes COVID's world-wide resurgence and China's zero-tolerance approach may exacerbate these stresses and push rating momentum further into the negative if outbreaks continue to bring mobility restrictions that disrupt large parts of the country.

We anticipate the government will continue its push against excessive leverage and market abuse. Unlike last year, we do not expect a large stimulus to boost corporates over the near term. As a result, corporate risks will remain elevated as the pandemic persists, overshadowing our outlook for the second half of this year.

Latest Outbreak Shows Potential Of Rapid Spread and Broad Disruptions

The latest outbreak in China showed that new COVID strains can spread rapidly and that mobility restrictions resulting in broad disruptions will be the response under the country's zero-tolerance approach.

Weeks after a reported outbreak in Nanjing on July 20, 2021, confirmed COVID cases in China spiked to a seven-month high as they grew at a pace not seen since their December 2020 and January 2021 peaks (see chart 1).

As new cases spread to over 50 cities across 19 provinces, the government ordered mass testing within two days of all cities with less than five million population, and within three days, for cities with more than five million. Travel restrictions were re-imposed, including by the capital Beijing, and social distancing measures came in to force in over 200 medium-and-high-risk regions across 13 provinces.

These measures effectively drove down case growth, but they showed that even a targeted response involves disruptions across large parts of the country. The need to manage recurring episodes of outbreaks and lockdowns under the zero-COVID approach adds additional burdens to corporates in the country, which have yet to fully recover and are seeing weakening credit trends.

Chart 1

Rating Momentum Turning Negative Again

As new infections hit, COVID's past waves continue to weigh on Chinese corporates. And even before the pandemic, companies had for two years been grappling with the country's slowdown and a trade war with the U.S.

As a result, net rating actions in our portfolio have been negative since 2018. In 2020, COVID pushed the balance deep into the negative until stimulus measures and an initial recovery drove a reversal late in the first half of 2020.

Positive momentum followed but began to lose steam by the middle of this year (see chart 2). There's less scope for a similar reversal since stimulus measures won't come to the rescue. Further exogenous shocks, such as the pandemic digging in again, could lead to negative rating actions.

Chart 2

Negative Outlook Bias Points To Risks Ahead

Chinese corporates are showing a 10% negative bias in rating outlooks (see table 1). This indicates materially more downside than upside risks ahead. Our outlook bias is derived by subtracting positive from negative outlooks and CreditWatch statuses and dividing the balance by the number of ratings outstanding.

Sectors with nearly 80% of issuers are showing negative outlook biases. Among them, larger sectors with particularly negative biases include auto (39%), capital goods (17%), local government financing vehicles (LGFVs) (17%), media and leisure (60%), and real estate (13%).

Table 1

Issuers in the capital goods sector will face several tests, including slowing demand, environmental-related disruption, and higher raw material prices (see "China's Capital Goods Cycle Is At The Top Of The Roller Coaster," July 28, 2021).

Weaker LGFV and real estate issuers are still exposed to elevated refinancing risk under the government's leverage containment policies. This has tightened financing conditions and driven rising defaults among state-owned enterprises (SOEs) and developers, a trend we expect to continue in 2H21 (see "China Bond Defaults 2021: More Tolerance For Bigger Hits," June 23, 2021).

In the auto sector, the outlook bias remains highly negative, even though the downward momentum has moderated since late last year alongside the market recovery (see "China Auto Industry Is On Track For Healthy Growth," March 9, 2021). While the recovery should continue, key risks cloud the horizon. These include recurring chip shortages and COVID controls that are disrupting global production and supply chain, and rising raw material prices and freight rates that are adding to cost pressures (see "Nexteer's Margin Recovery Could Steer Off Course On Supply Chain Stress," Aug. 19, 2021)

Debt Growth To Moderate As Capex Slows

COVID led to an escalation of leverage at our rated entities, with median ratio of adjusted debt to EBITDA rising to 4.7x in 2020 from 4x in 2019. This reverses a three-year declining trend.

We expect leverage to normalize this year and next year, but it will likely remain at historical highs and stay well above pre-pandemic levels until at least 2022 (see chart 3).

Chart 3

We project debt growth to moderate among our rated corporates (see chart 4a) since leverage levels are already high: 3.7x for investment grade and 5.7x for speculative grade. There is also restrained investment appetite and active government policies against excessive debt.

Capital expenditure, while high compared with last year's low base, will grow at only a two-year average of 7.7%. This is slower than the pre-pandemic level of 10%, which helps reduce the need to undertake additional debt (see chart 4b).

Chart 4a

Chart 4b

Weaker Margins and Slower Revenues to Delay Deleveraging

While debt growth should slow, we also project EBITDA margins to decline and revenue growth to moderate (see chart 5). This could strain companies' ability to generate cash flow for servicing interest and debt payments under their existing debt stock.

Chart 5

A key driver of margin pressures is higher input costs. Higher commodity prices can benefit some upstream enterprises, but they can also squeeze profit margins downstream for firms that face higher raw material costs.

China's producer prices have been accelerating since late last year, but its consumer prices have been relatively flat and remain well below pre-pandemic levels (see chart 6). The pass-through from higher producer prices to consumer prices in the country is typically weak. This leaves firms caught in the middle to bear the difference. (See "Asia-Pacific's Recovery Regains Its Footing," June 23, 2021.)

Chart 6

As the effect of higher input costs plays out, margins are likely to weaken further. Revenue growth should be healthy this year on the back of the recovery. However, we expect it to decelerate meaningfully next year as investments slow and the recovery provides less of a boost.

Shorter Maturities And Tighter Liquidity Build Risks

Many Chinese corporates face relatively shorter maturities as financing conditions tighten.

For speculative-grade issuers, the median weighted average debt maturity is only 2.3 years. For investment grade, it is only a year longer at 3.1 years (see chart 7).

Around these medians, meaningful numbers of issuers face shorter maturities and tighter liquidity, with little or no access to long-term financing.

Chart 7

Among our rated issuers, roughly 14% have less-than-adequate to weak liquidity, in our view. The largest sectors where maturities are shorter and such risks are higher include consumer products, real estate, and mining and minerals. These three sectors witnessed the most defaults last year. So far this year, real estate and mining and minerals have had the most defaults (see chart 8).

Chart 8

Regulatory Risks Exacerbate Vulnerabilities

Weaker fundamentals, shorter maturities, and tighter liquidity and financing conditions leave issuers more vulnerable to shocks. Recuring episodes of COVID outbreaks and broad mobility restrictions could add to a near-term outlook already overshadowed by regulatory risks.

We anticipate these risks will continue as the government increasingly focuses on addressing the imbalances between economic growth and social equity. Its many and varied objectives include leveling the playing field, ensuring data security, and protecting consumer and worker rights. At the same time, it seeks to reduce the cost of living, particularly housing, education, and health care.

Such objectives are not new. It's the way they are implemented and communicated that could bring surprises and drive market volatility. This could in turn raise funding costs, aggravate liquidity risks, and unexpectedly restrict capital market access.

The message from the Political Bureau meeting held on July 30, 2021, implied a less optimistic view of economic growth. Yet, the government has shown no sign it will backtrack on its regulatory efforts because of growth concerns.

Balance Of Defaults May Change Between POEs And SOEs

Many recent policies, including those above and those aiming to reduce leverage, can inadvertently have a greater effect on privately owned enterprises (POEs).

Market volatility, compounded by unexpected regulatory actions, makes it harder for POEs to access funding. As a result, the slowdown in POE defaults over the past few years may now reverse (see chart 9).

In the case of SOEs, defaults have accelerated in recent years, and are likely to continue rising. However, cases may grow at a slower pace. Concerned by the impact of escalating SOE defaults, the central government has pushed local governments to improve debt management among their SOEs (see "Institutional Framework Assessment On China's Local Governments Raised On Central Government's Tightening Control," Aug. 30, 2021). These efforts may start to bear fruit if associated policies and guidance continue with sufficient force.

Chart 9

Related Research

• Institutional Framework Assessment On China's Local Governments Raised On Central Government's Tightening Control, Aug. 30, 2021
• Nexteer's Margin Recovery Could Steer Off Course On Supply Chain Stress, Aug. 19, 2021
• Pandemic Is Disrupting 2021 Growth Outlooks In Southeast Asia, Aug. 18, 2021
• China Internet: Navigating A New Regulatory Landscape, Aug. 2, 2021
• China's Capital Goods Cycle Is At The Top Of The Roller Coaster, July 28, 2021
• China Bond Defaults 2021: More Tolerance For Bigger Hits, June 23, 2021
• Asia-Pacific's Recovery Regains Its Footing, June 23, 2021
• China Tweaks Its Template On SOE Defaults, April 27, 2021
• China Defaults Flag Provincial Risks, March 11, 2021
• China Auto Industry Is On Track For Healthy Growth, March 9, 2021