China's zero-COVID policy and weak property market are hurting activity and confidence. At the same time, geopolitical risks are elevated, given the war in Ukraine and the ongoing tech-trade dispute between China and the U.S. S&P Global Ratings analysts discussed these issues at a recent webcast on the country's outlook.

In this article, we summarize discussions on growth and regulatory conditions for various corporate and financial sectors. Please also see two related reports covering other topics addressed at the event: "A Slower China: What Are The Macro Implications?" and "A Slower China: Is Stimulus Working And Who's Paying For It?".

A replay of the webinar is available here: "A Slower China: Cross-Sector Credit Updates." Registration will also provide slides and other related materials.

Zero-COVID--Subdued Economic Growth And Risks On Sectors

Both 2020 and 2022 have been characterized by COVID lockdowns in China. How does S&P Global Ratings measure the impact now versus then?

The more recent COVID strategy is in some ways harder on economic activity. This is particularly so in the case of industries most sensitive to people movements.

We sought to measure the intensity of the COVID situation by defining high-case days as days when total new cases exceeded 100 over a 14-day period, inclusive (see "China's Zero-COVID Stance Poses A Bigger Threat To Firms Than Inflation ," published on RatingsDirect on Sept. 20, 2022). Based on our calculation, about 19 provinces (representing two-thirds of China's GDP and population) had more high-case days in 2022 compared with 2020. And this comparative parameter is quite dramatic for a number of provinces. For example, Fujian (6x), Guangdong (4x), or Shanghai, Sichuan, and Zhejiang (3x-4x).

The real issue is that under a zero-COVID policy, these high-case days imply the activation of mobility restrictions--disrupting both the traffic of goods as well as people. Due to government efforts to resolve supply-chain problems, freight traffic has recovered very quickly from such disruptions. The same cannot be said for the volume of passengers--for example, it was down about 25% year on year as of end-July 2022, and that has a drag across multiple sectors.

Furthermore, we found that the correlation between GDP growth and high-case days has gone up to 0.6 this year versus 0.4 in 2020. In terms of GDP per capita and provincial growth, the correlation in 2022 is 0.4 against 2020's 0.24. This implies a stronger correlation between negative growth impact and income levels across provinces--which is to say that the higher-income population centers have been hit harder under these restrictions.

Mobility restrictions on passengers are having a direct hit on sectors such as business and consumer services, media, entertainment and leisure, real estate, and transportation cyclicals. These sectors also happen to be the ones that have the most negative outlook biases. So the story coming together is that the negative effects of COVID on China are now more or less driven by the zero-COVID policy and are specifically hurting companies that are more reliant on people mobility.

Could China fade as a global manufacturer? What does this mean for Chinese demand on commodities, coal and gas?

We think China is still resilient and will retain its strong global manufacturing position despite trade disputes and the pandemic disruptions in recent years (see "Cutting China From Supply Chains--Easy To Say, Hard To Do," June 1, 2022). Many long-term factors contribute to this: well-established production and transportation infrastructure, domestic supply chains, industrial ecosystems, a large skilled and well-trained labor force, and a very large and growing market. These provide incentives for global companies to build more facilities for production and research and development in China.

Gas and coal demand should stay relatively robust. Among coal-fired electricity generators, power demand growth is likely to moderate to 4.5%-6.5% over the coming several years. The increasing use of renewables will not immediately lower the demand on these resources in the short run, given energy security is a top priority.

What do the tougher U.S. restrictions on semiconductor-related exports to China mean for chip companies?

The U.S.'s recently passed CHIPS Act is another move in a long-term game for the U.S. and Europe to regain their footing in this industry. The measures may slow the development of advanced technologies elsewhere, but China is going to find its way to develop its own advancements. Various stakeholders are investing in a range of future technologies across the supply chain, from electric vehicles to semiconductors.

This latest move is not likely a surprise to the Chinese and we expect the government will push on with various supports and incentives to boost technology research and development (R&D). Even so, uncertainty has increased and the long-term implications are clearly negative for Asia-Pacific tech companies. The pain will be felt acutely for certain chip makers. Depending on the scope of the restrictions, there could be broader ramifications for the technology supply chain.

The slowing economy and low interest rates in China create special challenges for financial institutions (FIs). What are the implications on leasing companies' asset quality and profitability.

The challenging operating environment will definitely hurt the metrics of the leasing companies. The sector's net interest margin is on a downward trend due to the slower interest rate environment in mainland China. And asset quality continues to be under pressure; this is partially reflected in additional weighted-impairment losses, which will further squeeze the profitability of these sectors.

Polarization in this sector is already wide and will only intensify. Bank-affiliated leasing companies are top-ranking with relatively good asset quality and collateral levels as well as strong funding and liquidity positions. Hence, we assess the ratings on these companies as stable. However, smaller leasing companies and some privately owned companies will suffer more due to the economic slowdown and changing operating environment.

Do the COVID lockdowns and slowdown in consumption also hurt the Chinese insurance sector?

Yes. We see a negative credit trend for both China's life and property/casualty's insurance sectors due to constraints on their profitability. Tough macro conditions in China are spilling over to capital markets and keeping interest rates relatively low. This is weakening investment income and weighing on overall earnings for insurers. A prolonged market rout could erode their capital buffers. In addition, insurers may be tasked to support some distressed names to limit the market fallout.

In terms of premium income, slowing consumption and the strict COVID stance will likely challenge topline growth. Life insurers have been trying to shift their product offerings to those with higher margins, but progress is stymied. This is mostly due to COVID lockdowns, which deter interactions between agents and clients and subsequently hits distribution. However, in our view, long-term growth prospects are supported by rising insurance awareness and still-low penetration rates. In addition, the sector also benefits from government initiatives, especially in agriculture liabilities and health insurance.

Property Pain--Shaken Confidence Is Bad For Developers And Lenders

Will China's property sales bottom soon?

At this juncture, we are expecting sales to stabilize. However, uncertainty is still high. For example, over August and September, the central government intervened to support markets amid a "homebuyer strike" for uncompleted pre-sale units. The central government put up its own money to help ensure project completion and restore homebuyers' confidence. Nonetheless, it will take time for these policies to come into effect and for confidence to be fully restored. For September and "national week" holiday sales in early October, sales declined 20%-30% year on year.

For the full year of 2022, we estimate national property sales will fall by 28% to 33%--led mostly by volumes, with home prices down by 6%-7% (see "China Property Sales Set To Drop By A Third As Mortgage Strikes Break Out," July 26, 2022). Based on official statistics, year-on-year property sales have declined by about 30% year-to-date as of October, which is in line with our base case. We thus don't anticipate significant deviation from our numbers.

Will China continue with the "three red lines" policy? And what would that mean for the property sector?

Yes, the policy will likely continue, in order to contain leverage within the real estate sector as well as bank exposure to the sector. Over the past 12 months, voluntarily or involuntarily, a lot of public companies already reduced debt by the scale needed to avoid crossing the relevant "red lines." Meanwhile, we expect the overall policy to persist, giving the government's focus on curbing speculation around house prices.

How big is the exposure to real estate for the major AMCs; and are they helping to resolve property sector challenges?

The big four distressed asset management companies (AMCs) have relatively higher property concentration compared with other FIs such as banks. Nonetheless, their concentrations have been gradually shrinking in recent years. One indication of this is their exposure to the property sector--which averaged 40%-45% of their restructured-type distressed assets as of June-end this year, declining from more than 50% before 2019. In addition, these companies' securities investments and underlying assets or collateral on traditional distressed assets further add to their sensitivity to the troubled property sector.

We also note that as the big four distressed AMCs deepen their return to core businesses, they are guided by the government to shoulder more political functions. Examples include resolving the risks in property sector by participating in bankruptcy restructurings of property developers, establishing relief funds, and reviving stalled projects. However, we believe the AMCs will still prioritize putting money in more commercial-oriented projects and operate in a more "asset-light" way.

We do not expect AMCs to use their balance sheets to provide large amounts of direct liquidity support to troubled property developers, given their smaller size relative to banks and stringent regulatory capital requirements.

How has the property sector risk implicated banks? What does the recent stimulus by the government mean for the banks?

The direct impact is still quite manageable for banks at this stage. For loans to the property developers, we estimate the segment's nonperforming loan (NPL) ratio will further rise this year before improving next year. However, property development loans account for roughly 6%-7% of the total loan book in China, which is not that high.

Chart 2

For residential mortgage loans, asset quality has stayed relatively good, with reported NPL ratios far below the industry average. Recent mortgage strikes might put more bank loans at risk. However, we estimate the affected assets will roughly account for 2.5% of China's mortgage loans (see chart 2).

Property loans are usually well collateralized. And the banking sector, on average, has sufficient buffers even if provisioning is now slightly less conservative than the long-standing tradition for China banks.

Banks are still playing a very important role for property stimulus. For example, as per recent media reports, the Chinese regulator asked state-owned megabanks to extend at least Chinese renminbi (RMB) 600 billion (US$82.5 billion) of net financing to the embattled property sector in the final four months of this year.

In addition, banks are setting up real asset relief funds with local governments or state-owned enterprises to help restart stalled property projects and thereby reassure mortgage borrowers. During this process, banks carrying such policy burdens would see an increase in their property-development exposure. While the risk is elevated given the nature of the additional funding, a more stable property market with restored confidence is beneficial for the banking sector as a whole.

What are implications of the property sector challenges on structured finance issuances?

Negative. A decline in the origination of mortgage loans during the first half of this year will reduce the market need for residential mortgage-backed securities (RMBS). In the past, banks used to issue RMBS to offload their mortgage loans. The reduced need for this type of loan-book management has contributed to a total absence of RMBS issuance since mid-February. For the first half of the year, RMBS issuance dropped by more than 90% year-over-year.

Have mortgage strikes and COVID lockdowns hurt consumer credit, particularly for outstanding RMBS?

Not much so far--but we don't rule it out. Our rated RMBS transactions are not exposed to mortgage strikes because the underlying mortgage loans are backed by completed homes. In addition, thus far we see minimal impact from events such as mortgage strikes and COVID lockdowns, based upon the delinquency rates of our rated RMBS and cumulative default rates of the total RMBS outstanding.

Nonetheless, the vulnerability remains and potential damage may come from multiple fronts. Firstly, lockdowns disrupt mobility-related sectors. Retail borrowers working in such sectors may temporarily lose their income and therefore miss their payments. That said, after lockdowns are lifted, their liquidity could come back, enabling them to cover the payments.

Secondly, it's quite common to see Chinese mortgage lenders outsource their late delinquency collections to third-party collection agents. These collection agents tend to adopt intensive in-person methods to collect late delinquency loans and receivables. Due to lockdowns slowing down such in-person collections, we expect slightly greater volatility in late delinquency for the RMBS sectors for at least a quarter or two.

Editor: Cathy Holcombe

Digital designer: Evy Cheung

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