1. Finance Lease Market Dynamics In China

1.1 Key Developments In China's Lease Market

Increasing penetration rate, albeit lower than more developed countries 

Leasing offers a funding alternative to traditional bank loans. This provides more viable and accessible funding to support operations for many start-ups and small and midsize enterprises (SMEs) with diverse credit profiles. Even for large enterprises, leasing has become an important supplement to bank credit in China.

China's leasing penetration rate, defined as the percentage of investment financed by leasing and hire purchase, has increased to around 10% in 2020 from mid-single digits in 2016, according to estimates by various market participants. Despite the upward trend, penetration remains lower than most countries in North America and Europe.

Market participants believe China's leasing sector has great potential to grow, largely driven by the country's structural adjustment efforts to upgrade the industrial sector since 2016, as well as its continued infrastructure development in recent years.

Slower growth after 2020 due to pandemic and economic slowdown 

Leasing balance in China saw double-digit growth during 2015-2017 (see Chart 1). Since 2018, the growth rate slowed, mainly due to China's tightened regulations on nonbank financial institutions following sweeping reforms to the banking and shadow-banking sectors. The COVID-19 pandemic and China's slowing economic growth in recent years also dragged down business momentum, although the overall leasing balance was still more than Chinese renminbi (RMB) 6 trillion --similar to the pre-pandemic level.

Chart 1

2. Characteristics Of Lease Market In China

2.1 Regulatory dynamics

The effective legal foundation of China's finance lease transactions is the PRC Civil Code, which prescribes the contractual rights and responsibilities of the finance lease contract. China is developing a Finance Lease Law for a specific and comprehensive legal and regulatory framework for this industry, but the legislation remains in the consultation stage.

Before 2018, China adopted a dual-track regulatory mechanism for leasing companies. 

China reopened the leasing market to domestic enterprises in 2004, and implemented measures to encourage foreign investment in leasing companies in 2005. Commercial banks were allowed to engage in leasing in 2007. Before April 2018, there were two licensing authorities--China Banking Regulatory Commission (CBRC, later merged into China Banking and Insurance Regulatory Commission; CBIRC) and Ministry of Commerce (MOFCOM). Each regulator is responsible for lease companies registered under their decrees--bank-affiliated leasing companies were regulated by CBIRC, while captive and independent leasing companies were regulated by MOFCOM.

In general, CBIRC-regulated leasing companies are licensed entities that are subject to higher entry thresholds, more comprehensive capital requirements, and a more frequent supervision process.

Since 2018 China has unified the regulatory environment for leasing companies. 

In April 2018, the CBIRC took over regulatory oversight for three types of quasi-financial institutions that were previously managed by MOFCOM: leasing companies (Shangzu); factoring companies, which specialize in financing accounts receivables; and pawn shops. The new regulatory framework has led to more stringent regulation of leasing companies that were previously supervised by MOFCOM.

On May 26, 2020, the CBIRC issued the "Interim Measures for Supervision and Administration of Finance Leasing Companies," imposing stringent regulatory requirements to leasing companies that were previously regulated by MOFCOM. For financial leasing companies owned by large financial institutions, CBIRC also issued "Financial Leasing Company Regulatory Assessment Measures (Trials)" in July 2020, providing greater clarity on regulatory measures and assessment procedures for financial leasing companies. In general, Chinese regulatory authorities have bolstered regulatory transparency and efficiency.

Table 1

Policy support for the development of the leasing industry 

China's government recognizes the benefits of leasing in facilitating and financing the country's investment needs and supporting SME and agricultural growth. For example, the General Office of the State Council issued guidance on promoting sound development of the finance lease industry in September 2015. This underpins the key role that leasing will play in the development of the economy, the support to SMEs, and start-ups, as well as industry upgrades and transformation.

2.2 Types of lease originators

Leasing institutions in China fall under three categories: financial leasing companies licensed by CBIRC, domestically owned leasing companies (Domestic Shangzu), and foreign-owned leasing companies (Foreign Shangzu). These categories differ greatly in terms of approval authority, nature of company, level of regulation, and business scope.

The leasing sector is quite fragmented. As of end-June 2022, there were 70 financial leasing companies, 431 domestically owned leasing companies, and 11,100 foreign-owned leasing companies in China. However, the top 10 financial leasing companies accounted for around a quarter of financial leases outstanding.

Chart 2

2.3 Types of lease products

Finance lease and operating lease 

A lease contract can be classified as either a finance lease or an operating lease. In a finance lease, the lessee will possess and use the leased asset during the lease term, and gain ownership of the asset upon the expiry of the contract. Lease payments return the full cost of the asset upon the end of the contract. In this arrangement, a finance lease is akin to a financed sale or, simply put, a secured loan.

In an operating lease, the lessee has only the rights to use the leased asset within the agreed lease period, and the risks and rewards of ownership remain with the lessor. The lease payment is consideration for the use of the leased asset, which does not include the component of capital buyout of the ownership.

The primary credit risk in a finance lease is related to the lessee's repayment ability (i.e., default risk). The lessor is not exposed to any market-value risk associated with the sale of the leased asset, which is a risk that may be associated with other lease products, such as operating leases.

Table 2

Direct lease and sale-and-leaseback  

Depending on how the lease agreement is settled, a lease can also be classified as a direct lease or sale-and-leaseback. Financial leasing companies as large-ticket lessors tend to adopt the sale-and-leaseback model, given their focus on aircraft and shipping vessel leasing. On the other hand, leasing companies with manufacturing backgrounds often adopt the direct-lease model, considering most leased assets (usually construction or manufacturing equipment) are manufactured by their affiliates. Other stand-alone leasing companies without banking or manufacturing backgrounds focus more on SME customers, and may employ sale-and-leaseback as well as direct leasing for their relatively diversified and broader industry coverage.

Underlying assets vary and require management expertise 

One global feature for leasing is the variety of assets leased, which generally reflects varying leasing demand. In China, leasing demand from state-owned and privately owned enterprises serves as a major driver for leasing volume. As a result, lease asset types largely reflect fixed-asset investments by such enterprises that are concentrated in the manufacturing and infrastructure segments over recent years. Rising demand for medical facilities and government support measures also promote demand for medical equipment leasing. Other industries, such as information technology, water conservancy, environment, public utilities, transportation, storage, and postal services also represent notable shares in the leasing market.

Given the variety of leased assets, leasing companies require industry-specific expertise in managing the leasing operation of different assets. Industry cycles could also pose challenges to leasing companies if their operations are highly concentrated in specific sectors. In view of the increase in investor inquiries regarding China's equipment lease asset-backed securities (ABS) market, S&P Global Ratings is providing a market overview in the following context focusing on equipment lease ABS to address some common queries.

2.4 Typical terms of equipment lease agreement

SMEs are major customers in the leasing sector. Such companies that are finding it difficult to obtain traditional bank financing often resort to leasing companies as an alternative. The interest rate under lease contracts is therefore higher than that of secured lending offered by banks, ranging from 5% to 20%.

Typical assets under equipment lease include manufacturing and processing machinery, industrial equipment and components, construction and decoration-related appliances, and electrical and electronic equipment.

Lease tenor mostly ranges from one to 10 years, depending on the leased assets' economic life.

Most lease agreements include a security deposit clause, which requires the lessee to post a certain amount of cash upfront to mitigate risk. In some cases, guarantors or other collateral (other than the leased asset) would also be required to further mitigate risk.

Lessees are required to make lease payments based upon the agreed amortizing schedule, which could entail payments every month, quarter, or six months. Balloon payments are rare, but still present in some lease agreements.

2.5 Origination and underwriting

Leasing companies in China follow regulatory guidelines, which specify lease asset types, maximum leverage ratio, and concentration limit. Financial leasing companies are also subject to additional capital adequacy requirements.

The leasing companies' target market segments and product offerings vary depending on their shareholder backgrounds and business strategies (see 2.3 Types of lease products). Nevertheless, companies across the board have made efforts to improve underwriting and risk management in recent years, based upon disclosures in publicly available offering circulars.

Financiers frequently employ scorecards for credit evaluation and risk classification. They also increasingly focus on lessees' operating condition and purpose of lease, and conduct onsite visits to varying degrees, depending on industry segment and asset type.

2.6. Servicing practices

Lease payments are typically made monthly or quarterly, depending on the associated agreement. Similar to other securitization transactions that we rate in China, most lessors (as deal originators and servicers) employ similar processes, procedures, and systems to support lease management and payment.

Given leasing's asset-backed feature, lessors monitor lessees' operating conditions and keep tabs on their leased assets to ensure timely receipt of lease payments, in order to avoid losses in case of a default on the lease.

For example, lessors can use satellite tracking devices to locate the leased equipment using a pre-installed transmitter inside. This is commonly used for expensive equipment across a variety of industries, such as heavy equipment for construction, refrigerated trucks and trailers, portable generators, stationary trash compactors, and medical equipment. These tracking units with a starter interrupt device (which allows a vehicle to be disabled remotely) help lessors know where the leased vehicle is, so as to take appropriate action when unauthorized or unusual usage is detected. This can supplement other risk models or behavior scorecards that lessors may use to identify risks before a potential delinquency occurs.

2.7 Arrears management practices

Like other financiers related to the securitization transactions that we rate in China, equipment leasing lessors generally adopt a staged approach to arrears management. Depending on the degree to which lease payments are in arrears, lessors can take actions such as automatic text messaging, phone calls, or on-site visits and restricting access to leased assets.

Lessors would also seek payments from guarantors (generally the manufacturers of the leased asset), or offset the required payments against the lessees' security deposit. For leases deemed to be in default, lessors initiate a foreclosure process, which may involve legal petitions and liquidation, or leasing the assets to a different customer. The length of the foreclosure process and recovery rate vary by asset type. Generally, arrears management tends to be more complicated for specialized and niche leased assets because the second-hand/resale market for these assets is not as developed as others, and it would be more challenging to identify a new lessee for these assets.

3. Lease-backed Securitization In China

3.1 Issuance size

Issuance of lease-backed securitization has been rising over the past few years. From 2015 to 2022, issuance volume grew at a compound annual growth rate of 25%, with leasing volume increasing to RMB312 billion from RMB67 billion, reflecting growth in the market. Lease-backed securitization accounted for about 15% of total securitization issuance during 2022.

In terms of originator type, leasing companies previously regulated by MOFCOM (Shangzu) have dominated issuance in recent years. This reflects surging demand for finance leases and Shangzu's funding needs, especially in the medical, manufacturing, and infrastructure segments.

We believe China's leasing market still has potential to grow, given the country's increasing focus on infrastructure development, and the adoption of automation in the construction and manufacturing processes. This could support securitization issuance in the next few years.

Chart 3

3.2 Key originators

There are quite a few frequent issuers in the equipment lease ABS sector. Ping An Leasing, Far East Horizon, Yuexiu Leasing, and Xuzhou Construction Machinery Group (XCMG) Leasing dominate issuance volumes as major originators. Each company has originated more than 10 transactions over the past two years.

These originators have diverse backgrounds and focus on different market segments. For example, Ping An Leasing and Far East Horizon, as stand-alone leasing companies without a manufacturing background , focus more on SME customers in a variety of sectors. These sectors include urban public utilities, healthcare, infrastructure construction, retail and consumption, and machinery. On the other hand, Yuexiu Leasing, as a state-owned enterprise, focuses more on civil engineering, water production and supply, and transportation. XCMG Leasing leases construction machinery, considering the group's background in manufacturing and that its parent is a state-owned enterprise. Depending on the originator's strategic focus, levels of industry exposure and obligor concentration vary, which may lead to differing performance trends and issuance prospects, subject to market demand.

3.3 Asset characteristics

Diverse profiles of lessees 

Lessees' profiles are highly diverse in China, similar to other countries. For many start-ups and SMEs with relatively weak credit profiles, a leasing contract is more viable and accessible. Even for large enterprises, leasing has become an important supplement to bank credit.

Based on our observations, underlying pools of lease securitizations may contain dozens to thousands of obligors, with varying tenors, interest rates, and contract amounts (see Table 3 for sample pool characteristics). Depending on the specific market segment in which an originator operates, lease performance could be highly sensitive to customer profiles and concentration in the specific pools.

Table 3

S&P Global Ratings analyzes the pool composition to derive its base-case default assumptions. Key factors include an obligor's credit quality and concentration, the industry mix, and geographic diversification. When single-obligor concentration exceeds approximately 1.5% of the relevant pool, the base-case default assumption will be supplemented with a test in case the largest obligor defaults, in order to address concentration risk.

Variety of leased assets 

In China's equipment lease securitization, the underlying leased asset could range from big-ticket items such as construction and factory machinery to relatively lower-value ones, including office machines and point-of-sale terminals for retailers. Lessors usually develop specialties in narrow market segments, financing different types of assets to lessees in various industries. Some originators could operate in many different sectors simultaneously to diversify exposure, but this requires additional efforts and expertise in managing different types of leased assets.

S&P Global Ratings conducts management meetings with originators and servicers during the rating process. Our qualitative assessment sets the base-case default rate. Potential qualitative adjustments include originator history and business model, competitive strategies and market position, market segment and management experience, as well as origination, underwriting, and servicing practices.

In addition, since operating assets and leases generally entail more operational risk, cash flows from the assets backing the securities would depend more heavily on active servicing, such as re-leasing, repossession, maintenance and/or remarketing servicers. Accordingly, from an operational risk perspective, equipment leases generally have higher severity risk for the servicer's importance to the assets' performance, compared with asset classes such as prime auto loans and residential mortgage-backed securities that we rate in China.

Amortizing lease as the majority  

Most lease receivables securitized in China are fully amortized, with payment to be made every month or every quarter. Customized repayment schedules exist, based upon our observations on frequent originator's securitized portfolios.

S&P Global Ratings assesses commingling risk exposure with the servicer, based on the amortization schedule and remittance frequency of asset collections to the issuer. We will address potential loss or delay in cashflow analysis to address the commingling risk if there is no sufficient structural mechanism in the transaction to protect the issuer from any loss or delay in receiving funds in the event of the servicer's insolvency.

Varying seasoning with contract tenor of three to five years  

Frequent originators are offering equipment leases with tenors of three to five years. The seasoning of securitized pools ranges from one month to 15 months in most transactions.

S&P Global Ratings considers seasoning and the remaining term to maturity in its ratings analysis. While a higher level of seasoning is typically a positive factor in our credit analysis, it does not always result in a reduction to the expected defaults that a pool may experience over its remaining life. A reduction in our default assumption to adjust for pool seasoning generally applies to assets with default-timing patterns that are consistently front-loaded.

Security deposit as common collateral 

Equipment leases in China generally require lessees to leave some money with the lessor when the lessor makes disbursements under the lease agreement. The security deposit is meant to protect the lessor by discouraging the lessee from defaulting, or reducing the loss of the lessor if the lessee defaults. The lessor could keep the security deposit if the lessee defaults on payment obligations. The security deposit amount may vary based on lease asset type and customer profile, but mostly ranges from 0%-25% of the lease amount in frequent originators' securitized portfolios.

In most securitization transactions, the originators will continue to hold all security deposits rather than transferring them to the issuer upon transaction close. Commingling risk associated with security deposit setoff may arise in such circumstances. Should the originator go into bankruptcy and in case the lessees try to set off those deposits against their obligations under the lease agreements, the lease receivables under the lease agreements payable to the securitization issuer could be reduced due to the potential setoff. In such a scenario, the originator may not be able to indemnify the securitization issuer for such setoff due to the difficulty in differentiating lessees' security deposits from the originator's other assets, known as the commingling risk. This can be viewed as a set-off risk because it arises from lessees exercising their set-off rights.

S&P Global Ratings considers potential set-off loss in its cash flow analysis, in the absence of a sufficient structural mechanism to mitigate the risk of originator insolvency before security deposits are transferred to the issuer account.

Asset ownership with the lessor  

In a typical securitization of finance lease receivables, the ownership of the leased assets and the underlying lease contracts will not be transferred to the issuer by the originator (or the receivables seller) upon transaction close. And the originator will remain the nominal owner of the leased assets until a rights perfection event occurs.

Despite the sale of the lease receivables to the securitization issuer, the bankruptcy administrator of the originator (upon the bankruptcy of the originator) may disclaim or terminate the contracts (executory contracts) per Article 18 of China's Enterprise Bankruptcy Law, on the basis that those contracts remain "outstanding and performance yet completed by both the lessor and the lessee." Were the contract termination risk to materialize, the bankruptcy administrator could require the lessee to return the leased assets, and the lease payments to the issuer would cease.

S&P Global Ratings typically assesses this risk by reviewing the nature of lease agreements and the effects of lessor bankruptcy. For example, we will look into when and how the title of the leased asset will be transferred to the issuer, and how that links to changes in the ratings/creditworthiness or financial performance of the lessor. We also consider other elements, such as contractual obligations constraining the lessor or its bankruptcy administrator's rights of contract termination. We might apply a rating cap in the absence of structural arrangements to mitigate this risk.

3.4 Typical deal structure

Simple capital structure 

Like most other ABS transactions in China, equipment lease-backed ABS typically adopt simple payment hierarchies, with two or three classes of notes issued. The capital structure is generally made up of senior and subordinated notes, with subordinated notes generally unrated and held by the originator. Credit enhancement therefore mainly comes from note subordination. Some transactions also have the originator or its affiliate acting as payment shortfall provider. This trend, seen commonly in China, is mainly driven by local investors.

Single waterfall as well as separate principal-and-interest waterfalls are common  

Equipment lease ABS transactions in China can adopt a single waterfall or separate principal-and-interest waterfalls. In either kind of payment waterfall, principal collections can be used to cover liquidity shortfalls when needed, before being used to pay down notes in a typical pass-through and sequential manner.

S&P Global Ratings' cash flow analysis reflects the transaction's payment priority and structural arrangements.

Excess spread serves as soft credit support 

Due to the relatively high asset yield compared with the note coupon, excess spread can serve as soft credit support under the single waterfall structure, or the turbo-pay arrangement in a separate waterfall structure. The turbo-pay arrangement of note principal payment usually comes along with acceleration event triggers linked to asset performance and other material events, such as originator insolvency or servicer termination.

S&P Global Ratings models excess spread and its usage under various stressed scenarios. We have observed that transactions tend to have more soft credit support when the excess spread is larger and can be used to pay down notes, with relatively loose turbo-pay conditions to be met.

Revolving structure  

Like other ABS transactions in China, the adoption of revolving structures is becoming popular, driven by originators' funding efficiency and investors' needs. Under a revolving structure, additional lease receivables will be purchased per in line with asset eligibility criteria during the reinvestment period. Upon the end of the reinvestment period or the occurrence of an early amortization event, the transaction will stop reinvestment and start amortization. Those amortization events are generally performance-based triggers, such as the cumulative default rate exceeding a certain threshold, and material adverse events, such as enforcement or servicer termination.

S&P Global Ratings considers asset eligibility criteria and structural arrangement for the purchase of additional assets. This helps form our view of the potential migration of pool features upon deal amortization.

4. Asset Performance Will Likely Fluctuate Along With Economic Conditions

Based on our observations of equipment lease ABS issued under the credit asset securitization scheme, there have been no asset arrears recorded during the past five years.

The credit quality of assets, which is linked to China corporations' industry and business performance, is sensitive to macroeconomic conditions and policy risk in China. It is also highly correlated to customer profiles and industry concentration for the specific pools and market segment in which the originator operates.

Related Criteria

• Global Equipment ABS Methodology And Assumptions, May 31, 2019

Related Research

• China Securitization Performance Watch 4Q 2022: Issuance Set For Modest Recovery In 2023, Feb. 15, 2023
• China's New Financial Leasing Rules Strengthen The Overhaul, Jan. 9, 2020
• Financial Leasing Firms Are Next In Line As China Reform Gets Granular, Nov. 15, 2019
• How S&P Global Ratings Assesses Certain Legal Risks In China Finance Lease receivables Securitization, Feb. 25, 2019