Chinese banks exposed to considerable latent asset risks: Moody's

Almost a fifth of corporate debt is supported by cash flows that do not fully cover interest expenses.

Moody's Investors Service says that Chinese banks are exposed to considerable latent asset risks, based on a bottom-up analysis of a large sample of the financial results of Chinese corporate borrowers.

Moody's analysis suggests that almost one fifth of corporate debt in the sample is supported by cash flows that do not fully cover interest expenses. Nevertheless, Moody's believes that only a fraction of this potential debt at risk is likely to crystallize in the form of non-performing loans (NPLs) in the banking system.

Here's more from Moody's:

In recent years, the aggregate financial metrics for the sample non-financial corporates have weakened, with a rising debt/EBITDA ratio and a falling EBITDA/interest expense coverage ratio.

If debt "at risk" is defined as borrowing by companies that have an interest coverage ratio (EBITDA/interest expense) of below 1x, then 19.7% of the outstanding debt of the sample companies in the Moody's analysis would be classified as "debt at risk".

At the same time, Moody's believes that it is difficult in practice to draw a direct relationship between the corporate debt at risk data in the study and the banks' stock of NPLs. In addition to bank loans, sources of debt funding for corporates in the sample would include bond issuances and borrowings from non-bank financial institutions and from wealth management products.

Bank loans, on the other hand, include not only lending to the large and medium-sized corporates represented by the sample companies, but also small- and medium-sized enterprises (SMEs) and individuals.

Even though Moody's estimate of corporate debt at risk is significantly higher than the banks' reported NPL ratios, Moody's does not consider the debt at risk estimate in the sample to represent the true level of corporate NPLs, given that:

- A large proportion of the incremental corporate debt in recent years funded investments in infrastructure and urban development, which tend to have long payback periods and slow ramp-ups in cash flow. Despite current weak interest coverage, a portion of such projects will eventually turn out to be viable.

- A large proportion of the corporate debt has been incurred by central and regional/local government state-owned enterprises (SOEs). Potential support from governments for such entities reduces the likelihood of losses for the banks and other creditors.

- A significant proportion of borrowers experienced weak cash flows and interest coverage due to a cyclical downturn in their industries, for example, mining, commodities and steel. A reduction in excess capacity and a recovery in commodity prices should strengthen such borrowers' credit profiles.

- Sustained economic growth in China, the government's control of the largest banks and borrowers, the strong liquidity profiles of the largest Chinese banks, and capital account restrictions reduce the likelihood of widespread corporate defaults.

The sample of companies in the analysis consists mainly of large and medium-sized enterprises. The credit profiles of small and medium sized enterprises (SME) may differ from those of the medium and large enterprises that Moody's analyzed.

Lending to SMEs accounted for one third of overall corporate bank loans. To the extent that the distressed debt ratio on SME lending differs from that for lending to large and medium-sized corporates, it would lead to changes in overall estimates of loans at risk for the system.