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September 30, 2021 | GSAM Connect

Credit Check-In: The Reach of Chinese Regulations

With the goal of achieving “common prosperity,” the Chinese government recently tightened regulations across a targeted yet diverse set of sectors, including education, gaming and property development, among others. The market reaction has been cautious to negative, but to widely varying degrees as investors seek to understand the full scope of the regulation and its direct and indirect impacts.

In this month’s Credit Check-In, we’re stepping back to take a wide view of what could be the knock-on effects of this latest round of regulatory action in China on credit issuers in the developed markets. Our overall assessment is that direct impacts are limited and indirect impacts stem largely from an increased risk of slower Chinese growth, varying by industry and even region.

Direct impacts: China’s latest regulatory tightening cycle

The latest China regulatory tightening cycle is unparalleled in terms of its duration, intensity, scope, and velocity (of new regulation announcements) as discussed in a recent Exchanges at Goldman Sachs podcast. Private education companies were the first to come under pressure, with negative market sentiment quickly extending to the gaming industry amid casino license uncertainty. But the reaction to regulatory tightening has been most severe in the property market. We expect policymakers will manage idiosyncratic situations but are mindful of negative sentiment spillovers to the broader Asia high yield (HY) market. We expect limited direct impacts in European and US credit markets, given their orientation towards domestic property markets.

Indirect impacts: risk sentiment and slower Chinese growth

The general uncertainty associated with the regulatory tightening in China can impact sentiment in global markets. For example, recent market volatility led several corporate bond issuers to postpone new issue plans, though primary market activity has since picked up.

In addition, a slowdown in the property sector owing to tighter regulations could present headwinds to Chinese growth, presenting indirect impacts for developed market corporate bond issuers that benefit from Chinese demand. Overall, we think these indirect impacts will be manageable given healthy corporate fundamentals, though we are mindful of divergent industry- and issuer-level impacts.

Industries most exposed to slower Chinese growth

Below we summarize our thoughts across the sectors with the greatest exposure to a slowdown in China:

China is the largest auto market, so any slowdown could be negative for the biggest auto companies. We think that auto credit issuers can absorb a modest decline in demand but a large downtrend could present negative implications for cash flow and earnings, particularly if the Chinese currency depreciates.

Commodity companies could face headwinds from any price volatility that arises from lower Chinese demand due to slower growth (though this is not our emerging market debt team’s base case). For perspective, China imports 10%-15% of the global crude oil market; its influence is not as great on natural gas prices as a relatively smaller importer (compared to oil) and the regional pricing of the gas market. China is by far the largest buyer of copper, nickel, and zinc, accounting for roughly 50% of global demand; reduced construction and manufacturing activity in China would pressure prices of these metals. A slowdown in China’s property sector would add further pressure to prices for iron ore and metallurgical coal, which are used in steel production. Thermal coal prices could see small negative impact if China imports less, but demand is likely to be resilient.

Interestingly, recent iron ore price declines have impacted metal and mining stock prices but corporate bond performance has been more resilient given improved balance sheet positions in the sector. Volatility in bonds issued by oil and gas companies has also been limited. Overall, we think there is cushion for IG issuers to absorb some price weakness given the run-up in prices this year.

Large US capital goods companies generate anywhere between 6% and 12% of revenues from China. Many European companies do not break out their exposure to China specifically, but the Asia-Pacific region can account for 15%-25% of revenues at some European companies and over 30% in some cases. Any slowdown in China is more likely to manifest in slower revenue growth for foreign IG companies with some potential impact on margins. The impact on credit quality should be limited, especially for US companies.

We are monitoring the impact on demand for commercial aircraft given the importance of the Chinese market, but do not expect to see a major impact on orders or deliveries given the current supply-demand outlook.

Some large consumer and luxury apparel companies have material exposure to China but we see the major players as having ample credit cushion to absorb any slowdown in that market.

Overheard at Goldman Sachs

“Spillover from China and the unwinding of easy monetary policy are headwinds. But economic growth is positive, aggregate corporate balance sheets are healthy, and yield remains in demand. While supply-chain issues and rising input costs are additional challenges, it’s important to note that more industries have high levels of pricing power, which should keep margins healthy. This is sufficient to keep the spread-sector ship sailing in a mid-cycle environment.”

— Ben Johnson, Global Head of Corporate Credit

Goldman Sachs Asset Management Forum | September 2021

 

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