IFR Asia Outlook for Asian Credit Roundtable 2019: Part 2

Morgan Lau, Fidelity: The Chinese economy is really, really big, with a lot of people of various wealth and education levels, so it’s going to take some time to reform.

In the last four or five months, we’ve definitely seen some changes in client enquiries and sell-side market commentaries. Two to three years ago, the focus was on how to access the China onshore bond markets, about the basic supply demand dynamics of CGBs and onshore rates, etc. In the last four or five months, we are seeing more people talking and asking about onshore investment-grade or high-yield credits.

That’s a big change in the capital market. Even foreign investors care and have the confidence to look into the onshore credit market. Looking at the really big January aggregate financing figure, part of that had to do with the front loading of local government bonds issuance. This could be a way of replacing the role of allocating credits in shadow banking, in the form of letting local governments do their local financing. Just like Monica was saying, when the Chinese government wants to lend, they will lend. But there’s always the missing mechanism of going from the top level of easing, to the SME needing the money. And that’s one thing the large traditional commercial banks have not been efficient with over the years.

It was never just about leveraging or deleveraging in China, even in the last two years, but it was about the reallocation of credit. It hasn’t really worked for the last two years, but I’m seeing a bit of hope in terms of capital market development, as we are seeing more credit differentiation.

It’s a roundabout way, but, now that we have more local government bonds being issued, the hope is that they might go to the right place.

Ed Tsui, Deutsche: I agree with Cliff’s observation, and the manifestation of that in last year’s offshore credit market was very clear. There were clearly the “haves,” which had ample access to onshore liquidity, and the “have-nots” of property names which found securing onshore liquidity more challenging. In some of the conversations we had with investment-grade SOE issuers which were clearly in the “haves” camp, they felt pricing on the dollar offshore deals was very expensive versus onshore funding rates, and chose not to access the offshore markets. On the other hand, it would be interesting to monitor whether China property developers regain better access to the onshore financing markets. When issuers have diversified funding channels, that’s when you could see offshore credit spreads tighten.

Jini Lee, Ashurst: I think the story on the haves and the have-nots is really quite an interesting one. That’s really consistent with what we hear, talking to issuers and talking to bankers. You can get a really quite disparate story. You talk to a bunch of people and they’re saying how terrible it is. It’s the worst market they’ve seen. They can’t access any funding.

Really, that’s the have-nots. They’re really struggling to meet all their repayments. There have been a lot of companies that have raised very short-term paper last year, so 360 is actually not bad. We’ve seen some 180-day paper, right? You’re talking about that type of maturity.

Cliff Tan, MUFG Bank: The commercial paper.

Jini Lee, Ashurst: Yes, but you’ve got to ensure that you’ve got steady access to capital.

Ed Tsui, Deutsche: At double digits.

Jini Lee, Ashurst: At that sort of pricing, it really is quite frightening. Then you talk to another bunch of people and they say, “the market is awash with cash. There’s a lot of supply.” It’s really quite interesting how different that story is, really, depending on who you talk to. I think I’m not sure how much convergence we’re going to see in that this year, but the rally in these two months, we’re not quite sure how long it’s going to last.

IFR ASIA: Talking about the have-nots, we saw Qinghai Provincial Investment run into trouble. What are the main takeaways for prospective other defaults that could happen this year?

Jini Lee, Ashurst: They missed a coupon payment last Friday. I’ve looked at documents and technically there is no grace period for a missed coupon, so essentially they have defaulted, which will cross-default on their other financing, including the other offshore bond they have due 2021.

We hear some rating agencies have said that “We’re going to give them a couple of days’ grace period to see if they pay up.” I hear that the payment probably will go through this week, so that essentially will get cured, but it just kicks the can down the road.

There are other big payments coming due soon, so it’s pretty tough, I think, for some of the issuers out there at the moment. I think the credit differentiation point is a really important one. Obviously, the rating agencies have a big part to play in that.

Michael Taylor, Moody’s: We’ve been saying for some time that credit differentiation is the name of the game. When we’ve been looking at various categories of issuers in China, especially the likes of local government financing vehicles, we’ve been saying for some time that the old assumption around everyone essentially getting bailed out and all issuers effectively being equal in that respect, that assumption really has given way.

Jini Lee, Ashurst: It’s actually an interesting one on LGFVs because, if you read the prospectus or the offering circular, there is a risk factor to say that local government funding vehicles do not have implicit government support. The government is not obliged to bail them out.

Morgan Lau, Fidelity: Yes. The Chinese government advised the local governments that unless it’s related to the daily life of citizens, like utilities and transportation, local authorities are not actually allowed to bail LGFVs out anymore.

Jini Lee, Ashurst: Sure, and I think you do see that in the rating reports in terms of how important that local government funding vehicle is to the local economy, how many jobs it provides, whether or not the local government can really afford for this company to go under, because of the wider impact it will have on the local economy. As lawyers, we do our jobs, we do our due diligence, we write it in the documents, but obviously that’s got to be set in context with what the wider economic repercussions will be.

IFR ASIA: Can structures become more investor friendly, given this chain of events?

Jini Lee, Ashurst: Yes, when the markets were really quite exuberant a couple of years ago when they were starting to open up, we saw quite a lot of inverted structures that were really designed to get around difficult governmental approvals, such as approval from the NDRC that was required for direct issues. That’s where we started seeing keepwell structures, equity interest purchase undertakings and agreements to provide liquidity.

NDRC regulations have been amended for the quota system to allow PRC companies to issue directly so the structures are more straightforward. Otherwise there are cross-border guarantees from the onshore parent, which are a lot more straightforward than the structures before.

I think in terms of structuring a deal in China, it really is around the regulators and what sort of consents issuers are willing to get, because for them direct issuance or a guarantee will give you the best pricing, rather than a convoluted subordinated structure. We always work with issuers to see what they’re trying to achieve, and usually pricing is key.

Morgan Lau, Fidelity: I think overall it’s an education process. Comparing what we know about LGFVs now and three years ago, we have become more educated. Even onshore investors are more aware of the risk involved.

I remember a discussion I had with some onshore bond portfolio managers during a conference in Shanghai two-ish years ago. I was telling them about an offshore new issue by a privately owned Chinese developer that performed really well, and they told me that they wouldn’t buy that because of the lack of government background of the issuer. Then they told me of the LGFVs they would buy and I told them that offshore, we would be cautious of those. That kind of view is converging over the last two years. Offshore managers like us are learning more about the LGFVs, and onshore they are also differentiating between different provinces. I think it’s a very healthy development of the market although there will be growing pains. The market will continue to buy bonds from Chinese issuers, but investors will factor in those lessons and ask for the right price. That’s going to be quite healthy for the offshore and onshore markets.

Monica Hsiao, Triada Capital: I think we need to see more test cases, but I do think that the market has at least wisened up to, again, differentiating on what kind of assumptions to assign to credit enhancement packages and coming back to at least having a discussion about the underlying standalone credit first. I think we should always be starting with that and then thinking about layering what sort of assumptions of support based on the strategic value of the business.

KJ Kim, ANZ: One thing that we will have to monitor is how the China bid plays out. Whilst we have international investors here at the table, historically a large part of the LGFV demand has been from the Chinese investor base. Similarly to what Morgan has said, our conversations with investors onshore now show they’ve really woken up to the growing risks and they are not just buying anything anymore. That credit differentiation is happening onshore, as well as the Chinese investors offshore.

The international investors have been a lot more alert to the trend early on. In the past Chinese investors had been a little bit more indifferent when it came to their investment decisions, but now they’re clearly taking a look at this. That’s going to be a major factor, going forward, in terms of the haves and have-nots. We are going to see a clearer separation and a growing numbers of issuers potentially not being able to come back into the markets.

Cliff Tan, MUFG Bank: I hope that China will read all the rules and figure out what’s the right thing to do, but in the rest of Asia – in Japan, and I can certainly tell you about the rest of Asia outside of China – you did not see the issuers’ behaviour really change until after the Asian financial crisis. That is, after actual consequences struck.

IFR ASIA: Michael, what’s your take on LGFVs from a ratings point of view?

Michael Taylor, Moody’s: There have been a whole series of government documents that have tried to enforce this kind of differentiation, but again, as we’ve been talking about it, a lot of it comes down to whether or not this actually happens in practice. There have been a lot of government directives in terms of this not providing bailouts and support for LGFVs, and making this kind of differentiation, and restricting access to credit for those that are deemed to be performing a more, kind of, commercial function. All of these things have been around for some years.

I think we are now starting to see the cumulative impact of these different documents, although again I think, as we’ve been talking about, it comes back to incentives. You can produce all kinds of government directives, administrative decrees, but, if the incentive structure itself isn’t addressed, then trying to implement these directives is very difficult.

I think we are seeing more differentiation, though. The automatic bailout has effectively been ended.

IFR ASIA: I want to turn our questions to specific areas of the Asian credit market. Any ideas on issuance expectations for this year?

Ed Tsui, Deutsche: From our analysis, we see refinancing needs including bonds that are callable at approximately US$170bn this year. Net new financing last year was in the context of closer to US$135bn. I think net new financing comes down this year as there is heightened economic uncertainty, so I would expect net new financing to be in the context of US$100bn, so call it total U$275bn of issuance this year.

If you look at the supply dynamics so far this year, we’re up about 5% year-on-year, while corporate high yield is up over +50% yoy and investment grade is down -5% yoy. You can see that a lot of the high yield issuers who had a more challenging time in accessing financing last year have really jumped in to opportunistically access this strong offshore credit market.

Morgan Lau, Fidelity: Bonds by Chinese issuers account for over 50% of offshore outstanding issuances right now. But as the local market develops, will we see less offshore issuance two to three years down the road, just like how local capital markets in Malaysia and India led to less issuance offshore from these countries?

KJ Kim, ANZ: There’s going to be more offshore issuance from China, but as a percentage I don’t think it will increase a great deal. If you look at dollar G3 issuance from Asia, close to 70% comes from China. Whilst I think the overall volume will grow, is that going to increase in a percentage? I don’t think so. As a percentage, we feel that ex-China issuance will hold its own. If you look at the issuance growth in the other major centres I don’t think Korean volume will increase materially. Korean volume is very much just refinancing every year with the usual US$20bn-$25bn gross issuance per year. In South-East Asia there’s more legs, particularly in terms of where you see economic fundamentals and potential for investment growth. India in particular – whilst we’ll have to see where the elections fall out, looking at issuance patterns and the investments the corporate sector is looking to make – we’re hoping to see larger volumes.

China, however, will continue to take the majority of offshore volume unless we see the continued trend to what we’ve already seen this year – i.e. a prolonged outperformance of the onshore market. A large part of the refinancing coming due this year is in the SOE corporate and financial sector; whilst the financials will continue to issue internationally for their offshore requirements, we may see a drop in corporate issuance if they continue to favour the onshore market.

Just going back to your question in terms of where we think overall issuance will fall, I agree with Ed in that gross numbers are going to be up, we’re estimating a 15% increase, largely driven by a 50% jump in redemptions due; but overall net numbers are likely going to be down. We’ll most likely lose a part of the refinancing volume to the onshore markets but also to the other financing alternative – the loan market, which has been very strong recently.

IFR ASIA: Jini, do you know if we’ll continue to see private deals? We saw quite a bit of that activity, especially in the China high-yield space.

Jini Lee, Ashurst: We did see quite a big number of private-placement club deals last year. It’s just that when they’re building the book, I think there’s so much risk when they go out on a public deal that, if they manage to just get a couple of investors and get it done quickly, they do, because why not?

I think this year is different, at least at the start because the quotas have been easier to get from NDRC – and some of the issuers are also doing it to increase their publicity offshore. We’ve heard that even though offshore is, maybe, more expensive – and we asked them, “So, why would you want to issue offshore?” – they just want to build up their brand recognition. They want to diversify their investor portfolios, all of those reasons.

Yes, I think there will still be a healthy sort of private market there, which we’re happy for because things get quicker and there is more certainty to the deal getting done.

IFR ASIA: Are docs easier to do for private placements?

Jini Lee, Ashurst: Yes, because private placements generally are done where the investors are “big boys” and may know the name already, so documentation is lighter and often in the space of public disclosure. They may also be well known to the investor or have tapped the market before.

KJ Kim, ANZ: The thing that’s going to throw everything out the door is China’s TLAC in the next couple of years. There are estimates of TLAC requirements of US$0.5trn and up, with potentially half onshore. That means US$250bn plus has to come to the international markets.

Morgan Lau, Fidelity: Don’t we have, like 10 years’ time to do that?

KJ Kim, ANZ: Regulators have stated, by 2025 they will need to start implementing TLAC for 2028, but if the corporate and financial debt to GDP ratio in China hits the FSB’s 55% threshold they will need to accelerate implementation. With the debt to GDP ratio already at 50% and talking to the banks now, they are already assessing the markets. They will, however, have to wait to see whether the regulators come out with the allowed issuance structures and then assess the market accessibility. This is not an immaterial amount. If we’re talking north of US$250bn over the next five years that’s potentially going to be 20% of the Asia USD market annually.

IFR ASIA: Do you have any initial thoughts on TLAC right now, because I heard that the first TLAC China deal could come as early as the end of this year?

Morgan Lau, Fidelity: I think it’s a bit like, when offshore AT1s first came out, people were very concerned with the senior to AT1 spread ratios, and then after a while it became run-of-the-mill as AT1 curves are established. Same with Tier 2 when it first came out. As all those TLAC capital deals gained popularity, real senior bonds become a thing of the past, like those from Japanese banks. I think the same thing is going to happen with TLAC from China as well. When I think about it, I don’t just think about what bond issuance we’re going to see. I think about how that is going to change the business of the banks because, when 20% of your funding is going to come from capital markets rather than the deposit base, it’s going to change how you do business as well. It might even signal changes for the depositor. They might be pushed to buy more investment products and money managers like us are going to be investing more in deposit-like issuances. I think it’s going to have deeper implications to the market and to the economy than we think.

Cliff Tan, MUFG Bank: Do you get a sense, say among pension funds, that there will be a reasonable amount of appetite for this kind of stuff?

KJ Kim, ANZ: It will depend on the structure. If we look at the different TLAC structures: you have the holding company TLAC from the likes of Japan and the US, so effectively investors have been looking at this as senior debt from the hold-co, subordinated to op-co, and therefore the structure has been more palatable for pension funds and insurance companies; but when you start moving into the senior non-preferred, Tier 3 type structures, with the whole bail-in-able contractual language, it starts getting a little bit hairy for some of the more conservative funds. Having said that, the investors here have become accustomed to loss-absorption language from Basel III.

We will have to bear in mind the stance the regulators takes on the banks, as well. If they start imposing heavier capital penalties on holding each others’ TLAC, we’ll start seeing a reduction in investor appetite from the banking community. Particularly for China, because China banks buy China banks to a large extent, a reduction in bank appetite will see a lot more paper flooding into other investor classes, which in turn will put pressure on the overall market.

Monica Hsiao, Triada Capital: I guess it will also depend on, in the first generation, how much premium you guys will pay us.

Ed Tsui, Deutsche: My thought is the premium will always be larger for the first issue.

Monica Hsiao, Triada Capital: Exactly.

Ed Tsui, Deutsche: The premium will only get smaller with greater market adoption.

IFR ASIA: Before we end the discussion, Michael, are there any areas in Asian credit where you see more downgrades or upgrades?

Michael Taylor, Moody’s: Overall, our view on Asian credit is quite stable. If you look at the balance of outlooks across all of the different sectors, most of them have a stable outlook. That said, I think we do expect credit conditions to become more challenging this year. We’ve been talking about the recovery in the market since the start of the year. As I explained, I think there are fundamentals driving that, but I think, if we look at the year as a whole, we still expect it to be quite a challenging year.

Market volatility is not going to go away. We’ve been through a period in the last two months where we’ve seen a recovery in markets, but that may not last. Some of the issues, I think, have been driving the markets could well come back. Cliff had mentioned about the Fed not really being that clear in terms of where it’s going, and I think that there is a question mark there in terms of the future direction of US interest rates.

I think trade is certainly not going to go away. We see that as being the big driver of credit in 2019: that these trade tensions are going to resurface from time to time. Even if we do get an agreement between the US and China in the coming weeks, there are going to be other trade tensions that surface. We haven’t talked about some of the geopolitical risks that are outside the region, but we’ve got Brexit, we’ve got Italy within the EU. There are a whole number of issues that could flare up over the course of the year, so we’re expecting still quite a challenging year.

In terms of how does that impact in sectors and particular industries, obviously there’ll be quite a varied impact there, but I think, if trade does resurface as an issue, as we expect it to, that will certainly imply more market volatility, and probably slower economic growth across the G20.

IFR ASIA: That’s all the time we have for today. Thank you so much for joining us.