China's banking sector deepens reforms

In late May 2019, China's financial regulators took administrative control of a city commercial bank.¹ Many market participants are wondering whether this was a one-off incident, or if other financial institutions will face similar challenges.

Based in Inner Mongolia, Baoshang Bank (BSB), which is rated AA+, had not published financial reports since the third quarter of 2017;² it faced accusations that its largest shareholder had misappropriated bank funds. According to the People’s Bank of China (PBoC) and the China Banking and Insurance Regulatory Commission (CBIRC), the administrative takeover was intended to safeguard against systemic risks, protect the legitimate rights and interests of depositors and other clients, and ensure that the business operations of BSB were not suspended.³ BSB was also an active participant in the interbank market: The bank had outstanding interbank liabilities (certificates of deposit) of RMB$60 billion when it was taken over. While small depositors will likely remain protected, larger creditors could potentially face losses.⁴

Looking at the bigger picture, we view this action as the government’s attempt to deepen reform in the financial sector, particularly for smaller, lower-tier banks. With approximately 4600 banks⁵ in China, ranging from the large state-owned and joint-stock commercial entities, to rural and city commercial banks, the move marks a deepening of the regulatory oversight on the lower-tier firms.

We noticed that some of the lower tier banks in China have similar disclosure issues to that of BSB. In fact, roughly one week after the takeover, the auditors of the Bank of Jinzhou (which had not published its 2018 annual results) resigned after they determined a portion of the bank’s loans to clients were not used for the stated purpose. Overall, 15 other Chinese banks have delayed or failed to disclose their financial reporting this year: 12 of which are rural commercial banks; the remaining three are city commercial banks.⁶

We think this event symbolizes important changes in the financial sector. Previously, investors believed that the government would backstop potential losses in the interbank market. This led to an increase in moral hazard. Although the final outcome of negotiations between creditors and regulators has not yet emerged, we believe investors should be aware that the implicit guarantee assumed by many for financial institutions likely may not apply in the future.

China’s banking sector: asset improvement amid increasing differentiation

Taking a broader look at the banking system, we see improvements in asset quality. Problem loans represented 4.8% of total lending at the end of March 2019, the lowest figure in five years; general reserves and capital levels in the system also stood at multi-year highs during the same period.⁷

However, the improvements are mainly being seen among the large state-owned and joint-stock commercial banks, while city commercial and rural commercial banks face ongoing difficulties due to deteriorating asset quality, inadequate capitalization, and an over-reliance on wholesale funding. We expect that this credit-differentiation trend within the banking sector will continue and investors could consider moving up in quality and focus on the large state-owned and selected joint-stock commercial banks.

That said, we do not anticipate a systemic shock or crisis among Chinese banks, even if there are more BSB-type incidents. The banking system will continue to de-risk; furthermore, financial regulators will ensure that any credit events in the banking sector will be well contained.

Looking ahead: refinancing efforts will be key

As the Chinese economy experiences challenges, we anticipate an uptick in defaults. Indeed, there has already been a rise in defaults among privately-owned enterprises in China as the onshore default rate rose to 4.6% in 2018 from 0.7% in 2017; the default rate has remained elevated in the first five months of 2019 at 2.1%.⁸

Moving forward, Chinese government policy should play an influential role in credit markets. The PBOC’s current accommodative monetary stance should be generally supportive of debt refinancing efforts. However, we believe that not all sectors will benefit equally. In particular, we see an increasing risk of defaults in the high-yield China industrial space, as many first-time issuers are scheduled to repay their offshore bonds over the next two years. We think that refinancing will be a challenge as investors have remained skeptical on some of these credits due to poor disclosure and weak corporate governance.

Active fiscal policy should also support key segments of the market. For example, we think that state-owned enterprises (SOEs) that are closely linked to government policies or have systematic importance should be one main beneficiary, as the government rolls out plans to support local enterprises with infrastructure and related government spending. Indeed, we have seen an uptick in onshore issuance by SOEs with lower funding rates as liquidity conditions have improved. Onshore default rates of SOEs have also stayed low as a majority of defaults this year are from privately owned enterprises. Nevertheless, we still hold a cautious view on lower quality SOEs with weak standalone credit profiles and limited strategic importance, some of which have experienced near-defaults or coupon payment delays in recent months.

As a key contributor to the Chinese economy, the China property sector is also likely to benefit as the government looks to stabilize growth amid the escalation of U.S.-China trade tension. In recent months, we have seen policy easing in selective cities on home purchase restrictions and lower mortgage rates, which led to a recovery in developers’ contracted sales.⁹ Refinancing risks for China developers have been reduced as many have pre-funded their maturing debt through new bond issuances in the first four months of this year.

Finally, we will be closely watching a new wave of funding needs for China’s local government financing vehicles (LGFVs) in the offshore U.S. dollar bond market, as offshore debt maturities will be elevated in the next three years with annual maturities of over US$10 billion.¹⁰ We believe this transition will be a true test of LGFV refinancing ability. Markets, to a certain extent, still expect that a majority of these bonds will be refinanced, as there has not been any recent default of offshore LGFV bonds. If that doesn’t happen, investors may revisit some of their assumptions regarding implicit guarantees of government debt.

Investor vigilance and security selection still key

Overall, we believe it’s in China’s best interest to allow some companies to default on the condition that it wouldn’t have a systemic effect, and is executed through a managed approach. Again, security selection is vital—with markets so tough, we should see increasing divergence. During good times, all companies trade well, but it’s only when the market turns that you will see which firms are the ones with strong fundamentals.

1 The People’s Bank of China, as of May 24, 2019. 2 Dagong Global Credit Rating Co., Ltd., October 31, 2017; Reuters, May 30, 2019. 3 The People’s Bank of China, as of May 26, 2019. 4 The People’s Bank of China announced on May 24, 2019, that it will backstop corporate deposits and interbank liabilities below RMB$50 million, while liabilities exceeding RMB$50 million would be negotiated with creditors. 5 China Banking and Insurance Regulatory Commission, as of December 2018. 6 Securities Times, May 27, 2019. 7 CBIRC, May 10, 2019. Problem loans are defined as special-mention loans and non-performing loans. 8 Bloomberg, May 8, 2018; Goldman Sachs, May 39, 2019. 9 “New home prices rise in almost all Chinese cities as lower mortgage rates, lighter restrictions spur demand,” South China Morning Post, May 16, 2019. 10 Citibank, January 2019.   

Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.

The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.

This material, intended for the exclusive use by the recipients who are allowed to receive this document under the applicable laws and regulations of the relevant jurisdictions, was produced by, and the opinions expressed are those of, Manulife Investment Management as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only as current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.

Neither Manulife Investment Management or its affiliates, nor any of their directors, officers, or employees, shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment, or legal advice. Past performance does not guarantee future results.

This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer, or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit nor protect against loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management.

Manulife Investment Management

Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than 150 years of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.

These materials have not been reviewed by, are not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at www.manulifeim.com/institutional.

Australia: Hancock Natural Resource Group Australasia Pty Limited, Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area and United Kingdom: Manulife Investment Management (Europe) Ltd. which is authorised and regulated by the Financial Conduct Authority, Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Asset Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad (formerly known as Manulife Asset Management Services Berhad) 200801033087 (834424-U) Philippines: Manulife Asset Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. Thailand: Manulife Asset Management (Thailand) Company Limited. United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Hancock Capital Investment Management, LLC and Hancock Natural Resource Group, Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited. 

505154

Fiona Cheung

Fiona Cheung, 

Head of Credit Research, Asia ex-Japan Fixed Income

Manulife Investment Management

Read bio