Preparing for a Turn in the Chinese Credit

Cycle

November 2018

Glenn Levine, Associate Director

David Hamilton, Managing Director

Preparing for a Turn in the Chinese Credit Cycle 2

Speakers

David Hamilton, PhD

Managing Director

Credit Risk Analytics, Asia-Pacific

Singapore

Glenn Levine

Corporate Stress Testing

Model Lead, Credit Risk

Analytics Group

New York

Preparing for a Turn in the Chinese Credit Cycle 3

1. Recent performance and outlook for the Chinese economy

2. Using an equity-based model to analyze Chinese corporate credit

risk

3. Early warning and monitoring strategies for corporate credit

exposures

4. Stress testing your corporate loan book

5. Q&A

Agenda

1Recent performance and

outlook for the Chinese

economy

Preparing for a Turn in the Chinese Credit Cycle 5

China’s Economy Has Been Growing Strongly…Chinese GDP growth, % year-over-year

0

1

2

3

4

5

6

7

8

2014Q1 2015Q1 2016Q1 2017Q1 2018Q1 2019Q1 2020Q1

Forecast

Source: Moody’s Analytics

Preparing for a Turn in the Chinese Credit Cycle 6

…But This is Partly Due to Higher LeverageChinese lending to non-financial corporates, % of GDP

0

20

40

60

80

100

120

140

160

180

2006Q1 2008Q1 2010Q1 2012Q1 2014Q1 2016Q1 2018Q1

Source: Bank of International Settlements

Preparing for a Turn in the Chinese Credit Cycle 7

Is China’s High Corporate Leverage a Problem?

» China’s corporate debt ratio (160% of GDP) looks dangerous compared to

the US (74%), Japan (99% currently; 150% in 1999), and its own recent

history

» But:

– Most debt is in RMB (which removes currency risk)

– The government has considerable control over lending and interest rates

“Canada, China, and Hong Kong SAR stand out, with both the

credit-to-GDP gap and the DSR (debt service ratio) flashing red”,

Bank of International Settlements, March 2018 Quarterly

Review

2Using an equity-based

model to analyze Chinese

corporate credit risk

Preparing for a Turn in the Chinese Credit Cycle 9

The EDF Model Can Signal Rising Risk Well Ahead of

Eventual Default Fushun Special Steel, Expected Default Frequency (%)

Bankruptcy

Preparing for a Turn in the Chinese Credit Cycle 10

Overview of Moody’s Analytics’ EDF model

DD = distance-to-default

A = market value of assets

X = default point

σA = asset volatility

Preparing for a Turn in the Chinese Credit Cycle 11

Overview of Moody’s Analytics’ EDF model

DD = distance-to-default

A = market value of assets

X = default point

σA = asset volatility

Preparing for a Turn in the Chinese Credit Cycle 12

Overview of Moody’s Analytics’ EDF model

DD = distance-to-default

A = market value of assets

X = default point

σA = asset volatility

Preparing for a Turn in the Chinese Credit Cycle 13

How Well Does the EDF Perform in China?Accuracy Ratio of the EDF model in China vs other regions, 2007-2015

Preparing for a Turn in the Chinese Credit Cycle 14

Aggregate Credit Trends in ChinaMedian EDF for Chinese and Global corporates

Preparing for a Turn in the Chinese Credit Cycle 15

Drilling Down to China’s Riskiest IndustriesMedian EDF of China’s 3 riskiest corporate industries vs overall median

3Early warning and

monitoring strategies for

corporate credit exposures

Preparing for a Turn in the Chinese Credit Cycle 17

Defaults Rise When Economic Growth SlowsYear-Over-Year Change in US GDP vs. US Corporate Default Rate, 1980-2015

-4

-2

0

2

4

6

8

100

1

2

3

4

5

6

19

80

19

81

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82

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GD

P Y

oY

% C

ha

ng

e (

Inve

rte

d)

An

nu

al D

efa

ult R

ate

Annual Default Rate GDP YoY % Change

Preparing for a Turn in the Chinese Credit Cycle 18

Can You Spot the Defaulters?Effective Early Warning Requires Us to Look at Things Differently

-100%

-50%

0%

50%

100%

150%

200%

250%

-40% -30% -20% -10% 0% 10% 20% 30% 40% 50%

ROA

% Change 2013-2014

Leverage

% Change 2013-2014

Clearly

Good

Clearly

Bad

Preparing for a Turn in the Chinese Credit Cycle 19

In A Sector-Wide Downturn, How Can We Identify

Firms Most At Risk?

ED

F %

Preparing for a Turn in the Chinese Credit Cycle 20

Which Firms Stand Out As Most Risky?Firm-Level EDFs for China Construction Group (selected companies)

ED

F %

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15

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Preparing for a Turn in the Chinese Credit Cycle 21

“When Should I Get Worried?”

» Which firms in a portfolio should be considered relatively more risky, and

merit deeper investigation?

» Moody’s Analytics research has identified several strategies for monitoring

early warning signals:

1. EDF level versus an industry threshold → EDF “trigger level”

2. Relative EDF level vs. industry group → Under- / out-performance

3. EDF level change → Momentum

4. Relative EDF change vs. peer group → Under- / out-performance

5. Slope of EDF term structure → Expectation of risk

Preparing for a Turn in the Chinese Credit Cycle 22

Setting Sector-Level Early Warning Trigger LevelsEDF Early Warning Trigger Levels Balance True Pos/Neg Signals vs.

False Pos/Neg Signals

Sectort *

(Pctile)

Banks0.281%

(75.5%)

Consumer Products4.406%

(79.0%)

High Tech13.715%

(95.5%)

Transportation4.344%

(83.9%)

t * Median 25th% 75th%

3.04% 0.70% 0.17% 3.00%

Optimal EDF Warning Level for

Selected Industry Sectors, 1999-2014Optimal EDF Warning Level for All

Firms Globally, 1999-2014

Preparing for a Turn in the Chinese Credit Cycle 23

Bankruptcy

Early Warning Triggered

Monitor EDF vs Industry Trigger Levels to Identify

Potential Credit Events

Historically, 92% of

corporate

defaulters breached

their trigger level

during the 12

months prior to

default

Fushun Special Steel’s EDF Triggered a Warning 3 Years Prior to Default

Preparing for a Turn in the Chinese Credit Cycle 24

EDF-Based Early Warning Signals Also Work for

Private Firms

Early warning level for the China Textiles sector

Jiangsu Qiaoli bankruptcy

Jiangsu Qiaoli’s EDF jumps past early warning trigger after reporting disappointing financials

Borrows 1-year loan of 140 MM RMB

Jiangsu Qiaoli Textile Products Co. CCA-EDF vs. Industry Trigger Level

Preparing for a Turn in the Chinese Credit Cycle 25

Which Firms Stand Out As Most Risky?Firm-Level EDFs for China Construction Group (selected companies)

ED

F %

0

5

10

15

20

25

YU

NN

AN

ME

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Sector-Specific EDF Trigger Level

Preparing for a Turn in the Chinese Credit Cycle 26

Monitor EDF Against Industry Peer Groups to

Identify Firm-Level Credit DeteriorationFushun Special Steel’s EDF Was High 2 Years Prior to Default

Preparing for a Turn in the Chinese Credit Cycle 27

Early Warning of Credit Risk is Also Critical for

Managing ECL Under IFRS 9Hidili Industry International Development (China)

Stage 1 Stage 2

1-Yr EDF

Data source: Moody’s Analytics

Stage 3

Preparing for a Turn in the Chinese Credit Cycle 28

The Business Case for a Strong Monitoring and

Early Warning System

OnboardingCredit

AssessmentMonitoring Action

» Pre-

qualification

assessments

» Loan loss

provisioning

» Inputs into

internal risk

ratings

» Challenger

model

» Benchmark

» Early warning

of credit

deterioration

» Peer

comparison of

relative risk

» Timely and

actionable

information

» A more

effective

watch list

4 Stress testing your

corporate loan book

Preparing for a Turn in the Chinese Credit Cycle 30

What Could Cause the Credit Cycle to Turn?

Results of Moody’s Analytics Singapore and Kuala Lumpur

conference surveys, November 20/21, 2018

What is your biggest economic concern at the moment?

Preparing for a Turn in the Chinese Credit Cycle 31

China’s Economy Under Alternative ScenariosChinese GDP growth %y/y under five economic scenarios

-2

0

2

4

6

8

10

Baseline s1 s2 s3 s4

Preparing for a Turn in the Chinese Credit Cycle 32

Chinese Credit Risk Under Alternative ScenariosMedian Chinese EDF under five economic scenarios

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

Baseline S1 S2 S3 S4

Preparing for a Turn in the Chinese Credit Cycle 33

High Risk Firms are Vulnerable to RecessionStressed EDF under different economic scenarios

Tencent Holdings Ltd Evergrande Group

Preparing for a Turn in the Chinese Credit Cycle 34

High Risk Firms are Vulnerable to RecessionStressed EDF under different economic scenarios

Tencent Holdings Ltd Evergrande Group

Preparing for a Turn in the Chinese Credit Cycle 35