Moody's: A dislocation in China's onshore bond market would be unlikely to lead to a systemic financial crisis

Moody's Investors Service says that a dislocation in China's onshore bond market would unlikely lead to a systemic financial crisis and the effects would be limited because of various mitigating factors.

"The bond market's limited role in financing China's corporate sector; the banks' capacity to increase lending to help distressed borrowers; and the authorities' ability to intervene and exercise moral suasion would all act as counters to a crisis," says Lillian Li, a Moody's Vice President and Senior Analyst.

"We note that, in the current situation, the rising yields of higher-risk corporate bonds in China's (Aa3 negative) onshore bond market since 3Q 2015 may have left the market at risk of dislocation, a situation which in principle would increase corporate funding costs and defaults, and could ultimately lead to a credit and liquidity crunch," adds Li.

"The likelihood of a financial crisis would increase if banks' balance sheets weaken significantly or the growing interconnectedness with the shadow banking system increases the transmission of shocks. These are not our baseline assumptions, however," says Li.

Moody's conclusions were contained in a just-released report on China credit, "China Credit - Spillover from Potential Dislocation in Onshore Bond Market Would Be Limited".

Moody's believes that the authorities would step in if systemic financial risk appeared likely, but in a shift from the past, they have begun to allow some defaults of SOEs with weak fundamentals, especially at those companies in overcapacity sectors, as China's economy begins to rebalance.

As a result, default risk will rise for struggling companies, especially those that are not critical to China's economic or social stability.

The widening yield spreads seen between lower- and higher-risk bonds reflect investors' greater awareness of credit differentiation than in the past. The yield divergence will raise financing costs for the issuers of higher risk, but will help market development and therefore is credit positive in the long run.

A tightening in liquidity is likely but would not trigger serious corporate funding problems. Bank loans account for the majority of non-financial companies' funding needs, while bond financing plays a relatively small role. State-owned banks have the capacity to step up their lending to distressed and significant borrowers if necessary. Additionally, the People's Bank of China has tools to ensure financial system liquidity.

The banks are also unlikely to face systemic challenges from the bond market, but pressures will rise. The direct effect of bond defaults on commercial banks' balance sheets will be limited, primarily because corporate bonds account for a small portion of banks' investment portfolios.

But indirect risks exist because the government will likely use moral suasion to nudge banks to help certain borrowers refinance, and to share the costs of defaults. If borrowers increasingly turn to shadow banks as an alternative to bond financing, there is the potential for risk to flow back to the formal banking sector, given the links between the two systems.

In principle, a bond market dislocation starts with a rise in yields of weaker bonds as investors' appetite for those bonds declines following a large number of defaults or credit events in a short period, says the new Moody's report. If investors are unnerved by the defaults and exit the bond market in large numbers, yields spike for bonds broadly.

Corporate financing costs subsequently increase, particularly for weaker companies, which then leads to more defaults. Consequently, bondholders suffer from capital losses. Investors' general loss of confidence triggers a credit crisis and liquidity crunch, which depress prices in other financial markets such as equities and real estate.

Such widespread disruption in financial intermediation then leads to real macroeconomic effects such as GDP growth shock and large- scale bankruptcies, the latter of which lead to high unemployment, says the new report.