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China Inc. Will Struggle to Stay on the Deleveraging Path


China Inc. will find it hard to maintain the current two-year deleveraging trend.

The median debt-to-EBITDA ratio improved to 3.3x in 2017, from 3.6x in 2016 and 3.8x in 2015.

State-owned upstream sectors deleveraged the most last year, due to supply-side reforms and continued price reflation.

In this year's survey of China's top companies, real estate surpassed oil and gas to be the third largest sector by total debt.

As per previous surveys, private-sector companies demonstrated more capital efficiency and stronger financials.

China's top 254 corporates have an overall business risk profile that we classify as fair and a financial risk profile of intermediate.

Our assessments map the portfolio to an anchor of 'bb+', compared with 'bbb' to 'bbb-' last year.

The weakening profiles reflect our forward-looking views, as well as our wider coverage of companies in this year's sample. This year we added 34 companies and two new sectors.

Our expectation of a pause in deleveraging is based on tougher credit conditions amid "shadow banking" reform, and slower earnings growth off a heightened base.

China's top companies will likely veer from the deleveraging path this year. S&P Global Ratings believes the slippage will come from slowing earnings growth rather than excessive outlays or borrowing. Overall we expect capital spending to remain more disciplined, setting the stage for China Inc. to eventually resume the major undertaking of reducing its debt burden.

After two years of improving debt to income, corporate balance sheets are in better shape to face potential economic headwinds brought by subsiding reflation and trade rifts. State-owned enterprises (SOEs) in upstream sectors have led improvements in capital discipline, under the close watch of state reformers. Property companies, on the other hand, have only recently begun to hem in debt-fueled expansions, partly in response to tougher financing conditions.

We expanded our survey this year, which brought some smaller and riskier companies into the mix. Overall, our portfolio of 254 companies represent the biggest players in their respective sectors.

In 2017, financial metrics improved for the second consecutive year, but business and financial risk profiles weakened. This is because our assessments are forward-looking. The deterioration also reflects our wider portfolio.

Who's Who In The Top Corporates?

Our 2018 study of China's top corporates includes 254 entities from 21 industry sectors. We added two new sectors. To improve coverage, we add chemicals with seven companies. We added package express to capture the rising importance of this sector in the consumer economy and online consumption over the past few years.

There is a net increase of 34 companies compared with last year, focusing mainly in capital goods (eight new companies), chemicals (seven), technology hardware (five), and consumer (five). The changes reflect China's positioning in the global supply chain, as well as the domestic economy's continuous shift to a consumption-led economy.

The portfolio for this study extends beyond our rated China universe. The number of rated entities make up one-third of the composition, similar to last year.

SOEs still dominate China Inc.

The constituents selected are leading or the largest borrowers in their industry. SOEs comprised 63% of the sample, slightly lower than last year. The declining trend in SOE composition should reflect the wider participation of private enterprises in the economy and rising services sectors.

We believe our sample has meaningful representation to gauge the financial health of "China Inc." As a group, the top 254 corporates (including infrastructure) account for 17.8% of the total borrowings of nonfinancial companies in China.

The SOEs dominate sectors that are strategic to China's national interests. These include energy (oil and gas, utilities, mining), infrastructure (telecommunications, transport, railway and metro), and engineering and construction. Companies in strategic sectors have a dual role: to support the state's policies in economic and social development, and maintain a reasonably healthy financial profile to execute these roles.

The areas in which SOEs are financially stronger than private enterprises usually have high barriers to entry due to policy or legacy reasons, a highly concentrated market, or special operating rights. These sectors include telecommunications, oil and gas, and electricity grid operators.

A good representation across sectors

For this year's survey, most represented sectors have at least five companies. The exceptions include telecommunications, which has only four operators. Both oil and gas and media entertainment also have only four companies. S.F. Holding Co. Ltd. and four delivery companies, were reclassified from transportation to the package express sector.

In terms of sheer number of companies, consumers (retail and goods) continue to be the largest sector in our survey, followed by capital goods and utilities. Each of these three sectors account for at least 10% of the total sample size.

In terms of assets size, the capital-intensive industries of utilities, railway and metro, and oil and gas dominate (see chart 1). On the debt front, utilities and railway and metro together account for about 40% of the sample's total borrowings (see chart 2).

China Railway Corp. (CRC), the commercial arm of the former Ministry of Railways, is the largest borrower in our sample and accounts for 19% of the total debt of sample corporates.

In this year's survey, real estate surpassed oil and gas to be the third largest sector by total debt, reflecting the aggressive expansions by property developers. In contrast, major state-owned oil operators followed the government's deleveraging initiative. As such, they demonstrated more disciplined control over debt growth.

In our analysis, we have used median rather than averages to gauge the credit metrics for each sector and for the sample. This removes the impact of the size of a company and outliers.