Morgan Stanley - Leveraged China

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					                                                                           MORGAN STANLEY RESEARCH
                                                                                           Morgan Stanley Asia Limited+                      Viktor Hjort
                                                                                                                                             Viktor.Hjort@morganstanley.com
                                                                                                                                             +852 2848 7479

                                                                                                                                             Nishant Sood
                                                                                                                                             Nishant.Sood@morganstanley.com
                                                                                                                                             +852 2239 1597

                                                                                                                                             Gaurav Singhal
               May 3, 2013                                                                                                                   Gaurav.Singhal@morganstanley.com
                                                                                                                                             +852 2239 7300
               Credit Strategy                                             Exhibit 1
Asia/Pacific                                                               China Leverage Now at or Exceeding the 2008
               Asia Credit Strategy                                        Peak
                                                                           Gross leverage: China SOE, private corporates
               Leveraged China                                                                     5.0x
                                                                                                   4.5x
                                                                                                   4.0x          Private             SOE
               Leverage for Corporate China has reached an all-




                                                                            Gross Leverage (x)
                                                                                                   3.5x
               time high based on bottom-up data. Credit                                           3.0x
               quality deterioration and supply pressures now                                      2.5x

               pose a bigger challenge to credit markets, and                                      2.0x
                                                                                                   1.5x
               we downgrade China IG SOEs to neutral.
                                                                                                   1.0x

               Corporate leverage at all-time highs. A                                             0.5x
                                                                                                   0.0x
               combination of rapid credit growth and a sluggish                                           2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
               economic environment in the past year has pushed            Note: Analysis carried out on MSCI China non-financial corporates. SOEs are defined
               corporate leverage to record highs in China.                as those corporates having more that 30% government ownership.
                                                                           Source: FactSet, Morgan Stanley Research

               Where is it rising fastest: SOEs, industrials,              Exhibit 2
               property. Leverage increase is a broad-based                Putting Leverage in Perspective
               trend, although with important exceptions. The              Gross leverage
               fastest credit quality deterioration is in the parts that
                                                                                                   5.0x
               dominate credit markets: SOEs, industrials and to                                   4.5x
                                                                              Gross Leverage (x)




               some extent property.                                                               4.0x
                                                                                                   3.5x
               Putting it into perspective: how leveraged is                                       3.0x
                                                                                                   2.5x
               corporate China? The bulk of leverage sits with                                     2.0x
               SOEs who, on average, also generate less return on                                  1.5x
                                                                                                   1.0x
               assets. To preserve credit quality these companies                                  0.5x
               may need to reduce investment spending. Private                                     0.0x
                                                                                                             China         US       EU        AxC China AxJ                  EU IG US IG
               sector corporates, on average, are less leveraged,                                            SOEs          HY       HY       SOEs Private
               generate better ROA and have better funding profile.                                                                               Corps
                                                                           Note: Leverage data for HK-listed China SOEs and Chinese private corporates are part
               We are downgrading China IG SOEs to neutral                 of the MSCI China universe. SOEs are defined as those corporates having more that
               and remain neutral on high yield. The combined              30% government ownership. Source: FactSet, Bloomberg, Morgan Stanley Research

               challenge of deteriorating credit metrics and supply
               pressures make us downgrade China IG SOEs to
                                                                                                   Due to the nature of the fixed income market, the issuers or bonds
               neutral. We remain neutral on China high yield with                                 of the issuers recommended or discussed in this report may not be
               a preference for property over industrials.                                         continuously followed. Accordingly, investors must regard this
                                                                                                   report as providing stand-alone analysis and should not expect
               China credit is increasingly dominating the                                         continuing analysis or additional reports relating to such issuers or
               Asian credit markets. Asian credit markets are                                      bonds of the issuers.
               subject to a gradual ‘Chinafication’: China accounts                                Morgan Stanley does and seeks to do business with
               for 35% of all corporate debt in Asia and growing                                   companies covered in Morgan Stanley Research. As a
               with a CAGR of 28%.                                                                 result, investors should be aware that the firm may have
                                                                                                   a conflict of interest that could affect the objectivity of
               Note to readers: no official data were used in this                                 Morgan Stanley Research. Investors should consider
               analysis. Official data in China are often subject to                               Morgan Stanley Research as only a single factor in
               much quality debate and polarised opinions. The                                     making their investment decision.
               analysis in this note was produced exclusively using                                For analyst certification and other important
               bottom-up, corporate data.                                                          disclosures, refer to the Disclosure Section,
                                                                                                   located at the end of this report.
                                                                                                   += Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated
                                                                                                   persons of the member and may not be subject to NASD/NYSE restrictions on communications with
                                                                                                   a subject company, public appearances and trading securities held by a research analyst account.
                                                               MORGAN STANLEY RESEARCH


                                                               May 3, 2013
                                                               Asia Credit Strategy




Asia Credit Strategy

Leveraged China
Viktor Hjort +852 2848 7479
Nishant Sood +852 2239 1597
Gaurav Singhal +852 2239 7300

 Leverage for Corporate China has reached an all-time          Corporate Leverage in China Is Now High
 high based on bottom-up data. Credit quality
                                                               China is the single biggest driver of the Asian credit market,
 deterioration and supply pressures now pose a bigger
                                                               accounting for nearly one-third of all performance. The biggest
 challenge to credit markets, and we downgrade China
                                                               driver of China credit, in turn, has historically been China’s
 IG SOEs to neutral.
                                                               liquidity and policy cycle: very bearish in 2011, very bullish in
 Corporate leverage at all-time highs. A combination of        2012, more neutral today. Underpinning the cycle, however,
 rapid credit growth and a sluggish economic environment in    are two important trends. First, China is going to dominate
 the past year has pushed corporate leverage to record         supply and market growth in Asia through a corporate sector
 highs in China.                                               that accounts for 35% of all debt in Asia and grows at a CAGR
                                                               of 28%. Second, the credit quality of Corporate China is
 Where is it rising fastest: SOEs, industrials, property.
                                                               deteriorating and is now at a point where we think it’s going to
 Leverage increase is a broad-based trend, although with
                                                               become a headwind for further outperformance.
 important exceptions. The fastest credit quality
 deterioration is in the parts that dominate credit markets:   Exhibit 3
 SOEs, industrials and to some extent property.                China Leverage Now at or Exceeding the 2008 Peak
                                                               Gross leverage: China SOE, private corporates
 Putting it into perspective: how leveraged is corporate
                                                                                      5.0x
 China? The bulk of leverage sits with SOEs who, on
                                                                                      4.5x
 average, also generate less return on assets. To preserve
                                                                                      4.0x      Private      SOE
 credit quality these companies may need to reduce
                                                                 Gross Leverage (x)




 investment spending. Private sector corporates, on                                   3.5x

 average, are less leveraged, generate better ROA and                                 3.0x
 have better funding profile.                                                         2.5x
                                                                                      2.0x
 We are downgrading China IG SOEs to neutral and
                                                                                      1.5x
 remain neutral on high yield. The combined challenge of
                                                                                      1.0x
 deteriorating credit metrics and supply pressures make us
                                                                                      0.5x
 downgrade China IG SOEs to neutral. We remain neutral
                                                                                      0.0x
 on China high yield with a preference for property over                                     2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
 industrials.
                                                               Note: Analysis carried out on MSCI China non-financial corporates. SOEs are defined as
                                                               those corporates having more that 30% government ownership.
 China credit is increasingly dominating the Asian             Source: FactSet, Morgan Stanley Research
 credit markets. Asian credit markets are subject to a
                                                               In the past year, growth has decelerated while credit has
 gradual ‘Chinafication’: China accounts for 35% of all
                                                               accelerated in China. GDP growth has slowed to +7.7% (from
 corporate debt in Asia and growing with a CAGR of 28%.
                                                               8.1%) while M2 growth has picked up to 15.7% (from 13.6%).
 Note to readers: no official data were used in this           That suggests that economy-wide leverage would have
 analysis. Official data in China are often subject to much    increased and bottom-up corporate earnings for 2012
 quality debate and polarised opinions. The analysis in this   confirms this. The broadest quality measure of corporate
 note was produced exclusively using bottom-up, corporate      leverage (MSCI China’s non-financial corporate universe)
 data.                                                         reached an all-time high of 3.1x (gross debt/EBITDA), driven
                                                               by SOEs (4.6x) – more than a turn higher than during the


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                                                                                   Asia Credit Strategy




2008 downturn – and to a lesser degree private sector                              Corporates Have Been Slow to Adapt to a More
corporates (2.8x) still short of the 2008 levels. 2008 is a useful                 Sluggish Growth Reality
point of comparison in that this was in the midst of an
                                                                                   What’s behind this? Leverage is increasing partly because
economic downturn and in downturns the denominator –
                                                                                   credit conditions have been easy. Chinese banks extended
growth and cash flow – invariably decline. China’s not in a
                                                                                   credit aggressively in 2012, taking the credit multiple (China
recession today; hence, at least some of the leverage
                                                                                   bank asset growth to nominal GDP growth) to 2.3x. That's the
increase is deliberate.
                                                                                   fastest pace since the government-sanctioned credit boom in
This trend has exceptions, and some of the largest listed                          2009, with the difference being that much of the credit
SOEs (e.g., telecom operators) often have fairly strong                            expansion is through banking ‘innovations’, through so-called
balance sheets. But the increase in leverage is a broad-based                      interbank assets and at least part of this potentially involves
trend. Two-thirds of Chinese investment grade bond issuers                         classifying loan-like assets as interbank assets (see China
and three-quarters of high yield issuers reported higher                           Banks: Tougher Balance between Liquidity & Bank Risks in
leverage in 2012 (see Exhibit 4) – a breadth of deterioration                      2013; Interbank Key Swing Factor, Xu and team, December
which is on par with or exceeds even that during the 2008                          10, 2012).
downturn.
                                                                                   But leverage is also rising because corporates have been
Exhibit 4                                                                          slow to adapt to a more sluggish growth environment than in
Leverage Increase Is a Broad-based Trend                                           the past. In most markets and most cycles, corporate animal
% of IG corporates reducing/increasing leverage                                    spirits and demand for credit are a function of how corporates
                   Lev Chng >0.5x                      Lev Chng: 0x -0.5x          perceive the demand outlook. As Exhibit 5 shows, corporate
                   Lev Chng: (0.5)x - 0x               Lev Chng <(0.5)x            China’s capex plans and the debt that funds them have
 100%
  90%
                                                                                   followed the earnings cycle, but with a lag.
  80%
                                                                                   Exhibit 5
  70%
  60%
                                                                                   Leverage Is Increasing Because Corporates Have
  50%                                                                              Been Slow to Adjust to a More Sluggish Growth
  40%                                                                              Environment
  30%                                                                              Corporate EBITDA, capex and total debt growth (YoY)
  20%
  10%                                                                                             50%
                                                                                                                  EBITDA             Total Debt                Capex
   0%
    2008Q2            2009Q2           2010Q2          2011Q2             2012Q2                  40%


% of HY corporates reducing/increasing leverage                                                   30%
                                                                                     YoY Change




                  Lev Chng >0.5x                       Lev Chng: 0x -0.5x                         20%
                  Lev Chng: (0.5)x - 0x                Lev Chng <(0.5)x
 100%
  90%                                                                                             10%
  80%
  70%                                                                                             0%
  60%
  50%
  40%                                                                                       -10%
  30%                                                                                                   2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
  20%                                                                               Note: Analysis carried out on non-financial corporates within broad MSCI China equity
  10%                                                                              universe. Source: Bloomberg, FactSet, Morgan Stanley Research
   0%
                                                                                   The spending/leverage cycle that picked up in 2010/11 now
    2008Q2            2009Q2           2010Q2          2011Q2             2012Q2
                                                                                   appears to have been in response to a perceived return to
Note: Analysis carried out on China IG and HY non-financial corporates.            high growth in 2009 after the downturn. Today, after more
Source: Bloomberg, Morgan Stanley Research
                                                                                   than two years of sluggish earnings, corporates are again
Among the broad set of listed SOEs, three-quarters have                            turning more conservative being hesitant to spend. A closer
seen leverage increase since 2007 – the eve of the last                            look at the 2012 numbers reveals that capex spending and
downturn – and 60% saw leverage increase in the past year.                         debt growth are actually slowing, though not yet at the same

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                                                                                              May 3, 2013
                                                                                              Asia Credit Strategy




pace as earnings growth (see Exhibit 5). It would be more                                     Exhibit 7
accurate to describe corporates as being ‘not conservative                                    SOEs Have a Sizeable Funding Gap to Plug
enough’ rather than being ‘too aggressive’. Should growth and                                 Funding profile: China SOEs, private sector corporates
earnings pick up later in 2013 it may well result in improving                                                                      8%                Private          SOE
credit metrics, however temporarily.




                                                                                                Funding Position/Enterprise Value
                                                                                                                                    6%

Where Is Leverage Rising the Fastest?                                                                                               4%

Corporate leverage increase is broad based but most intense
                                                                                                                                    2%
in the parts of the economy where credit conditions have been
easiest (e.g., SOEs, property) and where growth has been                                                                            0%
weakest (e.g., industrials). All three are key components of
                                                                                                                                    -2%
the traded bond universe, together accounting for more than
20% of the total risk in Asia credit and over 85% of the risk                                                                       -4%
contribution from China: SOE (IG) leverage increased by a                                                                                 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
turn, private sector industrial leverage (HY) by 0.8x and                                     Note: Funding Profile = (FCF+Cash-ST Debt)/EV. Analysis carried out on MSCI China non-
property (HY) by 0.7x (see Exhibit 6).                                                        financial corporates. SOEs are defined as those corporates having more that 30%
                                                                                              government ownership.
                                                                                              Source: FactSet, Morgan Stanley Research
Exhibit 6
Where Is Leverage Increasing Fastest?                                                         The other big debt raiser – property developers – has
2012 leverage change: SOEs, industrials, property                                             experienced a more modest increase in leverage. Revenues
                                                                                              improved in 2012 and companies used the improved access
    2012-2011 Leverage Differential (x)




                                          1.2x
                                                                                              to funding to raise debt, both onshore and offshore, but did
                                          1.0x                                                not invest heavily in capex, preferring instead to run down
                                                                                              existing inventories. Instead the higher leverage has been
                                          0.8x
                                                                                              used to improve their liquidity profile, albeit moderately and
                                          0.6x                                                from fairly stretched levels in 2011. While this is credit positive
                                                                                              and compares favourably to industrials (whose credit profile
                                          0.4x
                                                                                              continued to worsen in 2012), an uptick in capex poses the
                                          0.2x                                                key fundamental risk to China property developers’ credit
                                                                                              profiles. Following what looks like a sustained sales recovery
                                          0.0x                                                and last year’s land acquisitions and today’s much lower
                                                 SOEs   Industrials   Property     Other      inventory levels, that risk may be close.
                                                                                  Private
                                                                                 Corporates   Exhibit 8

Note: Analysis carried out on SOEs within MSCI China non-financial corporates and on the      China Property Saw Improved Liquidity
property and industrials within the AXJ HY universe.
Source: FactSet, Morgan Stanley Research
                                                                                              Cash to total debt for China property

SOEs’ debt raising today is mainly about plugging a fairly                                                                           55%
persistent funding gap. Growth is sluggish and the capex                                                                             50%
                                                                                                                                     45%
                                                                                                 Cash to Total Debt




trend is moderating but the funding position (defined as
starting cash less short-term debt plus free cash flows over                                                                         40%                                     Liquidity has
the year) for SOEs began to deteriorate in 2010, turned                                                                              35%                                     improved
negative in 2011 and continued to worsen in 2012 (see Exhibit                                                                        30%
7). Private corporates, by contrast, has seen their funding                                                                          25%
profile improve notably. SOEs have raised debt also to term
                                                                                                                                     20%
out their debt maturity profiles – short-term debt as a
                                                                                                                                     15%
proportion of total debt has steadily declined to 46% (from
36% in 2010) – but this has not been enough to plug the                                                                              10%
funding gap.                                                                                                                                   2009             2010         2011            2012

                                                                                              Source: Bloomberg, Morgan Stanley Research



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                                                                     Asia Credit Strategy




Putting Debt into Perspective: How Leveraged Is                      Exhibit 9
Corporate China?                                                     Putting Leverage in Perspective
                                                                     Gross leverage
How leveraged is China? This sometimes very heated debate,
                                                                                            5.0x
and one that tends to truly polarise investors, is often framed                             4.5x




                                                                       Gross Leverage (x)
in GDP terms. Our own data suggest that total debt/GDP in                                   4.0x
                                                                                            3.5x
China is approximately 232% with corporate debt/GDP at                                      3.0x
106%, which puts China’s corporate debt/GDP in line with                                    2.5x
                                                                                            2.0x
Europe but higher than US or Asia ex-Japan ex-China (for                                    1.5x
details, see China SOEs: Unlimited Supply Potential,                                        1.0x
                                                                                            0.5x
February 22, 2013, and China Banks: Connecting the Dots of                                  0.0x
New Financials Channels: What Will Be Scrutinized, How &                                           China   US   EU    AxC China AxJ         EU IG US IG
When? Xu and team, March 20, 2013). But when assessing                                             SOEs    HY   HY   SOEs Private
                                                                                                                          Corps
credit quality and the ability to service debt, particularly for
                                                                     Note: Leverage data for HK-listed China SOEs and Chinese private corporates are part of the
corporates, GDP is often a blunt instrument. First, the quality      MSCI China universe. SOEs are defined as those corporates having more that 30%
                                                                     government ownership. Source: FactSet, Bloomberg, Morgan Stanley Research
of Chinese GDP data is subject to much debate – our
colleagues Jonathan Garner and Helen Qiao, for instance,             China private sector leverage, on the other hand, at 2.8x is
estimate that official data understate household consumption         only moderately higher than the Asia ex-Japan and US
spending by as much as US$1.6 trillion (see China –                  investment grade average, which implies less pressure,
Household Consumption: Bottom-Up Data Suggest US$1.6trn              although we’d note that last time US investment grade
Larger Than Officially Stated – Reiterate Chinese Consumer           leverage was at 2.8x was at the peak of the TMT/capex-driven
as Key Theme, Garner/Qiao, February 28, 2013). Second,               downturn in 2001.
even if official data accurately reflected true economic activity,
the reality is that corporates do not “earn” GDP and can’t use       A Sustainably Improving Credit Trend Would
it to service debt.                                                  Require Less Spending and More Efficient Capital
Therefore, to gauge credit quality, we prefer focusing on
                                                                     Allocation
bottom-up data from individual corporate statements. Pairing         A rise in leverage doesn’t have to be viewed as a secular
debt with the cash flows that service it, China’s SOE leverage       problem inevitably leading to a systemic crisis: the
today is 3x higher than what it was in 2007 on the eve of the        deterioration of credit metrics is as much a function of failure
last downturn (see Exhibit 3 above) while only marginally            to adapt to a more sluggish growth environment. A vigorous
higher for the private sector universe. That suggests that if        growth rebound here would most likely lead to credit quality
China had a recession today, the credit fallout – in the sense       improvement, at least temporarily.
of companies finding it difficult to service debt – would most
                                                                     Exhibit 10
likely be worse than in 2008.
                                                                     Credit Flows Equally into Productive and Less
To illustrate it another way, leverage for the median listed         Productive Assets Implying Low Capital Efficiency
China SOE is 4.5x, about half-to-one turn higher than US and         Debt growth, ROA: SOEs, private corporates
European sub-investment grade companies are today and                 18.0%                                                                              6%
higher than other regional SOEs (see Exhibit 9). 4.5x is also         16.0%
                                                                                                                                                         5%
roughly where US sub-investment grade corporates are in               14.0%
recessions and typically associated with 10-12% default rates.        12.0%                                                                              4%
That’s not saying that a recession in China would see those           10.0%
                                                                                                                                                         3%
default rates – these are SOEs and the government response                    8.0%
                                                                              6.0%                                                                       2%
function would have to be considered – but the ability to
                                                                              4.0%
service debt is a more straightforward function of leverage                                                                                              1%
                                                                              2.0%
and cash generation.
                                                                              0.0%                                                                       0%
                                                                                                          SOEs               Private Corps
                                                                                                   Debt Growth (% YoY)             ROA (RHS)
                                                                     Note: Analysis carried out on MSCI China non-financial corporates.
                                                                     Source: FactSet, Bloomberg, Morgan Stanley Research




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                                                                          May 3, 2013
                                                                          Asia Credit Strategy




But for the trend to improve sustainably, credit extended need            Exhibit 12
to be channeled into productive parts of the economy, and this            To Avoid Further Credit Quality Deterioration Capex
is where bottom-up data raise some problems, in our view.                 Spending May Have to Moderate
Credit has been built up equally in SOEs and private sector               Capex/sales
corporates, but the ROA in the former is only two-thirds of                                20%
                                                                                                                                                       China - Private corps

what it is in the private sector (see Exhibit 10).                                         18%                                                         China - SOE

                                                                                           16%
We can see this in the aggregate corporate trend as well: the                              14%
                                                                                                                                            AxJ ex-China (1992-98) ave

rapid increase in leverage has so far failed to produce returns




                                                                           Capex / Sales
                                                                                           12%                                                    CEEMEA/LatAm ave

(see Exhibit 11). ROA fell back to post-2008 lows last year                                10%

and that point towards inefficient use of capital, something                               8%
                                                                                                                                                  AxJ ex-China (post-2000) ave
that undermines the ability to improve credit quality.                                     6%
                                                                                                                                                  Europe ave US ave
                                                                                           4%
Exhibit 11
                                                                                           2%
Rising Leverage Has Not Translated into Return on                                          0%
Assets                                                                                           2002   2003   2004   2005   2006   2007   2008     2009    2010    2011    2012
                                                                          Note: Investment Grade Issuers for US, EU. Analysis carried out on MSCI China non-
Gross leverage, ROA                                                       financial corporates. SOEs are defined as those corporates having more that 30%
                                                                          government ownership. Source: FactSet, Bloomberg, Morgan Stanley Research
 3.3x                          Gross Leverage                        8%
 3.1x                          ROA (RHS)
                                                                     7%   What Are the Credit Market Implications?
 2.9x                                                                     Downgrading China IG SOEs, Remain Neutral on
                                                                     6%
 2.7x                                                                     High Yield, and Preferring Property over Industrials
                                                                     5%
 2.5x
                                                                     4%    We are downgrading China SOEs to neutral. The
 2.3x                                                                       deterioration in fundamentals and the potential supply
                                                                     3%
 2.1x                                                                       overhang create a challenging mix for the asset class.
 1.9x                                                                2%     Chinese SOEs, on average, have sub-investment grade
                                                                     1%     balance sheets and credit metrics have been deteriorating.
 1.7x
                                                                            The funding requirements for SOEs are substantial and
 1.5x                                                                0%
                                                                            increasing and while domestic banks still provide the bulk of
         2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
                                                                            funding, an increasing reliance on bond markets together
Note: Analysis carried out on MSCI China non-financial corporates.
Source: FactSet, Bloomberg, Morgan Stanley Research                         creates a supply overhang, though bank loans still provide
                                                                            the bulk of the debt.
Therefore, to see sustainable improvement in corporate credit
quality, there would need to be more efficient capital                     We remain neutral on China high yield. Valuations
allocation. That may require a reduction in investment                      towards the tighter end of the historical range offer
spending – the topic of another heated and polarising debate                increasingly little cushion for an asset class that historically
among global market participants. Leaving official data aside               has been highly sensitive to ebbs and flows of credit and
again, a look at capex-to-sales ratios in China does confirm                liquidity in China, as we now forecast a period of moderate
that Chinese corporates invest more than many peers around                  tightening ahead (see China Macro - The Roadmap for
the world. This is particularly true for the SOE universe whose             Policy and for Markets, April 1, 2013).
capex ratio of 14-18% is particularly high in comparison with
                                                                           Within a neutral stance on China high yield, we see no
global peers (see Exhibit 12), something as seen earlier
                                                                            reason to change our preference for property
doesn’t appear to translate well into returns on invested
                                                                            developers over industrials. At the sector level, there is
capital.
                                                                            clear convergence in the fundamental quality of the two key
                                                                            high yield sectors in China – industrials deteriorating fast,
                                                                            property relatively more stable (see Exhibit 13) – and credit
                                                                            spreads have anticipated that trend: the two sectors now
                                                                            trade on top of each other. The main reason for the
                                                                            weakness in the industrial sector is the rapidly deteriorating
                                                                            RoA which is weakening credit metrics. That could be


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                                                                                                        May 3, 2013
                                                                                                        Asia Credit Strategy




          reversed should real-estate capex – a key demand driver                                       The corporate debt stock is big: exceeding 100% of the
          for the industrials sector (see Why We Are Downgrading                                        biggest regional economy, Chinese corporate debt makes up
          China High Yield Credit,, December 14, 2012) – finally pick                                   more than one-third of all corporate debt in the region. It’s also
          up it could serve as a positive catalyst to switch out of                                     growing fast, at 28% CAGR in the past six years.
          property into industrials, but not yet – both the fundamental
                                                                                                        A growing share of that large, fast growing corporate debt
          and policy cycle continue to favour property for now.
                                                                                                        stock is also being refinanced by debt capital markets, both
Exhibit 13                                                                                              onshore and offshore (see Exhibit 15). Traditionally, all bank
Property Credit Quality Trends Stable, Industrial                                                       loan financed, listed SOEs now fund 29% of their debt in bond
Trends Are Weak                                                                                         markets with a reliance on the onshore markets where their
Gross leverage and Return on Assets                                                                     government association facilitate market access. This trend
                   6x   Property Leverage           Industrials Leverage        16%                     matters because behind the SOE offshore bond universe that
                        Property RoA (RHS)          Industrials RoA (RHS)
                                                                                14%                     exists today, sits on our estimates another US2.8 trillion worth
                   5x
                                                                                                        of SOE loans that will ultimately need refinancing by
                                                                                     Return on Assets

                                                                                12%
  Gross Leverage




                   4x
                                                                                10%                     someone.
                   3x                                                           8%
                                                                                                        Exhibit 15
                                                                                6%
                   2x
                                                                                4%                      Where Chinese SOEs Borrow Money
                   1x
                                                                                2%                      Debt capital structure of Hong Kong listed SOEs
                   0x                                                           0%                       100%
                         2010                2011                  2012
                                                                                                          90%
Note: Analysis carried out on China non-financial HY universe.                                            80%
Source: Bloomberg, Morgan Stanley Research
                                                                                                          70%
                                                                                                                                                            73%       70%        70%      71%
                                                                                                          60%                 82%       82%       83%
China Credit to Increasingly Dominate Asia Credit                                                                    84%
                                                                                                          50%
Markets                                                                                                   40%
                                                                                                          30%
China’s credit trends matter beyond its own corporate sector. The
                                                                                                          20%                                                                    26%      24%
macro aspects aside – the world’s biggest contributor to global                                                                                             26%       27%
                                                                                                          10%        12%      15%       15%       16%
GDP – there is also a very specific Chinafication under way of                                             0%         4%       3%        3%        2%        1%          2%      4%        5%
Asian corporate debt markets. China accounts for the biggest                                                         2005    2006      2007       2008      2009      2010      2011      2Q12
and fastest stock of corporate debt, and these corporates are                                                               Bonds - Hard Ccy         Bonds - Local Ccy         Loans

engaged in the early stages of a process of reducing their
reliance on bank lending in favour of capital markets. With some
                                                                                                        Where Chinese Private Corporates Borrow Money
justification: where China goes so does Asia credit.
                                                                                                        Debt capital structure
                                                                                                         100%
Exhibit 14                                                                                                90%
Why Chinese Debt Will Dominate Asian Bond                                                                 80%
                                                                                                          70%
Markets: Because There’s Already a Lot of Debt and                                                                                                                                        78%
                                                                                                          60%                                               84%       83%        79%
                                                                                                                     86%      86%
it’s Growing Fast                                                                                         50%
                                                                                                                                        91%       88%

China % of MSCI AXJ’s total corporate debt; CAGR of                                                       40%
Chinese total corporate debt                                                                              30%
                   40      China's Debt                          … and it's
                                                                                                          20%
                                                                                                                                                                                 12%      13%
                           Stock is big...                       Growing fast                             10%                 8%                            12%       10%
                   35                                                                                                13%                4%        9%
                                                                                                                              6%        5%        3%         4%        7%        9%        9%
                                                                                                           0%         1%
                   30
                                                                                                                     2005    2006      2007       2008      2009      2010      2011      2Q12
                   25           35%
                                                                                                                             Bonds - Hard Ccy        Bonds - Local Ccy        Loans
    ( )
     %




                   20
                                                                   28%
                   15                                                                                   Note: Analysis carried out on HK-listed China SOEs and Chinese private corporates that are
                   10                                                                                   part of the MSCI China. Source: FactSet, Bloomberg, Morgan Stanley Research

                    5
                                                                                                        The private sector trend is similar and relatively more focused
                    0
                        China as % of AxJ's              CAGR of Chinese                                on offshore markets (9% of all debt funding), although their
                          Corporate Debt                  Corporate Debt
                                                                                                        smaller size and weaker onshore access make them more
Note: CAGR calculated over the 2006-12 period. Source: FactSet, Morgan Stanley Research
                                                                                                        reliant on bank loans.


                                                                                                                                                                                                 7
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                                                                                      May 3, 2013
                                                                                      Asia Credit Strategy




‘Chinafication’ of Asian debt markets would increase over                             ‘SOE Reform’ = Supply Risk
time, but in some sense it’s already a fact. Chinese corporates
                                                                                      With a new government in place, much attention is focused on
account for more than one-third of all new bond supply and,
                                                                                      economic reform in China. As little is known about the
reflecting the huge corporate universe behind the existing
                                                                                      government’s reform intentions, this is not the place to
issuers, more than half of all issuers are first-time issuers.
                                                                                      speculate on this. However, it seems to us that any reform
Exhibit 16                                                                            that involves the SOE universe, while perhaps positive for the
Chinafication of Asian Bond Markets                                                   Chinese economy and ultimately needed to improve credit
China as % of total AXJ supply; % first-time issuers of                               quality, almost invariably has to be viewed as a short-term
total China supply                                                                    negative for credit investors.
               60%                                  …and more than half of            The reform agenda spelled out in “China 2030 – Building a
                                                    Chinese issuers are first time
                          China accounts for                                          Modern, Harmonious, and Creative High-Income Society”
               50%        over 35% of AXJ
                                                                                      jointly between the State Council and the World Bank includes
                          issuance...
               40%                                                                    numerous references such as “SOEs consume a large
  Percentage




                                                                                      proportion of capital, raw materials […] to produce relatively
               30%                                                                    small shares of gross output” and suggested remedies such
                                                                                      as tackling the distortion of “preferential access to credit by
               20%
                                                                                      large firms or SOEs”. There are numerous hurdles for any
               10%                                                                    such reform, but to the extent that SOEs’ “preferential” access
                                                                                      to domestic bank credit is taken away these companies will
               0%                                                                     need to rely more on alternative sources of funding, including
                     % of AXJ issuance from China     % of Chinese issuers that are   offshore bond markets (domestic bond markets are dominated
                                                               first time
                                                                                      by banks).
Note: Analysis carried out over 2010-13 YTD period.
Source: Bloomberg, Morgan Stanley Research




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                                                                                Asia Credit Strategy




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                         Coverage Universe    Investment Banking Clients (IBC)
                                        % of                   % of % of Rating
Stock Rating Category       Count       Total     Count Total IBC Category
Overweight/Buy              1034         36%         399        39%         39%
Equal-weight/Hold           1250         44%         479        47%         38%
Not-Rated/Hold                105         4%           27        3%         26%
Underweight/Sell              473        17%         123        12%         26%
Total                       2,862                   1028


                                                                                                                                                      9
                                                                                           MORGAN STANLEY RESEARCH


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                                                                                            Asia Credit Strategy




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                                                                                            Asia Credit Strategy




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