Will US Sanctions Disrupt China's Credit Market?

12 October 2020

4 min read

Hua Cheng, CFA| Director—Asia Credit Research

Elizabeth Bakarich, CFA| Portfolio Manager—Emerging Market Corporate Debt

Tariffs and sanctions haven’t yet hampered Chinese corporate bond markets too much. But escalating tensions between the US and China could reveal some cracks. We shine a light on which sectors and credits are most vulnerable.

We are more than two years into a long and bumpy period in US-China relations. From July 2018 through August 2020, the US imposed tariffs on US$550 billion worth of Chinese products. China countered with tariffs on US$185 billion worth of US goods.

Then, in late August, the US added 24 Chinese companies to its list of those banned from buying American goods, citing the companies’ alleged links to Chinese military projects. The US Department of Commerce banned mobile-app downloads of Chinese social media platforms TikTok and WeChat, to which China responded by announcing plans to sanction foreign entities that it considered to be harmful to its national interests.

Perhaps surprisingly, the US dam on China trade has not yet resulted in broad economic decoupling between the two countries. And, with one or two exceptions, credit spreads on Chinese corporate bonds haven’t been materially affected.

Because US-China tensions may escalate in the run-up to the US elections on November 3, we think caution is warranted.

Here’s where we see the risks to Chinese companies.

China Relies on US Technology

Sanctions are most likely to affect Chinese companies that are large purchasers of US products. In contrast, companies that are better integrated into global supply chains and the global financial system are less likely to be affected.

We regard three sectors of the Chinese credit market as key targets for US sanctions: technology companies, banks and state-owned enterprises (SOEs).

China relies on the US for most of its tech imports (Display).

China Relies Heavily on Technology Imports

Imports as Percentage of China’s Total Consumption

Current analysis does not guarantee future results.
As of September 14, 2020
*Auto-key parts include automatic transmission, continuously variable transmission, high-end engine timing chain systems, braking devices, etc.
†Manufacturing and testing equipment used for producing high-end digit control machine tools, high-quality equipment, carrier rockets, large aircraft, aero engines and automobiles

The US dominates the tech sector, especially in semiconductors. Its interest in holding a competitive edge may be a factor behind the export controls and economic and trade sanctions that it has threatened or imposed on Chinese tech companies.

The US government also cites concern about the data security of millions of users of Chinese social media platforms as another factor in its curbs on TikTok and WeChat. The measures include pressure for TikTok to partner with US companies in a new, US-controlled entity.

The US government also seeks greater scrutiny of Chinese companies listed on US exchanges. To that end, it has demanded access to the audit working papers of internet companies listed on NASDAQ. China has resisted such moves, citing its own data security concerns.

Given what appears to be at stake for both sides, we expect Chinese technology companies to remain a key target of US sanctions for the foreseeable future. The extent to which individual companies will be affected will need to be assessed on a case-by-case basis.

This is important, as some companies may be able to withstand the pressure better than others. In the case of Chinese internet companies on NASDAQ, for example, a worst-case scenario might be that they are forced to delist from the exchange as a way of avoiding unwanted scrutiny from US authorities. This would result in credit investors having less visibility into their capital structures.

But many would have a Plan B option of listing on stock exchanges in China or Hong Kong. This could help mitigate concerns about visibility into capital structures, and credit investors might take additional comfort from the fact that Chinese corporate bonds tend to be well supported by domestic Chinese investors.

Banks and SOEs Are Harder Targets

Investors should also make case-by-case assessments when looking at the potential vulnerabilities of Chinese banks and SOEs, in our view. Generally, however, we regard these sectors as less sensitive to US sanctions than technology.

China’s banks on the mainland and in Hong Kong have become well integrated into the global trading system—a measure by which they far exceed banks from other countries sanctioned by the US (Display). In addition, Hong Kong banks have large US dollar exposures.

China’s Banks Are Part of the Global Financial System

International claims on sanctioned countries compared with Chinese and Hong Kong banks’ US dollar assets and liabilities.

Current analysis does not guarantee future results.
As of September 14, 2020
Source: BIS, CEIC Data, Citi Research and company reports

This makes them a harder target than import-dependent technology companies. While we don’t rule out the possibility of the US trying to cut China from the international financial system, it seems unlikely, given the disruption it would cause to the US’s dominance of the system.

The US regards China’s SOEs with suspicion because of apparent links some have to the Chinese military. However, we think sanctions on SOEs are likely to have limited impact, for a variety of reasons.

First, most of SOEs’ overseas business consists of “Belt and Road” projects outside the US. Second, SOEs import relatively little technology and other materials from the US. And third, they are partly insulated from financial stress by being owned and supported by the Chinese government. In fact, we believe their strategic importance to the Chinese government will be the primary driver of their credit profile.

Take a Measured View

While US-China relations could deteriorate further in the short term and remain difficult for the foreseeable future, we think investors should take a measured view of how such an environment is likely to affect the Chinese corporate bond market.

As our analysis suggests, the Chinese technology sector is potentially more exposed to the effects of sanctions than the banking and SOE sectors, but some technology companies are more exposed than others.

Owners of Chinese corporate bonds may wish to bear these relative risks in mind when monitoring their exposures and to evaluate on a case-by-case basis the risks and opportunities presented by individual securities.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

About the Authors

Hua Cheng, CFA

Hua Cheng is a Senior Vice President and Director of Asia Credit Research. She joined AB in 2011 and now oversees the credit research capabilities in Asia. Cheng is also responsible for covering the technology sector in China, as well as banks and nonbank financial institutions in the Asia Pacific region, with an emphasis on China’s financial system and credit market. Earlier in her tenure at AB, she was an equity research analyst covering Chinese and Hong Kong banks. Cheng was previously an auditor at PricewaterhouseCoopers, where she audited China’s financial institutions. She holds a BA in finance from the Capital University of Economics and Business (Beijing) and an MBA from the Columbia Business School. Cheng is a CFA charterholder.

Elizabeth Bakarich, CFA

Elizabeth Bakarich is a Senior Vice President and Portfolio Manager, focusing on emerging-market corporate debt. She is a member of the Credit, Emerging Market Corporate Debt and Emerging Market Debt portfolio-management teams. Bakarich became part of the Emerging Markets team in 2014, working as an associate portfolio manager on corporate and local-currency debt portfolios. Prior to that, she worked in the firm's London office on the Global and European Credit teams. Bakarich joined the firm in 2006 as an associate with the US Municipal Group and later became supervisor of that group. She holds a BS and MS in mathematics from the Stevens Institute of Technology. Bakarich is a CFA charterholder. Location: New York

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