Anti-graft drive may prompt SOEs to be prudent

The anti-corruption campaign supports the Chinese government's goals of economic reform and rebalancing, macroeconomic stability and legal system reform. We expect that it will bring greater accountability and efficiency in the way that major State-owned enterprises are run and that it will encourage entrepreneurship over rent-seeking behavior.

Each of these factors will help place China's economy on a more sustainable long-term path. However, investors should be prepared for some event risk affecting individual companies.

Event risk is often used to refer to so-called black swan developments. Such events could affect a bond issuer's credit rating or its ability to service its debt.

There is an obvious need for a different approach in how China's economy is run. In the past 15 years, capital productivity - the marginal amount of investment required to generate an additional unit of economic growth - has worsened, reflecting the increasing misallocation of investment, partly fueled by the growth-linked incentives for local government officials. The anti-corruption campaign helps to address some of these distortions.

Despite the fears expressed by some analysts that the campaign will compound China's growth slowdown, we believe that it will have only modest macroeconomic effects. There could be some delays or cancellations in public-sector investment projects, given public officials' concerns over possible investigations. Such a scenario could weigh on near-term economic growth, but the overall impact will not be great compared with the much bigger impact of reform and rebalancing.

Similarly, while there might be some negative effects on consumption, especially in the luxury goods market, this market accounts for less than 0.5 percent of overall retail sales, so it is not a big driver of the economy. The positive effects of the campaign should be most obvious among the larger strategic SOEs, which will gain from enhanced efficiency, better decision-making and accountability.

Even if individual managers face investigation or removal, experience suggests that anti-corruption investigations will have a limited impact on the operations of large, strategically important SOEs, because these entities are integral to both the government's policy agenda and China's economy at large and will therefore continue to receive a high degree of State support.

Nevertheless, the anti-corruption investigation will likely make strategically important SOEs more prudent in their investment decisions, such as on commercially driven overseas expansion. They are also likely to tilt their investments toward areas that fit the government's changing economic priorities, such as key infrastructure projects, environmental protection and the "One Belt, One Road" initiatives.

Companies that provide services to SOEs but do not receive the same level of government support could see new orders soften, as the contracting process is subject to greater scrutiny as a result of the campaign.

As for the gaming sector, tighter budget constraints and greater scrutiny of State officials are weighing on revenues for gaming operators in Macao.

The biggest risk appears to be among high-yield, lower-rated private companies, which are generally more dependent on key individuals. These companies are typically more exposed to "key-man risk", which could become an issue if senior executives are placed under investigation or relieved of duty. Moreover, such companies typically do not receive any explicit or implicit government support.

Negative news about a company's senior management or major shareholders could reduce its ability to refinance upcoming bonds or retain access to bank funding, and more generally dent investor confidence in companies perceived to possess similar features.

The property market is one such sector where headline corruption risks have affected credit conditions. Although it is unclear to what extent the events surrounding Kaisa Group Holdings Ltd were linked to the campaign, the speculation concerning these developments led to a spike in Chinese property bond spreads and a temporary slowdown in new issuance.

Foreign bond issuance by Chinese property companies totaled $5.5 billion in the first quarter of 2015, significantly lower than the $9.9 billion and $8.5 billion recorded during the same periods in 2013 and 2014, respectively.

Overall, the positive effects of reforms outweigh these event risks that are likely to be short-lived. The reforms will deliver growth that is less reliant on high levels of investment over time, and which will therefore be more sustainable. China's Aa3 sovereign rating has sufficient headroom to withstand slower growth in during the transition.

Michael Taylor and Rahul Ghosh are respectively managing director - chief credit officer APAC and a vice-president and senior research analyst for Moody's Investors Service