Corporate default risk rising in Asia due to capital outflow

With funds flowing out of emerging Asia to developed economies where recovery is underway and investment returns are becoming more attractive, the health of the many Asian corporations are increasingly under closer scrutiny, particularly now that many emerging Asian markets are facing some problems.

Emerging Asia from India to Indonesia, Malaysia to Myanmar had been a huge beneficiary of capital flows from developed economies where central bankers such as U.S. Federal Reserve had opened up the taps with quantitative easing, pouring billions of U.S. dollars to shore up the economies of these countries since 2009.

Now with developed economies recovering, not only are the taps being turned off, but money is also flowing out of emerging Asia to chase more attractive growth assets in developed markets. This has triggered the hikes in interest rates, a fall in asset prices and the weakening of currencies in many parts of Asia.

The deterioration of macro-conditions has raised concerns about the likely spike in corporate default risk in Asia. While companies usually do not default on their debts only because they are structurally flawed, or only because they encounter a rough patch, the collision of structural weakness such as excessive leverage and fragile economics with a tough situation, such as bad cycle and external shock, could trigger heightened stress and risk of default.

In order to understand the magnitude of the likely default risk in Asian corporate world, Standard Chartered Equity Research developed a corporate default risk framework premised on the interplay between structural factors liked operating and financial leverage and variable conditions such as profitability, cash flow and liquidity. The research firm used this approach in measuring the risk by country and industry in 9,003 listed corporations across Asia.

The study found that systemic financial leverage is rising among Asia corporations in the backdrop of currency turmoil and worsening fundamentals among some emerging Asian economies such as India and Indonesia. Indeed, India was found to have the highest overall corporate default risk in Asia, with a combination of high structural risk and particularly elevated cyclical stress.

According to Standard Chartered, China is structurally the riskiest but has surprisingly moderate cyclical stress, whereas China's Hong Kong has high cyclical risk results due to the size of property developers' fixed assets and operating leverage.

Rising financial leverage across the region certainly justified concern, but operating leverage has declined across much of Asia with falling fixed asset holding. China property may appear to be one of the risky sectors, but Standard Chartered said in its study that high financial leverage is balanced by low operating leverage among most Chinese property developers.

Indeed, developers' structural risk levels differ considerably across the region, reflecting fundamentally divergent business models based on landlords and real estate investment trust practiced in China's Hong Kong, Singapore and India, and fast- turnover develop-for-sale approaches in China and South Korea. Based on Standard Chartered's framework, the former are more fixed- asset-heavy and have higher operating leverage, and therefore higher structural risk than those in China and South Korea.

Concerns about the solvency of real-estate developers are most acute in Indiaoperating and financial leverage is in line with Singapore and China's Hong Kong, but cyclical conditions are very weak. India's developers foreshadow the vulnerability of China's Hong Kong and Singapore peers should property-market and broader macro conditions deteriorate. While China's Hong Kong and Singapore developers have more rigid fixed asset and fixed cost structures, this is balanced by their lower financial leverage.

As for the highest-risk sectors likely to default, Standard Chartered identifies four sectors across most countries: construction materials; capital-intensive process industries such as utilities, energy, and chemicals; resources; and transportation. Even within these sectors, economic risk is mitigated by policy supports, or the structural risks under control by sectors still cyclically robust in many Asian economies.