While Asia-Pacific has shown that it can weather shocks better than a decade ago, the region's credit quality has been negatively impacted. Declining economic growth and collapsing trade flows have put pressure on exports and manufacturing industries such that credit quality and collateral values have been badly affected.
Tentative signs of economic recovery suggest 2009 will be the worst of the cycle, with defaults peaking at levels similar to those experienced during the late 1990s. Of the entities rated by Standard & Poor's in the region, there have been 12 defaults so far this year, which is already more than in 2008. And while outlook for 2010 is much stronger, risks need to be managed with 30% of rated entities on negative outlook (268 credits). The potential for a further deterioration in credit quality and defaults remains, and market confidence is still brittle.
Since the late 1990s, banking-sector reforms, the strengthening of public-sector finances and reserves, and general corporate-sector deleveraging have helped support the region's markets. Also, the region was less exposed to opportunistic investment flows and asset bubbles ahead of this latest financial crisis than it was just prior to the Asian financial crisis. Asia-Pacific certainly has not experienced the bursting of asset bubbles to the extent seen in US and European markets. Nor did we have as much direct exposure to subprime and securitised assets -- so the region's banks did not need to be bailed out.
That said, Asia-Pacific relies heavily on international trade flows and has not been able to "decouple" from the global economy in this current crisis. Nor has any government action been strong enough to fully insulate market participants from the acute dislocation of credit markets or the harmful impact of a global economic slowdown. The upshot is that most countries in the region have experienced recessionary conditions in 2009.
While the region's credit quality has suffered, government actions to stimulate flagging economies and shore-up the banking sector (through guarantees and funding support) have reduced the potential depth and duration of the economic downturn. Signs of a recovery are already appearing. But credit tends to be a lagging indicator and while these early signs of easing are positive, they are coming too late for some. Defaults are expected to peak in 2009, while the survivors will likely reap the benefits of increased economic activity.
In 2008, Standard & Poor's Asia-Pacific ratings portfolio moved to a negative bias with downward actions exceeding positive ones by two to one -- reversing the previous strong positive position. This downward trend has continued in 2009 with rating downgrades at mid-year (130) exceeding the downward movements in 2008 as a whole (122). Downgrades have exceeded upgrades for 12 consecutive months with the downgrade ratio (the number of downgrades to total rating actions) reaching peaks similar to those observed during the Asian financial crisis. Most downgrades (about 85%) have been in the corporate and industrial portfolios, while bank ratings have been underpinned by sovereign support. Most of the region's sovereigns have been able to support their economies and banking systems without material adverse impact to their credit profiles.
The difficult economic conditions have had a more profound impact on speculative-grade credits than on investment grade credits, with 48% of speculative grade credits on non-stable outlooks (negative or positive). This compares with 68% of the entire ratings portfolio having a stable outlook.
Strong downward ratings activity in 2009 (130 downgrades) has helped bring stability to the portfolio because the number of ratings on non-stable outlooks has decreased from its peak in March 2009. We expect this trend will continue through 2009 and into 2010 as the improving economic outlook ameliorates some of the pressures on credit quality.
The region has seen a sharp rise in corporate defaults in 2008 and so far in 2009. Defaults have been spread across the region and have been concentrated in the weaker end of the credit spectrum; all were rated 'BB+' or below one year before default, and most were 'B' or below. A number of defaults took the form of distress debt exchanges, where investors agreed to a buy back (in full or partially) the outstanding debt/bonds at a substantial discount. The advantage of this for the issuer is that it reduces the debt burden and allows the entity to continue to operate. For the investors, it allows them to liquefy their position (albeit at a loss) and may, in their view, provide a higher or quicker return of funds than bankruptcy. Standard & Poor's views distress exchanges as akin to defaults because of the economic loss they cause to the investor.
While Asia-Pacific's speculative-grade default rate has risen sharply to about 5.6%, it remains below that of the US (6.2%) and the global rate of 6.7%, reflecting relatively lower leverage of the corporate sector coupled with relatively stronger, albeit still-weak, economic performance. Defaults are expected to rise further in 2009, peaking at about 10% of speculative-grade credits in our regional base-case scenario.
The outlook for the next 12 months
In our regional base-case scenario, we forecast an improvement in corporate earnings and cash flows off the back of a strong economic recovery during 2010. Anticipating this, we expect the corporate sector to start restocking and to undertake capex in late 2009 and through 2010.
Reflecting improving economic prospects, defaults are expected to decline in 2010 to about 5% of speculative-grade entities while staying above historical lows (of one or two defaults per year). The market is likely to continue to test credits; access to funding will remain selective with speculative-grade entities likely to continue to experience constrained access to funding.
We expect companies will remain risk averse -- growth strategies will be pursued very selectively -- while the banking sector will remain profitable despite having to contend with rising credit losses in their loan portfolios. Continued emphasis will be placed on restoring balance sheet strength. While government funding and liquidity measures proved a timely safety net, these measures will inevitably be unwound. With the exception of Australia, the reliance of the region's banking sector on international wholesale funding is relatively modest with the banks enjoying high deposit-to-loan ratios.
The current investment environment and the decline in business volumes will constrain the earnings outlook for the insurance sector, but its credit quality remains solid on the back of a strong regulatory environment and capital resources that can absorb insurance and investment losses.
In a downside scenario -- where the recovery is delayed for another 12 months -- corporates and the industrial sector would likely tighten their belts further by deferring capex, running down stocks, and reducing staff levels. Tapping equity markets and proactively buying back debt would enhance capital structures and reduce debt burdens. A prolonged downturn would inevitably result in more casualties; we'd expect to see an increase in defaults and distressed exchanges and the renegotiation of bank loans to try and stave off default. The banking sector would experience a spike in non-performing loans along with a likely reduction in lending activities and a contraction in interest margins, which would result in a number of participants being unprofitable in the short run. In this scenario, government liquidity and funding support measures would be needed for longer. Banks would need to recapitalise to restore balance sheet strength. While some downward rating actions would be likely in this scenario, ongoing government support would be an ameliorating factor.
However, Asia-Pacific has shown resilience in the face of difficult global economic conditions. Good intraregional trade flows, structural reforms put in place since the Asian financial crisis, and rapid policy responses to current challenges have all helped provide some insulation -- but not isolation -- from the collapse of export markets. The outlook for 2010 is much stronger with all economies forecast to improve. With regard to credit quality, while defaults in the region have risen sharply in 2008 and 2009 they remain below the global experience and the negative bias in the ratings portfolio is less than in other regions.
Ian Thompson is a managing director and chief credit officer at Standard & Poor's Ratings Services.
