Low domestic market capitalization relative to GDP reflects the extent of market underdevelopment. China’s domestic market capitalization was modest at 59% of GDP as of 2019, significantly below those for developed countries like 174% for the US and 122% for Japan but more in line with developing ones like 76% for India and 64% for Brazil. This points to China’s high economic growth being driven mainly by reliance on indirect borrowing, i.e. bank and shadow-bank lending. Indirect financing’s share of total financing was 64.5% in 1H20. The result was that overall leverage in the financial system is high and transparency is opaque.
China's capital market development still lags behind global peers
Source: Fitch Ratings, Fitch Solutions, The World Bank, World Federation of Exchanges
Chinese regulators have introduced a series of new regulatory measures on capital markets starting from 2015. The regulations were centered on improving transparency, imposing operation guidelines on different stock exchanges in China, including the Shanghai Stock Exchange, Shenzhen Stock Exchange, and STAR Market, and on promoting investor protection. These initiatives, if implemented well, will aid the development of capital markets and lead to a more comprehensive framework to encourage fund-raising and strengthen foreign investor confidence. These regulatory initiatives bode well for Chinese securities firms’ long-term growth prospect.
Chinese securities firms generally enjoy high levels of profitability compared with the largest securities firms in Asia Pacific, as measured by return over average equity. Strong profitability among Chinese securities firms is attributable to their larger trading gains and brokerage commissions relative to APAC peers, as well as more efficient cost structures. However, as a result, earnings are sensitive to market movements and confidence-linked brokerage activity. We believe that leading Chinese firms will still be able to sustain their relative earnings strength in the next few years, with the help of further franchise differentiation and rising market demand.
Chinese securities with generally lower leverage but higher average ROAE
Bubble sizes denote net revenue of 1H20 (annualized) in USDbn. Yuanta is considered on a consolidated Financial Holding basis. For Nomura and Daiwa, financials are as of end-Mar 2020 (the latest available) Source: Fitch Ratings, Fitch Solutions, Company Financials
Larger securities firms in China have been increasing their market position, with the top ten players contributing more than half of the industry's profits. Fitch expects their dominance to continue on the strength of their superior product innovation and advantages from economies of scale, which are essential factors to sustain profitability amid securities firms’ business model evolution. These firms can no longer rely on brokerage fee income with commission rates falling quickly over time, driving them to diversify into other business activities such as proprietary trading, asset management operations, and investment banking business.
While securities firms benefit from diversified revenue streams thanks to new business operations, they also face associated risks. The most significant are market risks arising from proprietary trading activities, and default risks in relation to asset management products. The potential impact on balance sheet could be significant given that investment portfolios making up more than half of total assets and total asset management business are 6x the equity base for a portfolio of our selected securities firms, which are of the larger players in the market. Nonetheless, their relatively high capital base and moderate leverage provide a reasonable cushion against potential impairment losses on funds, asset-management products, wealth-management products, trust products, derivatives and equity investments. Fitch scenario analysis shows that their regulatory capital leverage ratios would maintain at above the minimum requirement of 8% under a distressed scenario.
Chinese securities firms have grown their reliance on short-term funding during 2015-2020 despite the fact that their funding profiles have indeed become more diversified with the issuance of overseas bonds and hybrid securities, and via capital raising exercises. Short-term funding amounted to 48% of total funding for Fitch-tracked largest securities firms, flagging potential refinancing risks. Even with their size of financial investments appearing to be sufficient to cover their short-term funding, the transparency and credit quality of their investment assets as well as the liquidity and market volatility could undermine issuer liquidity as they address short-term debt repayment needs.
Corporate governance and potential intervention by the authorities are key factors driving ESG risks among Chinese securities firms, and could be relevant to determining their credit profiles. In particular, when equity markets have undergone material corrections in the recent past, authorities have used the securities firms to buy up stocks as a means of stemming the market correction.
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