restaurant brands’ acquisition of popeyes will increase...
TRANSCRIPT
MOODYS.COM
27 FEBRUARY 2017
NEWS & ANALYSIS Corporates 2 » Restaurant Brands’ Acquisition of Popeyes Will Increase
Leverage » Boston Scientific Recalls Its Lotus Valve, a Credit Negative » SourceHOV’s Reverse IPO Merger with Novitex and Quinpario
Is Credit Positive » Brazil’s Votorantim Steel Deal with ArcelorMittal Eases
Leverage » China’s Curbs on Secondary Equity Offering Reduce Funding
Flexibility for Listed Companies » Alibaba’s Strategic Partnership with Bailian and Further
Expansion into Offline Retail Is Credit Positive » Singtel’s Latest Digital Marketing Acquisition Keeps Leverage
Elevated » Oil India and ONGC Will Benefit from Government Royalty
Claims Settlement » Parkway Life REIT’s Acquisition of Japanese Assets Enhances
Portfolio Quality, Extends Lease-Expiry Profile
Infrastructure 16 » Japanese Utility Kansai Electric’s Preliminary Nuclear Restart
Approval Is Credit Positive
Banks 18 » Desjardins’ Sale of Subsidiary’s Insurance and Brokerage
Operations Is Credit Positive » Brazilian Measure to Stimulate Mortgage Lending Is Credit
Positive for Banks » Royal Bank of Scotland May Not Need to Divest Williams &
Glyn, a Credit Positive » Germany’s Overvalued Real Estate Market Poses Risks for
Banks and RMBS » Germany’s Deposit Protection Fund Reforms Make It More
Viable, Benefitting Banks » German Court’s Validation of Contract Cancellations Is Credit
Positive for Building and Loan Associations » BPCE’s Reduction of Its Domestic Branch Network Is Credit
Positive » Raiffeisen Schweiz's Mortgage Lending Grows as Margins
Shrink, a Credit Negative » Sweden’s MREL Framework Is Credit Positive
» China’s Coordinated Approach to Regulating Investment Products Would Be Credit Positive for Banks
» SMBC and Resona Combining Subsidiary Banks in Japan’s Kansai Region Would Be Credit Positive
Financial Market Infrastructure 36 » UK Proposals to Enhance Supervision of Financial Market
Infrastructure Companies Are Credit Positive
Sovereigns 37 » Hong Kong’s Budget Balances Economic Support with Fiscal
Prudence, a Credit Positive » Korea’s Rising Household Debt Poses Downside Risks to
Economic Growth
Sub-sovereigns 41 » German Laender’s Salary Pact with Public Employees Is Credit
Positive » Australian Universities to Benefit from Growing International
Student Enrollments
US Public Finance 44 » Kansas Governor Vetoes Tax Hike, a Credit Negative
RECENTLY IN CREDIT OUTLOOK
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NEWS & ANALYSIS Credit implications of current events
2 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Corporates
Restaurant Brands’ Acquisition of Popeyes Will Increase Leverage Last Tuesday, Restaurant Brands International Inc. (RBI), the parent company of 1011778 B.C. Unlimited Liability Company (B1 stable), announced that it had reached a definitive agreement to acquire Popeyes Louisiana Kitchen, Inc. (unrated) for approximately $1.8 billion in cash. The company expects to fund the transaction with approximately $1.3 billion of new debt and $600 million in cash. Should the transaction close as proposed, Moody’s-adjusted pro forma leverage would likely increase to around 5.5x from about 5.0x at year-end 2016.
After the announcement, we changed 1011778 B.C.’s rating outlook to stable from positive to reflect the increase in debt required to fund the Popeyes acquisition, which will adversely affect credit metrics, particularly leverage. However, we affirmed 1011778 B.C.’s B1 corporate family rating (CFR) despite the higher debt levels, given that pro forma credit metrics should be appropriate for the B1 CFR because credit metrics gradually strengthen through improved earnings and required amortization. The B1 rating affirmation and stable outlook also take into account the larger scale of the combined company, greater revenue diversification of its brands and product offerings, and potential growth in new markets with the addition of Popeyes.
Factors that could result in an upgrade include a sustained strengthening of debt protection metrics with debt/EBITDA migrating toward 4.5x and EBITA coverage of interest moving toward 3.0x. A higher rating would also require maintaining very good liquidity. Factors that could result in a downgrade include an inability to strengthen credit metrics with debt/EBITDA exceeding 5.5x or EBITA to interest approaching 2.0x on a sustained basis. A deterioration in liquidity for any reason could also result in a downgrade.
1011778 B.C. owns, operates and franchises more than 15,700 Burger King hamburger quick service restaurants and more than 4,600 Tim Horton restaurants. Annual revenues are around $4.1 billion, although systemwide sales exceed $24 billion. 3G Restaurant Brands Holdings LP, owns approximately 43% of the combined voting power of RBI and is affiliated with private investment firm 3G Capital Partners, Ltd.
This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history.
William Fahy Vice President - Senior Credit Officer +1.212.553.1687 [email protected]
NEWS & ANALYSIS Credit implications of current events
3 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Boston Scientific Recalls Its Lotus Valve, a Credit Negative Last Thursday, Boston Scientific Corporation (Baa2 stable) announced a voluntary recall of all of its Lotus transcatheter aortic valve replacement (TAVR) products. The recall is credit negative for Boston Scientific because if its resolution is delayed, and/or it takes longer to get US Food and Drug Administration (FDA) approval for the Lotus, the sales growth opportunity in 2018 and beyond will be diminished.
The recall affects all commercial and clinical trial sites using the product. In an 8-K filing, Boston said that it had initiated the recall because of reports of the “premature release of a pin connecting the Lotus valve to the delivery system.” Boston said it believes that this is because of excess tension in the pin associated with a manufacturing defect.
Lotus sales are not yet material so this development will not have a meaningful effect on Boston Scientific’s financial performance in 2017. The company reaffirmed overall guidance but reduced its 2017 sales estimate for structural heart products (including its WATCHMAN closure device) to $250 million from $300 million. It also said that it now expects the FDA to approve its Lotus platform in mid-2018 rather than in the first quarter of 2018.
Currently, the leading TAVR players globally are Edwards Lifesciences Corporation (Baa3 stable) and Medtronic, Inc. (A3 stable). They are also the only companies with TAVR products approved in the US. Boston Scientific expects to return to the market (Europe and other regions) with its Lotus products by fourth-quarter 2017 and to submit its Lotus platform for FDA approval around the same time.
As a newer treatment area addressing unmet needs, TAVR technology offers a very favorable growth opportunity for cardiac players. Underlying market growth rates of 15%-20% are significantly higher than the flat-to-low-single-digit growth rates for mature stent and cardiac rhythm management products. TAVR products are focused on treating aortic stenosis, or calcification of the aortic valve. These products provide a minimally invasive option for aortic valve replacement and were initially indicated for patients that physicians consider too high risk for open-heart surgery. Last year, Edwards received US approval and Medtronic received European Union approval for their respective products to be used in intermediate-risk patients, broadening the population beyond the high-risk pool. Longer term, companies are also seeking to introduce similar technology to replace mitral valves.
Diana Lee Vice President - Senior Credit Officer +1.212.553.4747 [email protected]
NEWS & ANALYSIS Credit implications of current events
4 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
SourceHOV’s Reverse IPO Merger with Novitex and Quinpario Is Credit Positive Last Tuesday, SourceHOV LLC (Caa1 negative) said that it had agreed to a reverse initial public offering (IPO) merger with Novitex Enterprise Solutions (B3 stable) and Quinpario Acquisition Corp. 2 (unrated). The planned transaction, which the companies expect to complete in the second quarter, is credit positive for SourceHOV because it should lower leverage and enhance liquidity.
Exela Technologies, as the combined company will be known, will be a stronger competitor in the business services outsourcing market than either SourceHOV or Novitex on their own, with greater scale, increased breadth of services and improved revenue diversity. With technology-enabled services across multiple industries, the merger would create a higher degree of customer stickiness for many of the companies’ blue-chip clients. In addition, the companies have identified at least $38 million in annual cost synergies that they expect to realize within 12 months of closing.
Exela will have stronger financial metrics than SourceHOV because of Novitex’s lower leverage and an additional equity contribution from Quinpario. We estimate Exela’s pro forma debt/EBITDA, before unrealized cost synergies and including our standard adjustments, at about 5.4x, versus 6.3x for SourceHOV as of 30 September 2016.
The planned merger, which is valued at about $2.8 billion, will be funded with $1.35 billion in new committed debt financing, as well as cash from Quinpario, rollover equity and cash on hand at closing, including from equity financing. Proceeds from the transaction will be used to repay about $1.5 billion of debt at SourceHOV and Novitex, and for general corporate purposes, including working capital. This would improve SourceHOV’s liquidity by reducing significant refinancing risk associated with the first-lien term loan and revolving credit facility due in 2019.
The transaction would also provide relief to SourceHOV’s minimal covenant cushion and weak internal liquidity, which is currently constrained by high quarterly amortization payments on the first-lien debt and low balance sheet cash of $8.7 million as of 30 September 2016. Upon closing, we expect SourceHOV’s existing first-lien credit facility (i.e., B3-rated term loan and revolver) and second-lien term loan (Caa3), as well as Novitex’s existing first-lien bank debt (B1) and second-lien bank debt (Caa2), to be refinanced with new debt issued by the surviving entity. We expect to withdraw SourceHOV’s and Novitex’s ratings at that time.
Another positive credit effect is that Novitex, a provider of outsourced mail, print, and digital document management solutions, will add significant scale (revenue of $547 million for the 12 months that ended 30 September) and opportunities to cross-sell services because of a product line that complements, rather than competes with, that of SourceHOV. The merger will also present opportunities for cost savings through improved capacity utilization in data centers.
Oleg Markin Analyst +1.212.553.1023 [email protected]
NEWS & ANALYSIS Credit implications of current events
5 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Brazil’s Votorantim Steel Deal with ArcelorMittal Eases Leverage Last Wednesday, Votorantim S.A. (Ba2 negative) said that it had reached a non-cash agreement to combine its long steel business with ArcelorMittal Brasil (AMB, unrated), a wholly owned subsidiary of ArcelorMittal (Ba1 stable), making the Brazilian operations of Votorantim Siderurgia S.A. (VSBR, unrated) a subsidiary of AMB. The deal is credit positive for Votorantim, removing around BRL850 million ($280 million) of gross debt from its balance sheet with almost no cost to its cash generation, since VSBR has been struggling to break even. In exchange for the Brazilian VSBR operations, Votorantim will receive a 15% minority stake in AMB’s Brazilian long steel business, creating a company with annual rolled steel production capacity of 5.4 million tonnes.
Brazil’s construction sector performed poorly in 2016, a year of weak economic activity in the throes of a political and economic crisis from which the country is only now emerging. Industrial production contracted significantly: Brazil’s industrial activity index was just 85.6 in December 2016, down from a peak of 105.7 in June 2013. As construction weakened, apparent consumption of long steel fell by 19%, slipping back to 2009 levels.
Pending Brazilian regulatory approval, the transaction will help Votorantim deleverage its balance sheet, and further increase the contribution of the metals and cement businesses within a conglomerate that spans metals and mining, pulp, financial services and even orange juice. Giving up VSBR’s Brazilian operations will reduce Votorantim’s adjusted debt/EBTIDA ratio to 3.3x from 3.4x for the 12 months through September 2016.
The deal does not include Votorantim’s long steel business in Argentina and Colombia. The Brazil operations equaled only about 5% of total assets for Votorantim, which generated nearly BRL30 billion in revenues in the 12 months through September 2016 – not including Banco Votorantim S.A. (Ba3/(P)Ba2 negative, ba21), whose revenues are recorded under separate financial accounting rules.
The deal will have a negligible credit effect on ArcelorMittal, the world’s largest steelmaker with $56.6 billion in revenues for the 12 months through September 2016.
1 The bank ratings shown in this report are Banco Votorantim’s deposit rating, senior unsecured debt rating (where available) and
baseline credit assessment.
Marcos Schmidt Vice President - Senior Analyst +55.11.3043.7310 [email protected]
NEWS & ANALYSIS Credit implications of current events
6 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
China’s Curbs on Secondary Equity Offering Reduce Funding Flexibility for Listed Companies On 17 February, the China Securities Regulatory Commission (CSRC) released new policies limiting the amount and frequency of secondary equity offerings by domestic listed companies. The new policies, which are part of an effort to reduce excessive fundraising, are credit negative for Chinese companies listed on domestic stock exchanges and those with major listed subsidiaries because the curbs will make it harder for these companies to raise equity for expansion or debt repayment in a timely manner.
The new policies require that companies wait at least 18 months between equity offerings and cap the amount that companies can raise from private placements to 20% of their total capitalization. The new policies also change the pricing benchmark date to the effective date of the equity offering from the date the board approves the offering, the latter of which has been used in most secondary offerings. This change seeks to reduce arbitrage opportunities arising from pricing differences between the dates, and to encourage equity investors to focus more on a company’s long-term growth prospects and earning potential.
Secondary equity offerings are a major channel for Chinese companies seeking equity capital, especially for the purpose of funding large capital investments such as acquisitions. The cash that companies generate from operations usually goes to support organic growth and is not nearly enough to fund large investments.
Because companies must often act quickly to capture investment and acquisition opportunities, they usually fund transactions mostly with debt and then aim to raise equity and use the proceeds to pay down the debt. Companies can issue debt more quickly than equity, in part because equity issuance requires regulatory approval. The new equity-issuance policies will likely slow the equity-issuance process and subsequently slow companies’ deleveraging.
The cap on equity offerings will reduce the amount of equity that companies can raise if they previously entered into sizable acquisitions relative to their equity base. This reduction will make it difficult for these companies to implement their original deleveraging plans. Chinese companies with high leverage and relatively small equity bases have been acquiring overseas companies of similar size over the past few years.
In addition, the new policies are likely to increase the use of hybrid securities such as preferred shares and convertible bonds, which are not subject to these policies. These securities have debt-like features that impede companies’ debt-reduction efforts. Although preferred shares can be recognized as equity under China’s generally accepted accounting principles, we are likely to treat the issuance as debt in whole or part in our analysis, subject to the terms and conditions of these instruments.
Nevertheless, we believe that the new policies will encourage value investing, reduce speculative and insider trading activities and adjust the investment flow between initial public offerings (IPOs) and secondary offerings. These are all factors that will support healthy growth of the Chinese equity market. The new policies are also likely to encourage companies to expand in a measured way, be more prudent in their investment decisions (i.e., selecting sound projects that are likely to be accretive to their stock price) and reduce the use of equity for investments in non-core areas, such as entrusted loans to unrelated companies, or investments in risky trust products or wealth management products.
Secondary equity offerings have grown much faster than IPOs during the past five years (see exhibit). Secondary offerings, which include investor subscriptions in the form of cash and assets, totaled about RMB1.8 trillion in 2016, according to data from Wind Information Co. IPO proceeds were around RMB139 billion in the same year.
Kai Hu Senior Vice President +86.21.2057.4012 [email protected]
NEWS & ANALYSIS Credit implications of current events
7 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
In China, Secondary Offerings Have Dwarfed IPOs and Have Grown Much Faster
Note: Total amounts of secondary offerings include investor subscriptions in the form of cash and assets. Source: Wind Information Co.
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
2010 2011 2012 2013 2014 2015 2016
RMB
Billi
ons
IPO Secondary Offering
NEWS & ANALYSIS Credit implications of current events
8 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Alibaba’s Strategic Partnership with Bailian and Further Expansion into Offline Retail Is Credit Positive On 19 February, Alibaba Group Holding Limited (A1 stable) and Bailian Group Co. (unrated), one of China’s largest supermarket and department store chains, announced a strategic partnership aimed at improving operational efficiencies and the customer experience. The companies said they will look for opportunities in a range of areas including store design, technology, supply-chain management, payments and logistics. The partnership is credit positive for Alibaba because it will strengthen the Chinese e-commerce giant’s presence in offline retailing without raising its leverage or capital spending.
The Bailian partnership furthers Alibaba’s expansion into physical stores and advances its push to deepen links between its online operations, Taobao and Tianmao, online payment platform Alipay, logistics network Cainiao, and offline retail stores. Alibaba will be able to gain access to Bailian’s customer and merchants’ data and further expand into offline retail, strengthening its multi-channel retailing presence via online and offline data integration.
We expect the partnership to help Alipay expand its offline penetration usage to a broader consumer base. Higher penetration of Alipay in offline settings will raise Alibaba’s income from associates and positively affect revenue and earnings from the expanded user base, increased sales and other monetization opportunities. As Exhibit 1 shows, Bailian was the sixth-largest offline retailer in China as of 31 December 2016.
EXHIBIT 1
China’s Offline Retailers’ Market Share in 2016
Source: Euromonitor 2017
The Bailian partnership does not require additional capital investment from Alibaba, and we expect no negative effect on leverage. Alibaba’s adjusted debt/EBITDA for the 12 months that ended 31 December 2016 was around 1.5x, lower than we expected, and its cash flow during the period was stronger than we expected (see Exhibit 2). Alibaba has a good track record of incubating new businesses without affecting its financial profile and maintaining solid cash holdings and strong cash flows from operations. These strategic investments and partnerships show Alibaba’s ability to enter into new business initiatives without jeopardizing credit quality.
1.4%
0.8% 0.8% 0.8%
0.6%
0.5% 0.4%
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
1.4%
1.6%
China Resources Auchan Group GOME Suning Wal-Mart Bailian Group Yonghui
Lina Choi, CFA Vice President - Senior Credit Officer +852.3758.1369 [email protected]
Dan Wang Associate Analyst +852.3758.1529 [email protected]
NEWS & ANALYSIS Credit implications of current events
9 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
EXHIBIT 2
Alibaba’s Adjusted Debt/EBITDA
Note: Fiscal years end 31 March. Source: Moody’s Financial Metrics
1.4x
1.6x
1.4x
1.5x
0.0x
0.2x
0.4x
0.6x
0.8x
1.0x
1.2x
1.4x
1.6x
1.8x
0
10
20
30
40
50
60
70
80
90
100
Fiscal Year 2014 Fiscal Year 2015 Fiscal Year 2016 Calendar 2016
RMB
Billi
ons
Adjusted EBITDA - left axis Adjusted Debt - left axis Adjusted Debt/EBITDA - right axis
NEWS & ANALYSIS Credit implications of current events
10 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Singtel’s Latest Digital Marketing Acquisition Keeps Leverage Elevated Last Thursday, Singapore Telecommunications Limited (Singtel, Aa3 stable) announced that it had acquired Turn, Inc. (unrated), a California-based advertising technology company, through its wholly owned subsidiary Amobee, Inc. (unrated), for $310 million (SGD439 million), subject to adjustments for working capital and net debt at closing. Although the acquisition will enhance Singtel’s digital-marketing service offering, it is credit negative because it will likely keep the company’s leverage elevated.
Singtel has not disclosed funding details, but if we assume the acquisition is entirely debt-funded, Singtel’s pro forma net leverage would increase to 2.1x-2.2x from 2.0x as of December 2016, keeping leverage at the upper end of our quantitative guidance for its rating. Additionally, the acquisition is likely to marginally reduce Singtel’s EBITDA margin, and will require additional cash investments, both of which are credit negative. However, the acquisition is small, equaling approximately 0.9% of Singtel’s total assets as of December 2016. Singtel said that it expects the deal to close by 30 June, subject to certain conditions including regulatory approvals.
The Turn acquisition is in line with Singtel’s strategy of investing in digital businesses with high-growth prospects in order to take advantage of the convergence of telecommunications, IT and media, and to diversify revenue away from the saturated voice and short message service (SMS) markets.
Since April 2012, Singtel has spent nearly $1 billion on acquisitions in the digital marketing space (see exhibit). Although the individual investments have been relatively small, cumulatively these acquisitions have weakened Singtel’s financial metrics because they register startup losses and generally produce much lower margins than the company’s core telecommunications business. For example, for the nine months that ended December 2016, Singtel’s digital business segment, which includes digital marketing, advanced data analytics and intelligence and premium over-the-top video, contributed around 3% of consolidated revenue, and recorded strong year-on-year revenue growth of 23%. But the digital business was still loss-making, a trend we expect to continue over the next one to two years.
Singtel’s Acquisitions
The company has spent nearly $1 billion since April 2012 on digital marketing acquisitions.
Acquisition Description Date Price
Turn, Inc. Real time multichannel ad buying platform To be completed by June 2017 $310 million
Adconion Media, Inc. and Adconion Pty. Limited
Multichannel digital advertising Aug-14 $209 million
Kontera Technologies, Inc. Digital content intelligence and marketing Jul-14 $150 million
Amobee, Inc. Mobile advertising Apr-12 $321 million
Total: $990 million
Note: Turn acquisition price is subject to adjustments for working capital and net debt at closing.
Source: Company filings
Given the highly competitive operating environments in its core markets of Singapore and Australia, we expect EBITDA growth to remain muted. Therefore, Singtel’s primary source of deleveraging will come from the proceeds of its planned sale of its stake in NetLink Trust (unrated). The value of assets transferred by Singtel to NetLink Trust is about SGD2.2 billion.
Singtel’s stable outlook incorporates our expectation that net adjusted leverage, based on cash dividends from associates added back to EBITDA, falls below 1.8x by December 2017. Any delay in leverage reduction
Maisam Hasnain Associate Analyst +852.3758.1420 [email protected]
Annalisa Di Chiara Vice President - Senior Credit Officer +852.3758.1537 [email protected]
NEWS & ANALYSIS Credit implications of current events
11 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
would lead to negative pressure on the company’s underlying credit quality. Downward rating pressure could also arise if the company undertakes further material capital returns within the next 12 months, potentially in conjunction with a cash/debt-funded acquisition, or if there is evidence of prospective weakness in the operating results of the company’s Singapore and Australia operations or in cash dividends received from overseas associates.
NEWS & ANALYSIS Credit implications of current events
12 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Oil India and ONGC Will Benefit from Government Royalty Claims Settlement On 20 February, government-owned Oil and Natural Gas Corporation Ltd. (ONGC, Baa1 stable2) and Oil India Limited (OIL, Baa2 stable) said that India’s central government will pay the royalty on crude-oil production from onshore fields to the state governments of Gujarat and Assam. This settlement is credit positive for ONGC and OIL because it removes more than INR261 billion ($3.9 billion) of contingent royalty liability for both companies without any further cash outlay from these companies.
The central government’s decision will likely set a precedent for similar claims from other state governments in India. Royalties on crude-oil production from onshore fields are paid to state governments, while royalties on offshore blocks are paid to the central government. At the same time, the central government subsidizes fuel and shares the cost with ONGC and OIL, which share the subsidy burden discounting (at a government-determined rate) the crude oil sold to government-owned refining companies.
Until March 2008, based on directives from the central government, the royalties were paid on the pre-discount price of crude oil. Since May 2008, however, the central government directed oil companies to pay the royalty only on post-discount prices. State governments maintained that they should receive royalties on the pre-discount prices of crude oil, and the matter has been under court adjudication ever since.
As of December 2016, ONGC reported contingent royalty liabilities of INR157 billion and OIL reported INR104 billion for production since April 2008. In July 2016, the central government directed ONGC and OIL to pay royalties to all crude-oil-producing states at pre-discount prices on onshore production since February 2014. Consequently, ONGC paid INR25.6 billion and OIL paid INR11.5 billion to the state governments (i.e., the difference between pre-discount and post-discount prices for onshore production since February 2014), raising the likelihood that ONGC and OIL would be required to pay the entire claimed amount since 2008.
However, the central government has now decided to pay the remaining royalty claims for production between April 2008 and January 2014. The amounts the two oil companies already paid, which the companies have treated as deposits, will no longer be recoverable and will lower the companies’ pre-tax incomes for the fiscal year ending in March 2017 by their respective deposit amounts.
Since October 2015, the central government has not asked ONGC and OIL to provide discounts, given low oil prices and consequently low fuel subsidies. Therefore, there was no difference between pre-discount and post discount prices, and no additional royalty claim on onshore production since then.
If Brent crude-oil prices increase to above $60-$65 per barrel on a sustained basis from $56 per barrel as of 21 February, we expect that ONGC and OIL will be asked to share the subsidy burden once again and there will be a difference between their pre-discount and post-discount prices. Paying royalties on a pre-discount basis would reduce the companies’ profitability.
The effect on OIL would be more negative than on ONGC because OIL derives its entire Indian production of crude oil from onshore blocks, whereas ONGC derives less than half of its production of crude oil in India from onshore blocks. However, we expect that the central government will base the share of any future subsidy burden after taking into account the difference in ONGC’s and OIL’s royalty claims and make OIL’s subsidy-per-barrel share lower than ONGC’s to compensate for its higher royalty payments.
2 This is ONGC’s local-currency issuer rating; its foreign-currency issuer rating is Baa2 stable.
Vikas Halan Vice President - Senior Credit Officer +65.6398.8337 [email protected]
Sweta Patodia Associate Analyst +65.6398.8317 [email protected]
NEWS & ANALYSIS Credit implications of current events
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Over the next 12-18 months, we expect the fuel subsidies to remain low because we expect oil prices will remain below $60 per barrel during this period. Thus, the royalty issue will not be an issue for at least next 12-18 months.
NEWS & ANALYSIS Credit implications of current events
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Parkway Life REIT’s Acquisition of Japanese Assets Enhances Portfolio Quality, Extends Lease-Expiry Profile On 17 February, Singapore-based Parkway Life REIT (PLife, Baa2 stable) announced that it had acquired four nursing homes and one group home in Japan for approximately SGD60 million (¥4.759 billion). The acquisition is credit positive because it will boost the healthcare real estate investment trust’s overall portfolio quality, allow the trust to benefit from strong demand in Japan and extend its lease-expiry profile.
The acquisition is part of PLife’s asset recycling initiative, which allows the trust to unlock value from its less strategic assets and acquire properties with higher yields. We expect PLife’s earnings to improve as a result of its enhanced Japanese portfolio. The acquired properties have a net property yield of 6.9%, which is higher than PLife’s average net property yield of around 6.0% at the end of 2016.
Additionally, PLife’s increased exposure to the fast-growing Japanese healthcare segment further enhances the quality of its asset portfolio. We expect demand for nursing homes in Japan to remain strong, owing to the country’s growing aging population given low fertility rates and longer life expectancy. The newly acquired assets are positioned well in key cities in Yamaguchi Prefecture and Chiba Prefecture, the latter of which is in the greater Tokyo area. The new assets will increase revenue generation from Japan. PLife’s assets in Japan as a percentage of the total portfolio will increase to 38% from 36%.
PLife’s credit quality is supported by the high revenue visibility from master-lease agreements with favorable lease structures. The master-lease arrangements at the newly acquired assets have remaining lease terms of 20-30 years, which will improve PLife’s overall lease-expiry profile to 9.81 years from 8.44 years at the end of 2016.
We expect PLife’s financial profile to remain strong for its Baa2 rating, although credit metrics will weaken slightly owing to partial debt funding for the acquisition. Still, PLife has a track record of exhibiting financial discipline in making acquisitions and we expect its credit metrics to improve with the full-year contribution of the new assets from 2018. Following the acquisition, we expect its adjusted debt/deposited assets to increase to 37%-38% from around 36% at the end of December 2016 (see Exhibit 1) and its adjusted net debt/EBITDA to weaken marginally to 6.7x from 6.3x (see Exhibit 2). EBITDA/Interest cover will remain strong at 9.8x.
EXHIBIT 1
PLife’s Ratio of Adjusted Debt/Deposited Assets
Sources: The company and Moody’s Financial Metrics
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
2013 2014 2015 2016 Post Acquisition-Normalized
Adjusted Debt/Deposited Assets Upper Range of Baa2 Guidance Lower Range of Baa2 Guidance
Saranga Ranasinghe Assistant Vice President - Analyst +65.6311.2615 [email protected]
NEWS & ANALYSIS Credit implications of current events
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EXHIBIT 2
PLife’s Adjusted Net Debt/EBITDA
Sources: The company and Moody’s Financial Metrics
0x
1x
2x
3x
4x
5x
6x
7x
8x
9x
2013 2014 2015 2016 Post Acquisition-Normalized
Adjusted Net Debt/EBITDA Lower Range of Baa2 Guidance Upper Range of Baa2 Guidance
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Infrastructure
Japanese Utility Kansai Electric’s Preliminary Nuclear Restart Approval Is Credit Positive Last Wednesday, Japan’s Nuclear Regulation Authority (NRA) concluded its safety assessments and began a month-long request-for-comment process for nuclear-focused Kansai Electric Power Company, Incorporated (A3 stable) to restart its Ohi 3 and 4 nuclear power plants. The two reactors will have the regulator’s preliminary approvals when the request-for-comment period ends on 24 March. A restart of these reactors would allow Kansai Electric to lower its electricity tariffs and become more price competitive in the deregulated environment, a credit positive. We expect that the reactors will restart within the next 12 months.
Kansai Electric was one of the most nuclear-reliant utilities in Japan before the 2011 Fukushima Daiichi nuclear accident (51% of the company’s electricity generation came from nuclear power in the 12 months to 31 March 2011), and the company has had to raise its tariffs twice since the accident. The second rate hike in June 2015, combined with the reduction in fuel prices, allowed the company to report positive operating profit of ¥256.7 billion in the fiscal year that ended 31 March 2016 after four years of losses. The rate hike, however, also led to a decline in its customer base.
The NRA’s latest approvals come amid intensifying competition in Japan’s power sector following the 1 April 2016 deregulation of electricity sales, whereby households and small businesses can choose providers. As of 31 January 2017, Kansai Electric has lost 568,700 customers, with Osaka Gas Co., Ltd. (Aa3 stable) having gained about 250,000 customers for the nine months period that ended 31 December 2016.
We expect price competition to remain intense between the two companies, especially with the deregulation of gas sales starting 1 April 2017. Kansai Electric has already announced its plans to set prices at levels that would save an average household currently buying from Osaka Gas 13% by switching to Kansai Electric. The nuclear restart will allow Kansai Electric to lower its electricity prices, and help staunch customer losses.
As shown in the exhibit below, Kansai Electric has nine nuclear reactors, and has applied to restart seven of them. With the Ohi 3 and 4 approvals, all seven now have received preliminary approvals. The company has not yet determined whether or when it will apply for the restart of the remaining two, Ohi 1 and 2.
Mariko Semetko Vice President - Senior Analyst +81.3.5408.4209 [email protected]
NEWS & ANALYSIS Credit implications of current events
17 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Status of Kansai’s Nine Nuclear Reactors
Unit Megawatts
Capacity Age of
Operation Restart Application Nuclear Restart
Reactors aged 23-32 years
Takahama 3 870 32 8-Jul-13 Feb 2016*
Takahama 4 870 31 8-Jul-13 *
Ohi 3 1,180 25 8-Jul-13 Likely Oct 2017-Mar 2018
Ohi 4 1,180 24 8-Jul-13 Likely Oct 2017-Mar 2018
Reactors aged 37-42 years
Takahama 1 826 42 17-Mar-15 Target October 2019
Takahama 2 826 41 17-Mar-15 Target May 2020
Mihama 3 826 40 17-Mar-15 Target Mar 2020
Ohi 1 1,175 37 Due Dec 2017-Mar 2018
Ohi 2 1,175 37 Due Sep-Dec 2018
Note: * A court injunction suspended Takahama 3’s operations shortly after restarting. Takahama 4 was also about to restart in February 2016, but had technical issues followed by a court injunction.
Source: Company disclosures
Ohi 3 and 4 will still need to undergo additional assessments before the reactors can actually restart. The company aims to restart them this fall and we expect the reactors to restart most likely in the second half of the fiscal year ending 31 March 2018. Five reactors in Japan have restarted, of which Kansai Electric’s Takahama 3 and 4 had to subsequently halt their operations because of a court injunction. The five reactors took about a year to restart after receiving preliminary approvals. Given that Kansai Electric already has experience with the processes subsequent to the preliminary approvals, it should be able to shorten the lead time.
NEWS & ANALYSIS Credit implications of current events
18 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Banks
Desjardins’ Sale of Subsidiary’s Insurance and Brokerage Operations Is Credit Positive On 16 February, Desjardins Group (parent of Fédération des caisses Desjardins du Québec, Aa2/Aa2 negative, a13) announced that it was selling the life insurance and insurance brokerage operations of subsidiary Western Financial Group (WFG, unrated) to Wawanesa Mutual Insurance (unrated) for CAD775 million. The selling price will result in a pretax gain of more than CAD330 million from the original purchase price of CAD443 million.
The transaction is credit positive for Desjardins because as a cooperative it cannot raise capital in the public equity markets, and we estimate that the transaction will enhance its capital position by up to an additional 25 basis points of Tier 1a capital. Additionally, the divestiture of WFG’s brokerage business will sharpen the cooperative’s insurance distribution focus to the captive agency model it acquired from the Canadian operations of State Farm Mutual Insurance Company (State Farm Canada, unrated). The companies expect the transaction to close in the third quarter, subject to regulatory approvals.
Desjardins is the largest cooperative federation in Canada and operates primarily in the province of Québec. As a cooperative, it is member-owned and does not have shareholders, or is its ownership traded on a public equity exchange. In 2011, it acquired four main business lines from WFG: Western Life Assurance (a life insurance company), The Network (property and casualty insurance brokers), Western Financial Insurance (pet insurance) and Bank West (a Canadian bank with a specific focus on western Canada). Desjardins last year sold Western Financial Insurance to Economical Insurance for an undisclosed sum and following this transaction will retain the banking operations as a source of deposit funding outside its Québec franchise.
We believe the brokerage business is the largest driver of the purchase price because the brokerage industries in both the US and Canada have undergone consolidation in recent years and valuation multiples have risen. We do not expect this sale to have a material effect on Desjardins’ insurance results going forward. WFG’s contribution to Desjardins’ insurance operations were approximately 4% of Desjardins’ gross written premiums in 2015 (see Exhibit 1).
EXHIBIT 1
Western Life Assurance’s Gross Written Premiums by Insurer
Note: State Farm Canada’s 2015 contribution estimate is based on using Desjardins’ 2014 estimate. Sources: Canada’s Office of Superintendent of Financial Institutions, Desjardins financials and Moody’s Investors Service
3 The ratings shown are Fédération des caisses Desjardins du Québec’s deposit rating, senior unsecured debt rating and baseline credit
assessment.
Desjardins57%
State Farm39%
Western Life Assurance4%
Jason R. Mercer, CFA Assistant Vice President - Analyst +1.416.214.3632 [email protected]
NEWS & ANALYSIS Credit implications of current events
19 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Desjardins has taken a number of steps over the past few years to refocus and expand its core banking and insurance franchise away from its historical regional footprint in Québec. Most notably, Desjardins in 2015 acquired State Farm’s Canada operations, increasing its insurance operations by almost 40%, raising the proportion of premiums written outside Québec to 69% from 46% (see Exhibit 2), and propelling Desjardins to a leading market share in the Ontario auto insurance market.
EXHIBIT 2
Provincial Distribution of Desjardins General Gross Written Premium
Sources: MSA Research and Moody’s Investors Service
3%
54%
37%
6%3%
32%
57%
9%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
Atlantic Canada Quebec Ontario Western Canada
2014 2015
NEWS & ANALYSIS Credit implications of current events
20 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Brazilian Measure to Stimulate Mortgage Lending Is Credit Positive for Banks On 16 February, Brazil’s National Monetary Council (CMN) announced a temporary change to allow households to use their accounts in the Fundo de Garantia por Tempo de Serviço (FGTS), the national workers’ fund, for down payments on larger mortgages than had been previously permitted. The policy change is credit positive for most large Brazilian retail banks because it will support their efforts to expand their portfolios of low-risk mortgage loans this year and provide a source of business volume growth amid a still-challenging economic environment. Although the change will increase competition among retail lenders, any negative pressure on margins will be offset by an increase in the volume of new loans.
FGTS is the severance indemnity fund for employees that can be accessed when a worker is dismissed or retired, and can be used as a down payment on a worker’s first residential mortgage originated under the government’s social housing program. Both employees and employers make contributions to the fund based on a percentage of an employee’s salary.
Under the new measure, borrowers until the end of 2017 will be able to use FGTS funds to secure mortgages for homes worth up to BRL1.5 million (approximately $500,000), provided that the loan is obtained through Sistema Financeiro da Habitaçao (SFH), a government program that requires banks to use savings deposits to fund mortgages at below market rates. Previously, the program could only be used for mortgages on homes worth up to BRL800,000-BRL950,000, depending on the region. The government’s goal with this policy is to stimulate credit markets following a period of sluggish lending growth, and to reduce homebuilders’ high inventories of new residences, which we estimate total more than 120,000 finished units and which threaten to trigger a collapse in housing prices.
The initiative targets middle- and high-income borrowers, and the banks that will most likely benefit include Itau Unibanco S.A. (Ba2/(P)Ba2 negative, ba24), Banco Bradesco S.A. (Ba2/(P)Ba2 negative, ba2), Banco do Brasil S.A. (Ba2/(P)Ba2 negative, ba2), Banco Santander (Brasil) S.A. (Ba1/(P)Ba1 negative, ba2), and, to a lesser extent, government-owned savings bank Caixa Economica Federal (Ba2/Ba2 negative, b1). These lenders have sizable bases of middle-class customers, and are already focusing on mortgage growth this year because credit risks remain elevated in other segments such as corporate and consumer lending owing to the lingering effects of Brazil’s deep economic recession. Brazil’s small and midsize banks are not likely to benefit as much because they do not have access to a base of savings deposits required to participate in this program, and consequently they do not tend to offer mortgages.
In addition to supporting an increase in business volumes that should help to offset margin compression as a result of the central bank’s ongoing easing of monetary policy, this initiative should also generate substantial cross-selling opportunities for banks targeting long-term mortgage borrowers. Furthermore, the changes will allow borrowers to use FGTS resources to make higher down payments than they could in the past, which will help reduce the risk of these newly originated mortgage loans.
Although Caixa, which has a 67% market share, will remain the largest mortgage lender in the system, we expect that the CMN’s new initiative will benefit Banco do Brasil and Brazil’s large private banks more because they are better capitalized than Caixa. This better capitalization gives those banks more capacity to grow their balance sheets. Additionally, these banks still have available savings deposits to fund home loans at more competitive rates. By contrast, Caixa’s mortgage portfolio is significantly larger than its base of savings deposits, forcing the bank to rely on more expensive market funding to finance 40% of its mortgage loan book, which totaled BRL401.5 billion as of September 2016.
4 The bank ratings shown in this report are the bank’s local deposit rating, senior unsecured debt rating and baseline credit
assessment.
Ceres Lisboa Senior Vice President +55.11.3043.7317 [email protected]
NEWS & ANALYSIS Credit implications of current events
21 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Royal Bank of Scotland May Not Need to Divest Williams & Glyn, a Credit Positive On 17 February, The Royal Bank of Scotland Group plc (RBS, Ba1 positive) said that it may not need to dispose of its Williams & Glyn (unrated) subsidiary. Although disposing of the unit was a condition of receiving state aid in 2009, the European Commission (EC) is considering an alternate plan that the UK Treasury has proposed.
Not having to divest Williams & Glyn would be credit positive for RBS. It would eliminate one of RBS’ major obstacles to restoring a sustainable business model, and would reduce the risk of a regulatory fine while limiting additional expenses. It would also remove a management distraction, allowing senior executives to focus on the bank’s ongoing challenges, including the completion of its restructuring plan, settlement of outstanding material litigation, and the implementation of UK ring-fencing.
To receive state aid in 2009, RBS agreed with the EC and UK Treasury to first separate and then divest around 300 bank branches to promote competition in the UK retail, small and midsize enterprise (SME) and mid-corporate banking sector by year-end 2017. The bank spent around £2 billion preparing Williams & Glyn for separation, at the peak involving around 7,000 permanent and contract staff. RBS recently acknowledged that none of the acquisition proposals for Williams & Glyn would meet the EC’s year-end 2017 divestiture deadline.
The UK Treasury’s plan would have RBS provide funding to eligible UK challenger banks to help them attract SME customers from RBS. Under the proposal, these banks’ SME customers would have access to cash and cheque handling at RBS branches. Two funds would be created, one to improve challenger banks’ business banking capabilities, and another to support financial technology investments. RBS set aside £750 million in the fourth quarter for these measures and would also incur some additional restructuring charges over 2017 and 2018 as it reintegrates Williams & Glyn into its business.
The EC approval of the UK Treasury’s plan would remove one of RBS’ top remaining restructuring challenges and a key management focus. In addition to limiting the financial costs RBS would have incurred, the proposal’s approval would allow RBS to retain a profitable part of its retail and SME business. Despite some likely franchise erosion, we expect that retaining Williams & Glyn would support RBS’ return to profitability and capital generation: in 2016, Williams & Glyn generated £402 million of adjusted operating profit (excluding restructuring costs, litigation and conduct costs, and other non-recurring items) and had an adjusted cost-to-income ratio of 47%.
Retaining the company would not have a material effect on RBS’ future ring-fenced bank. The biggest banks in the UK are required to separate their retail lending operations into independently governed and funded entities, beginning in 2019. RBS expects the EC decision after September 2017, and UK Treasury will need to renegotiate a new state aid agreement, which could take more time.
Daniel Forssen, CFA Associate Analyst +44.20.7772.1553 [email protected]
Laurie Mayers Associate Managing Director +44.20.7772.5582 [email protected]
Alessandro Roccati Senior Vice President +44.20.7772.1603 [email protected]
NEWS & ANALYSIS Credit implications of current events
22 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Germany’s Overvalued Real Estate Market Poses Risks for Banks and RMBS Last Monday, the Deutsche Bundesbank, Germany’s central bank, reported that residential real estate prices in German cities are overvalued by 15%-30% relative to fundamental measures of value, with the large cities at the upper end of the range (see Exhibit 1). Such overvaluation is credit negative for banks with concentrated retail mortgage books in urban areas, banks with large retail mortgage franchises and residential mortgage-backed securities (RMBS). Overvaluation creates the risk of losses if foreclosed properties backing mortgage loans are sold after a fall in house prices. The credit effect for covered bonds is limited owing to the statutory protection provided by Germany’s covered bond law (Pfandbrief Act).
EXHIBIT 1
German Residential Loan Mortgage Volume and House Price Index Index = 100 at June 2010
Sources: Deutsche Bundesbank and Moody’s Investors Service
For banks, the risk lies in their exposure to retail mortgages if a price correction occurs once interest rates rise materially, along with an acceleration in new housing loans originated in the past two years and margins that have shrunk. Although the combination of these factors in and of themselves do not immediately lead to higher defaults owing to the long-term fixed-rate nature of German residential mortgages, a lower recovery value following a price correction in a foreclosure would require the banks to increase cash provisions on defaulted exposures.
Bundesbank data also show that over the past two years, German banks have increased their new lending volumes by 20% versus the average origination volume during 2009-14 (see Exhibit 2). Hence, if residential property prices were to fall following an increase in interest rates or because of supply-demand imbalances, banks would face meaningful loan-loss provisions in case of default. As we have noted, if residential property prices were to retreat to 2010 levels, we would expect the share of loans with loan-to-value ratios (LTV) of more than 100% to increase to more than 40% of all outstanding mortgages.
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11
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11
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12
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12
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-13
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13
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13
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-14
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14
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14
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-15
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15
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15
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-15
Mar
-16
Jun-
16
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16
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-16
€Bi
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s
Total Mortgage Balance - right axis All Cities - left axis
Top 127 Cities - left axis Top 7 Cities - left axis
Patrick Widmayer, CFA, FRM Vice President - Senior Analyst +49.69.70730.715 [email protected]
Goetz Thurm, CFA Vice President - Senior Analyst +49.69.70730.773 [email protected]
Dr. Gaby Trinkaus, CFA Vice President - Senior Analyst +44.20.7772.5223 [email protected]
NEWS & ANALYSIS Credit implications of current events
23 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
EXHIBIT 2
German Residential Real Estate Loan Origination versus Margins
Sources: Deutsche Bundesbank and Moody’s Investors Service
The banks most exposed to these risks are savings banks with a strong urban focus, including Sparkasse KoelnBonn (Aa3/A2 stable, ba15) and Landesbank Berlin AG (Aa3/A1 positive, ba1), and banks with large residential mortgage books, such as ING DiBa AG (A2 stable, a2) and Deutsche Postbank AG (A3/(P)Baa2 negative, ba1).
RMBS would be negatively affected if house prices were to correct because loss severities (the proportion of the loan not covered by the proceeds from selling the property) would rise. German RMBS typically contain loans originated at high LTVs of 90%,6 on average, with some at above 100%. Deleveraging and house price increases in recent years have resulted in current market price LTVs averaging 55%.7 However, this ratio is primarily driven by one transaction (Pure German Lion RMBS 2008). For instance, EMAC-DE transactions and Kingswood Mortgages have LTVs of 80% on average.
The mortgage covered bonds of Sparkasse KoelnBonn and Hamburger Sparkasse (all rated Aaa) are most exposed to a potential correction of urban residential real estate prices. Both programs have a large share of residential and multifamily mortgage loans in the cover pools, and these issuers focus mortgage loan underwriting on urban areas. Nevertheless, German Pfandbrief are well protected against a potential fall in house prices. The 60% loan-to-lending-value threshold prescribed in the Pfandbrief Act ensures that only loan parts equal to the first 60% of a property’s lending value (defined in the act as the long-term sustainable property value excluding any speculative price components) are eligible for cover pools. The Pfandbrief Act also stipulates that property valuations are not adjusted upward after loan origination in case of property price increases, providing a buffer against price declines if borrowers default on their mortgage loans.
5 The bank ratings shown in this report are the bank’s deposit rating, senior unsecured debt rating (where available) and baseline
credit assessment. 6 This includes PROVIDE GEMS 2002-1, E-MAC DE 2005-I B.V., E-MAC DE 2006-I and 2006-II B.V., E-MAC DE 2007-I B.V.,
Kingswood Mortgages 2015-1 plc, Pure German Lion RMBS 2008 GmbH. Deals selected based on data availability. Weighted by original pool balance.
7 Weighted by current pool balance.
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3.5%
2009 2010 2011 2012 2013 2014 2015 2016
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New Housing Loans to Households - right axisAverage Annual Lending Margins on Loans for House Purchases - left axis
NEWS & ANALYSIS Credit implications of current events
24 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Germany’s Deposit Protection Fund Reforms Make It More Viable, Benefitting Banks On 17 February, the German Deposit Protection Fund (DPF, unrated), a voluntary scheme for depositors of Germany’s private commercial banks, announced reforms that will exclude most institutional investors from compensation for losses after a bank’s resolution or bankruptcy. The reform of the DPF will lower its cost to banks while making it more viable and reducing banks’ contingent liabilities.
The reform proposal, which the DPF member banks’ delegates will most likely approve on 5 April, aims to exclude from the fund’s protection all financial institutions and public-sector investors starting 1 October 2017. For other institutional investors such as corporates, insurers and government-related entities, the DPF will exclude the coverage of promissory notes and registered bonds issued from 1 October 2017. In addition, starting 1 January 2020, institutional bank deposits will no longer be covered if their maturity exceeds 18 months. However, notes and registered bonds outstanding on 1 October 2017 (and term deposits of more than 18 months as of 1 January 2020) will be grandfathered and continue to benefit from coverage until maturity. Retail investors in such products will remain covered.
By excluding most institutional investors from compensation and limiting protection to retail customers and foundations, the reform would remove a key weakness of the DPF and make it considerably more viable and credible. The fund’s weak point is its overly generous promise of compensating not just household depositors, but also certain securitised bank liabilities, specifically German promissory notes that are generally sold to institutional investors.
Although in theory this feature is beneficial for institutional investors, the fund would not be able to compensate losses in line with the defined promise if one of the larger Germans banks were to fail. With the promise for compensation per investor granted up to generous limits, a large bank failure would more likely cause major collateral damage for Germany’s private banks – or cause the DPF’s failure – rather than instil confidence in the market.
The DPF covers depositor claims exceeding €100,000 (which is the legally insured amount covered by a separate fund). The voluntary scheme currently compensates for losses up to a threshold of 20% of a failed bank’s liable capital per depositor, implying that protected amounts per depositor range between €1.0 million for the smallest bank and roughly €12.0 billion for the largest. The DPF’s high level of protection has its origin in the structure of the German banking system. The cooperative banks and savings banks in Germany principally promise full protection of depositors (i.e., without any threshold) because their institutional protection schemes aim to ensure the going-concern status of each member bank.
The DPF cited rising regulatory costs, especially for bank levies and Europe’s legally binding deposit insurance, as the main reason why it considered the reform. This may imply that the DPF plans to reduce banks’ contributions to the scheme. Although lower contributions would be a welcome cost relief for member banks, we consider that the key benefit will be the gradual reduction of the contingent liability that DPF membership represents. The payout required to compensate for losses caused by the 2008 bankruptcy of the relatively small former German subsidiary of Lehman Brothers Holdings Inc., Lehman Brothers Bankhaus AG (which was a DPF member), amounted to a hefty €6.7 billion. At that time, when member banks themselves had no capital to spare, the DPF requested, and received, a bridge finance facility from the German government.
Katharina Barten Senior Vice President +49.69.70730.765 [email protected]
NEWS & ANALYSIS Credit implications of current events
25 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
German Court’s Validation of Contract Cancellations Is Credit Positive for Building and Loan Associations Last Tuesday, the German Federal Court of Justice validated a widely used practice of contract cancellations by German building and loan associations (Bausparkassen). The court ruling is credit positive for these banks because it will improve their dim profit outlooks.
The Bausparkassen’s core product is the Bauspar contract, whereby customers make deposits over a flexible number of years and earn a locked-in, fixed interest rate in order to build up a predetermined down payment on a property. In return, Bauspar loans are typically offered at lower interest rates compared with regular mortgage loans and often are used as secondary mortgages by private house buyers and builders.
The Bausparkassen use the deposited funds from new clients to provide mortgages to clients who have already saved up their equity cushion. As vast amounts of these deposits accumulated during the high-interest-rate period of the mid-2000s and earlier, depositors did not withdraw them for property down payments and instead misused them as savings vehicles, significantly constraining sector profitability in the current low interest rate environment. Consequently, the court decision will be particularly credit positive for Debeka Bausparkasse AG (Baa2 negative, baa28) and Bausparkasse Mainz AG (BKM, A2 negative, baa2) because Bauspar deposits fund more than half of Debeka’s total assets and one quarter of BKM’s.
Drawing this loan after the contractually targeted savings period is optional. The court ruling validates that the Bausparkassen may cancel the contract 10 years after the saving period’s due date if the loan has not been drawn, even if the customer has not fully saved up the pre-determined amount.
Cancelling these contracts allows the Bausparkassen to reduce their stock of highly remunerated Bauspar deposits and manage down their average interest rate expense. The court ruling also removes litigation risks in the form of potential fines or costs from reinstating the contracts. Not addressed by the ruling is the persistent structural problem of mortgage loan interest rates declining faster than deposit interest rates (see Exhibit 1).
EXHIBIT 1
German Mortgage Loan Interest Rate Averages Mortgage loan interest rates are declining faster than deposit interest rates
Source: Deutsche Bundesbank
8 The bank ratings shown in this report are the bank’s deposit rating and baseline credit assessment.
0%
1%
2%
3%
4%
5%
6%
7%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Bauspar Deposits Mortgage Loans Outstanding - All German Banks New Mortgage Loans - All German Banks
Bernhard Held, CFA Vice President - Senior Analyst +49.69.70730.973 [email protected]
Torsten-Alexander Thebes Associate Analyst +49.69.70730.796 [email protected]
NEWS & ANALYSIS Credit implications of current events
26 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Under German law, the Bausparkassen’s activities are restricted to mortgage lending, either via the Bauspar contracts or in competition with retail banks on the open market. Generally, the Bausparkassen sector has struggled to reduce its interest expenses without reputational damage. Signs of client disenchantment with the banks’ core product emerged in 2016, when bridging loans for mortgages and new Bauspar contract volume declined sector-wide (see Exhibit 2). This decline also implies that fewer customers are resorting to Bausparkassen products, which can hedge against rising mortgage rates in the near future.
EXHIBIT 2
Bridging Loans and New Bauspar Contract Volumes, 2011-16
Source: Deutsche Bundesbank
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Bridging Loan Growth - left axis New Contracts Signed - right axis
NEWS & ANALYSIS Credit implications of current events
27 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
BPCE’s Reduction of Its Domestic Branch Network Is Credit Positive Last Tuesday, BPCE (A2/A2 stable, baa29) announced that it would reduce its domestic retail branch network by at least 5%, or 400 branches, by 2020. This reduction is credit positive because it will allow BPCE to cut costs and adapt its operating structure to a rapidly evolving landscape for retail banking activity.
This reduction in retail branches will involve both the closing and merging of branches. The bank will seek to shrink its regional bank count to 28 in 2020 from 35 as of year-end 2015, and expects to trim the number of regional banks to 31 by the end of this year after having completed three mergers of regional banks and one merger between overseas banks and a regional bank in 2016 and 2017. The branch reduction will also be enforced throughout BPCE’s entire network.
The announcement is part of a restructuring plan that targets €1 billion in annual cost savings by 2020. This involves a simplification and rationalization of its IT systems (approximately €270 million), a transformation of the customer relationship toward more automated and simplified interaction (around €240 million), improvements in real estate and purchasing (around €240 million) and a €250 million reorganization of subsidiary bank Natixis (A2/A2 stable, ba210). The overall cost of this savings plan totals €790 million, spread over five years.
BPCE is the latest European bank to scale down its branch network since 2008, and is part of an effort to cut costs and develop greater online services, which mitigates the need for an expansive branch network. French retail banks have lagged behind their European peers, with French banks having closed only 1,900 branches in total, (a compounded annual decrease of 0.7%, below the European average decline of 3.3%) between 2008 and 2015 (see exhibit).
French Banks Lag Behind European Peers in Closing Branches Number of branches per 100,000 inhabitants in select European countries.
Note: (1) Europe includes Austria, Belgium, Bulgaria, Croatia, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece,
Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden and the UK.
Sources: European Central Bank and Moody’s Investors Service
BPCE’s cost-cutting plan will improve the bank’s operating efficiency, which has long lagged other large French banks. BPCE’s cost-to-income ratio was a relatively high 69% in 2016, compared with an average of
9 The bank ratings shown are BPCE’s deposit rating, senior unsecured debt rating and adjusted baseline credit assessment. 10 The bank ratings shown in this report are the bank’s deposit rating, senior unsecured debt rating and baseline credit assessment.
61
4856
37
-12%
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1202008 - left axis 2015 - left axis Compounded Annual Growth Rate - right axis
Pierre-Alexandre Germont Associate Analyst +44.20.7772.1638 [email protected]
NEWS & ANALYSIS Credit implications of current events
28 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
66% for Societe Generale (A2/A2 stable, baa2), BNP Paribas (A1/A1 stable, baa1), Credit Agricole S.A. (A1/A1 stable, baa3) and Banque Federative du Credit Mutuel (Aa3/Aa3 stable, baa1).
So far, most other large French banks have largely maintained the density of their branch networks while investing significantly in digital technology, a so-called click-and-mortar approach in which branches continue to play an important role. It remains to be seen if this approach endures, given that revenue pressures amid low interest rates have prompted other banking groups in Europe to reconsider their business models, particularly their reliance on branches.
NEWS & ANALYSIS Credit implications of current events
29 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Raiffeisen Schweiz’s Mortgage Lending Grows as Margins Shrink, a Credit Negative On Friday, Raiffeisen Schweiz Genossenschaft (Aa2/A2 stable, a211) reported that its mortgage loan book had exceeded the pace of residential mortgage lending in Switzerland for 10 years, and its average interest margin had significantly decreased. The combination of above-market growth rates, ever-falling margins and the risk of financing overvalued properties in Switzerland is credit negative.
Over the past 10 years, growth at Raiffeisen Group (unrated), a group of numerous cooperative banks that are controlled by the central organization, Raiffeisen Schweiz, has considerably outpaced the Swiss mortgage market. Raiffeisen Group has rapidly grown its mortgage book (which accounted for 76% of its total assets and 95% of its lending book as of year-end 2016) at a compound annual growth rate of 6.5% in 2007-16, above the 4.2% market average, and has increased its market share to 17.2% from 14.2% in 2007 (see Exhibit 1).
EXHIBIT 1
Raiffeisen Group’s Mortgage Book Growth Has Outpaced the Swiss Average
Sources: Swiss National Bank and Moody’s Financial Metrics
Raiffeisen Schweiz’s market expansion has come at a cost. Its reported interest margin has fallen considerably in recent years, to 106 basis points in 2016 from 112 basis points in 2015 and 118 basis points in 2014, illustrating an aggressive growth strategy (see Exhibit 2). The bank’s key revenue driver, net interest income, was up by 2% to CHF2.2 billion in 2016, but failed to keep up with a reported balance sheet growth of 6.2%. This reflects the bank’s ongoing appetite to increase its market share at the price of lower margins. Additionally, the Swiss banking system overall is facing the continued profitability challenges from a low-yield environment.
11 The bank ratings shown in this report are Raiffeisen Schweiz’s deposit rating, senior unsecured debt rating and baseline credit
assessment.
10%
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Switzerland Mortgage Loan Growth - left axis Raiffeisen Mortgage Loan Growth - left axisRaiffeisen Market Share - right axis
Andrea Wehmeier Vice President - Senior Analyst +49.69.70730.782 [email protected]
Mark C. Jenkinson Associate Analyst +49.69.70730.756 [email protected]
NEWS & ANALYSIS Credit implications of current events
30 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
EXHIBIT 2
Raiffeisen Schweiz’s Interest Margin
Note: The margin on Swiss mortgages is the Swiss 10-year mortgage rate minus the Swiss savings deposit rate and is a proxy comparable to
Raiffeisen Schweiz’s mortgage lending business profile. Sources: Swiss National Bank, the company and Moody’s Financial Metrics
Although the combination of above-market loan growth, shrinking margins and the risks associated with overvalued properties do not in and of themselves immediately lead to higher defaults, lower foreclosure recoveries following a price correction would require banks to increase provisions on defaulted exposures. Decreasing margins limit the cushion to cover potential loan losses in an adverse scenario.
Only recently has the Swiss Financial Market Supervisory Authority and the Swiss National Bank raised fresh concerns about already-elevated house prices in Switzerland, after which Raiffeisen Schweiz’s decided to abandon its plan to loosen parts of its lending standards. House prices have risen nationally to elevated levels, posing a potential risk to the stability of the financial system. Real estate price growth has begun to decelerate owing to a combination of stricter and active regulatory oversight and moderate economic growth in 2016, factors that we expect will result in prices softly plateauing.
0.0%
0.3%
0.5%
0.8%
1.0%
1.3%
1.5%
1.8%
2.0%
2.3%
2.5%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Margin on Swiss Mortgages Net Interest Margin Raiffeisen Schweiz
NEWS & ANALYSIS Credit implications of current events
31 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Sweden’s MREL Framework Is Credit Positive On Thursday, the Swedish bank resolution authority Riksgälden published its framework on own fund minimum requirements and eligible liabilities (MREL). Sweden will require domestic systemically important banks to hold loss-absorbing liabilities that would be used in times of crisis to resolve a bank. Banks will need to hold substantially more subordinated liabilities than they do now, which will provide a greater cushion to protect senior creditors, a credit positive. If the new MREL-compliant debt offers significantly greater protection to senior creditors than currently, upward pressure on long-term debt and deposit ratings could gradually materialise.
Sweden’s four largest banks, Nordea Bank AB (Aa3/Aa3 stable, a312), Swedbank AB (Aa3/Aa3 stable, a3), SEB (Aa3/Aa3 stable, a3) and Svenska Handelsbanken AB (Aa2/Aa2 stable, a2), already have outstanding debt that exceeds the MREL requirements, but the banks will need to replace part of their senior debt with subordinated liabilities and/or capital.
When fully implemented, the MREL requirements can only be met with capital and subordinated liabilities, but implementation will be gradual. As of 1 January 2018, large banks must fulfil their bank-specific MREL requirements in terms of amount (i.e., have sufficient capital and liabilities that can cover losses and recapitalise the bank) as determined by Riksgälden. Banks have until 2022 to fulfil the subordination requirement, meaning that the eligible liabilities must be subordinate to senior unsecured debt. The bank-specific MREL requirements will be determined during fourth-quarter 2017, in conjunction with Riksgälden’s decisions on resolution plans.
At this point, Riksgälden has not taken a stance on how the banks should achieve the subordination. It notes that there are current limitations with all three types of subordination, (i.e., structural, statutory and contractual subordination). Swedish banks do not have the holding company structures that would be required to achieve structural subordination. Statutory subordination through a special debt category (like the non-preferred senior in France) is not possible under current Swedish law, but will likely be introduced because the European Commission has proposed the introduction of a special debt category for the European Union. The ability to issue contractually subordinated debt is limited for many Swedish firms. We believe that Sweden will most likely follow the French approach, namely introducing a junior-senior debt category.
Riksgälden estimates that the large Swedish banks will need to issue SEK500 billion in subordinated debt over the next five years, and that this amount is roughly half the outstanding debt that will need to be refinanced during this period. Although banks’ funding costs will increase somewhat, we expect that they will be able to transfer the higher funding costs to their clients and preserve profitability.
Swedish banks already rely on wholesale funding and this renders them more sensitive to swings in investor confidence. In a stress scenario, when banks will have to roll over greater volumes of subordinated debt to meet the MREL requirements, pricing and refinancing risks for subordinated debt are likely to be more pronounced than for senior debt.
12 The ratings shown in this report are the banks’ deposit rating, senior unsecured debt rating and their baseline credit assessment.
Louise Lundberg Vice President - Senior Credit Officer +46.8.502.565.68 [email protected]
NEWS & ANALYSIS Credit implications of current events
32 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
China’s Coordinated Approach to Regulating Investment Products Would Be Credit Positive for Banks Last Wednesday, China’s State Council Information Office confirmed that the central bank, together with regulators of the banking, insurance and securities industries, have been drafting a comprehensive regulatory framework to tighten supervision on all investment products available to retail and institutional investors. Such a framework would be credit positive for banks because it would enhance regulatory capacity to manage the growth of shadow banking sectors such as bank wealth-management products.13 Exhibit 1 shows wealth-management product issuance by bank type between 2014 and the first half of 2016.
EXHIBIT 1
Chinese Banks’ Wealth-Management Product Issuance to Total Liabilities and Equity
Note: For more information, see China’s Proposal to Revise Banks’ Off-Balance-Sheet Exposure Regulations is Credit Positive, 1 December 2016. Source: China Banking Wealth Management Registration System
The planned regulatory framework also covers banks’ investments in bonds and repackaged loans and receivables known as asset-management products that are offered by non-bank financial institutions such as trust companies, insurance companies, fund companies and subsidiaries, securities and futures companies (see Exhibit 2). A coherent supervisory framework will improve banks’ creditworthiness because of reduced scope to engage in regulatory arbitrage, avoid adequate reserve and capital provisioning, and increase product leverage through opaque structuring of investment products.
13 See Quarterly China Shadow Banking Monitor, 13 February 2017.
0%
3%
6%
9%
12%
15%
18%
21%
24%
27%
30%
Big Five Banks Joint-Stock Banks Local Banks
2014 2015 1H 2016
Nicholas Zhu, Ph.D. Vice President - Senior Analyst +86.10.6319.6536 [email protected]
NEWS & ANALYSIS Credit implications of current events
33 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
EXHIBIT 2
Composition of Listed Banks’ Investment Portfolios, 2015
Note: For more information, see Chinese Banks: Investments in Loans and Receivables Increase System Risks, 22 June 2016. Sources: Banks’ annual reports
The planned supervisory framework will apply across the jurisdictions of individual regulatory agencies, thus allowing a more comprehensive approach to monitoring and supervising systemic risks posed by wealth-management and asset-management products. Previous efforts to regulate the asset management industry have emanated from individual regulators and created opportunities for regulatory arbitrage through the use of “pass-through” channels and credit enhancements across banking and securities products. The broader scope of the planned regulatory framework will discourage the use of piecemeal, institution-specific rules and shift regulators’ focus to the underlying economic fundamentals of the financial markets.
According to China Insurance Regulatory Commission Vice Chairman Chen Wenhui, one aspect of the planned framework will focus on improving the transparency of asset-management products. The use of pass-through channels and credit enhancements by asset-management products obscures the true extent of investors’ exposure to the ultimate borrowers. One option is to limit multiple layers of cross-ownership among investment products. Doing so would provide investors better knowledge of the underlying assets of asset-management products, strengthening the industry’s market discipline and reducing the operational risk and contagion among banks and non-bank financial institutions. We see the current opaqueness in the asset-management sector as a key source of banking system risk. The opaqueness of asset-management products makes it difficult to assess the adequacy of banks’ reserve and capital provisioning for their investment products.
The opaqueness of investment products also makes it difficult to assess the level of system-wide leverage. Mr. Chen has indicated that the planned regulation will address the issue of high leverage. Since January 2017, the central bank has included wealth-management products in its macro-prudential assessment in order to deleverage the economy.14 Improved transparency, coupled with stricter leverage ratios, would moderate the growth of wealth-management products and reduce banks’ exposure to leveraged asset-management products.
The creditworthiness of small and midsize banks (i.e., joint-stock and local banks) will benefit most from the latest regulatory development. More than 90% of these banks’ disproportionally large and fast-growing investment portfolios are concentrated in asset-management products and other banks’ wealth-management products (see Exhibits 2 and 3).
14 See Quarterly China Shadow Banking Monitor, 13 February 2017.
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Big Five Banks Joint-Stock Banks Local Banks
Asset Management Products Other Banks' Wealth Management Products Bonds Others
NEWS & ANALYSIS Credit implications of current events
34 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
EXHIBIT 3
Ratio of Listed Banks’ Holdings of Asset-Management Products to Total Assets
Note: For more information, see Chinese Banks: Investments in Loans and Receivables Increase System Risks, 22 June 2016. Sources: Banks’ annual reports
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
Big Five Banks Joint-Stock Banks Local Banks
2012 2013 2014 2015
NEWS & ANALYSIS Credit implications of current events
35 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
SMBC and Resona Combining Subsidiary Banks in Japan’s Kansai Region Would Be Credit Positive Last Monday, Japan’s Nikkei newspaper reported that three Japanese regional banks in the Kansai region – Kansai Urban Banking Corporation (KUBC, A3 stable, ba315), The Minato Bank, Ltd. (A2 stable, baa3) and The Kinki Osaka Bank, Ltd. (A2 stable, ba1) – were in negotiations to combine their operations under a new bank holding company and reach an agreement by the end of March 2017. Such a combination would be credit positive for the banks because it would enhance their competitive position in the Kansai region. None of the banks involved in the negotiations has confirmed or denied the discussions.
The new bank holding company would be jointly owned by two of Japan’s large banking groups, Sumitomo Mitsui Banking Corporation (SMBC, A1/A1 stable, a3) and Resona Holdings, Inc. (unrated). SMBC is the parent bank of KUBC and Minato Bank, and the core operating bank of Sumitomo Mitsui Financial Group, Inc. (SMFG, A1 stable), one of Japan’s three mega banking groups. Resona Holdings owns Kinki Osaka Bank, along with Resona Bank, Ltd. (A2 stable, baa2) and Saitama Resona Bank, Ltd. (A2 stable, baa2).
The three banks’ total consolidated assets of ¥11.6 trillion as of September 2016 would exceed Bank of Kyoto, Ltd. (unrated), which had total consolidated assets of ¥8.8 trillion as of year-end 2016 and is the largest regional bank in the Kansai region. If the negotiations are successful, it will mark the first time in Japan that two large banking groups combined their subsidiary banks’ operations. According to Nikkei, Resona Holdings would hold a majority stake in the new holding company.
The combination would also be credit positive for both Resona Holdings and SMFG. Resona Holdings would strengthen its core domestic retail business, while SMFG would focus on improving capital and cost efficiencies by making KUBC and Minato Bank non-consolidated entities. For the nine months that ended December 2016, KUBC’s tangible common equity to risk-weighted assets ratio (TCE ratio) was 2.9% and its cost-to-income ratio was 66.7%, while Minato Bank’s were 6.5% and 72.2%, respectively. By comparison, SMFG’s were a stronger 9.7% and 60.0%, respectively.
Beyond some immediate restructuring charges, the reorganization would enhance the underlying profitability of the three banks by reducing operating expenses, owing to the elimination of replications of shared functions. The three banks’ cost-to-income ratios (KUBC at 69.5%, Minato Bank at 69.4% and Kinki Osaka Bank at 68.8% in the fiscal that ended March 2016) are much higher than Japanese rated regional banks’ average of 57.4%. This suggests considerable cost savings for all three banks from their business integration.
15 The bank ratings shown in this report are the banks’ deposit ratings, senior unsecured debt ratings (where available) and baseline
credit assessments.
Tetsuya Yamamoto Vice President - Senior Analyst +81.3.5408.4053 [email protected]
NEWS & ANALYSIS Credit implications of current events
36 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Financial Market Infrastructure
UK Proposals to Enhance Supervision of Financial Market Infrastructure Companies Are Credit Positive Last Wednesday, the Bank of England’s Independent Evaluation Office (IEO) published its evaluation of the central bank’s supervision of financial market infrastructure companies and made recommendations aimed at maintaining its global leadership amid a period of regulatory and technological change. Given the importance of oversight in ensuring financial market infrastructure strength, the recommendations are credit positive for UK financial market infrastructure participants. This includes the UK’s payment and settlement systems and central counterparties (CCPs), notably London Stock Exchange Group plc’s (Baa1 positive) LCH.Clearnet Ltd. and Intercontinental Exchange, Inc.’s (A2 stable) ICE Clear Europe.
The IEO’s findings underline the strength of the Bank of England’s current financial market infrastructure supervision and is consistent with the International Monetary Fund’s (IMF) earlier recognition of its leadership in shaping reforms in this sector. The IEO report was commissioned in early 2016 to evaluate whether investments made by the central bank in its financial market infrastructure directorate (FMID) had been effective, gauge whether the FMID was equipped to keep pace with the fast-changing nature of the industry and ensure that the central bank’s supervisory approach was appropriately forward-looking and flexible.
Following G20 leaders’ agreement in 2009 to increase the use of central clearing of certain financial products, and with the implementation of central clearing obligations across jurisdictions, the proportion of the over-the-counter interest rate derivatives market now centrally cleared has risen to around 55% from about 30% in 2012. The central bank aims to stay ahead of an industry that is facing rapid change owing to advances in financial technology and the increasing concentration of risk at CCPs.
In 2016, the IMF concluded that the central bank had been successful in inducing change at supervised financial market infrastructure companies, notably in reforming board and committee structures. We expect the implementation of the IEO’s latest proposals to expand best practices to supervised financial market infrastructure companies, which will likely reinforce global practices as well, given the Bank of England’s prominent role as a supervisor globally.
The IEO’s proposals were comprehensive, starting with a recommendation to improve the clarity of strategy, objectives and risk tolerances for the supervision of financial market infrastructure companies. To this end, the central bank would promote an expectation of continuity of service and operational resilience for these firms among supervisory staff and reinforce the FMID’s systemic risk management responsibilities.
The IEO recommended that the FMID express risk tolerance in both operational and financial terms. In recognition of the industry’s need for a high standard of operational resiliency, the proposals called for increasing supervisory skill in operational risk and prevention of cyber threats. Another proposal called for the central bank to apply its best practices and broader expertise as well as formalize the use of resources from across the central bank. Doing so would help alleviate the weaknesses of the FMID’s specialist, quasi-standalone role as supervisor. Suggested improvements to the FMID’s workforce model also recognize the challenges of maintaining a high standard of sector expertise and succession planning within the FMID.
We expect these improvements to spread to the governance of the UK’s supervised financial market infrastructure companies. Such improvements would prepare the UK’s financial market infrastructure companies for challenges related to the UK’s planned withdrawal from the European Union, and reinforce the central bank’s leadership and oversight and support possible need for recognition of third-country equivalence with the European Union.
Michael C. Eberhardt, CFA Vice President - Senior Credit Officer +44.20.7772.8611 [email protected]
NEWS & ANALYSIS Credit implications of current events
37 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Sovereigns
Hong Kong’s Budget Balances Economic Support with Fiscal Prudence, a Credit Positive Last Wednesday, Hong Kong (Aa1 negative) Financial Secretary Paul Chan forecast a large fiscal surplus for fiscal 2017 (ending in March 2017) and announced the budget for fiscal 2018. Despite a revenue windfall for fiscal 2017, the fiscal 2018 budget saves much of the surplus for long-term development. This prudence supports an economy facing short- and longer-term challenges and maintaining fiscal prudence, a credit positive for the sovereign.
The revised estimate for the fiscal 2017 fiscal surplus is HKD92.8 billion ($12.0 billion or 3.7% of GDP), and consequently, the government forecasts fiscal reserves will reach HKD935.7 billion, or 37.6% of GDP by March 2017, versus its previous estimate of 35.2% of GDP. The ample reserves provide significant buffers against economic shocks. Hong Kong’s volatile land revenues and stamp duties drove the windfall gains and Mr. Chan’s budget is consistent with the territory’s history of fiscal prudence.
For fiscal 2018, Mr. Chan estimates a much narrower surplus of HKD16.3 billion (0.6% of our 2018 GDP forecast for Hong Kong), despite budgeting land revenues at a level similar to that of fiscal 2017. The authorities have tended to be conservative in their budget forecasts, and the fiscal balance has outperformed targets in four of the past five years (see Exhibit 1). We also think it is likely that Hong Kong will record a small surplus of around 0.5% of GDP in fiscal 2018, which will contribute to an additional slight accumulation of fiscal reserves.
EXHIBIT 1
Hong Kong’s Budget Outperformed Initial Targets in Four of the Past Five Years
Sources: Hong Kong Financial Services, Treasury Bureau and Moody’s Investors Service
As in previous budgets, tax cuts and increased spending are largely one-off measures in fiscal 2018. Temporary reductions in salaries and profits taxes, property tax rates, and the rise in the old-age allowance total more than 1% of our fiscal 2018 GDP forecast for Hong Kong. By contrast, the value of permanent tax cuts and increases in spending is only around HKD2 billion, or less than 0.1% of our fiscal 2018 GDP forecast, down from HKD3.8 billion in the last budget. Overall, the fiscal package is similar in size and nature to last year’s. It will provide material support to growth, without adding to the economy’s growth momentum.
-10
0
10
20
30
40
50
60
70
80
90
100
FY2013 FY2014 FY2015 FY2016 FY2017 FY2018
HKD
Bill
ions
Budget Revised Estimate Actual Moody's Forecast
Marie Diron Associate Managing Director +65.6398.8310 [email protected]
Serena Wang Associate Analyst +65.6398.8334 [email protected]
NEWS & ANALYSIS Credit implications of current events
38 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
We forecast GDP growth of 1.5% in calendar 2017, lower than 2.0% in 2016 and below the 2.0%-3.0% that Mr. Chan projects (see Exhibit 2). We expect global trade to remain lacklustre, weighing on Hong Kong’s exports. Meanwhile, higher interest rates will dampen growth in domestic demand. We forecast higher interest rates in Hong Kong because we expect higher interest rates this year in the U.S. (Aaa stable).
EXHIBIT 2
Hong Kong’s Real GDP Year-on-Year Percent Change Growth will be much slower than in previous years.
Sources: Haver Analytics and Moody’s Investors Service
Hong Kong’s prudent budgetary stance has led to the build-up of substantial fiscal reserves, which contribute to its high fiscal strength and are a major support of its credit quality. However, the territory faces gradually slowing growth potential because of its aging population and a sustained downshift in global trade.
Spending pressures will increasingly constrain Hong Kong’s scope for fiscal measures to stimulate the economy during periods of slowdowns as its society ages. The budget estimates recurrent expenditures, which account for more than 90% of operating expenditures, at HKD371 billion in fiscal 2018. That translates to a year-on-year increase of 7.4%, higher than a 5.3% rise in overall expenditure and nominal GDP growth of 4%-5% projected by Hong Kong’s government.
In a nod to global trade, the government pledged to maintain the competitiveness of Hong Kong’s pillar industries – trading and logistics, financial services, tourism and business and professional services – which together comprise around 60% of the territory’s GDP. The government is focused on negotiating more free trade and investment agreements, strengthening risk management capabilities in the banking sector to enhance its attractiveness to investors, further developing listing platforms and the local bond market, waiving licence fees in the tourism industry, and expanding the network of Economic and Trade Office into more countries.
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017F 2018F 2019F
Average: 6.5%
Average: 3.8%
Average: 2.0%
NEWS & ANALYSIS Credit implications of current events
39 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Korea’s Rising Household Debt Poses Downside Risks to Economic Growth Last Tuesday, the Bank of Korea reported that household debt at the end of 2016 had reached KRW1.3 quadrillion, or 82.9% of GDP, a KRW141.2 trillion increase from the year before and an increase of more than 20 percentage points since 2006. The increase is credit negative for Korea (Aa2 stable) because households’ high leverage raises their vulnerability to falling incomes or rising interest rates and poses downside risks to consumption and growth.
Household credit growth has accelerated since 2014 (see Exhibit 1), propelled by mortgage debt. However, there has been no corresponding rapid increase in property prices. Rather, higher levels of household debt partly reflect rising home-ownership rates amid low interest rates.
EXHIBIT 1
Korean Household Credit Outstanding
Sources: Bank of Korea and Moody’s Investors Service
Although high-income households whose financial assets are worth more than double their liabilities hold the majority of Korean mortgages, the structure of mortgages pose unique risks. Around 60% of mortgages are non-amortizing loans, which means that households make only interest payments until the final maturity date of the loan, at which point they must make a onetime bullet repayment of the full loan principal. Floating-rate loans also make up around 60% of mortgages, which exposes Korean households to interest rate risk, and, depending on income developments, could undermine debt-servicing capacity or constrain non-debt service consumption.
To address these risks, the government has introduced macro-prudential measures to shift household loans to fixed and amortizing structures. In 2015, for instance, the government introduced a one-off mortgage refinancing scheme, under which about 10% of system-wide bank mortgages were switched to longer-term, fixed-rate amortizing mortgages in place of short-term floating-rate and non-amortizing loans. The total amount of loans converted under the program equaled 3.7% of outstanding household debt, or 2.7% of GDP.
The shift to amortizing loans from bullet loans is positive and reduces financial stability risk. However, the shift to fixed-rate loans, although positive for households, is not necessarily positive for the financial system because it shifts interest rate risk to the banks. Nonetheless, most banks are shielded from the interest rate asset-liability mismatch risk because they transfer their fixed-rate mortgages to the government-backed Korea Housing Finance Corporation (Aa2 stable). This systemically important entity has nearly doubled in size since 2013 to almost 6% of GDP. The systemic risk associated with the increased concentration of
0%
2%
4%
6%
8%
10%
12%
14%
0
200
400
600
800
1,000
1,200
1,400
1,600
Q2-
2006
Q3-
2006
Q4-
2006
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2007
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2007
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2007
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2007
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2008
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Q3-
2010
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2011
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2011
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2011
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2011
Q1-
2012
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2012
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2012
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2012
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2013
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2013
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2013
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2014
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2014
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2014
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2014
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2015
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2015
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2015
Q4-
2015
Q1-
2016
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2016
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2016
Q4-
2016
KRW
Tril
lions
Amount - left axis Year-on-Year Change - right axis
Shirin Mohammadi Associate Analyst +1.212.553.3256 [email protected]
Steffen Dyck Vice President - Senior Credit Officer +49.69.70730.942 [email protected]
NEWS & ANALYSIS Credit implications of current events
40 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
mortgage loans on its balance sheet is mitigated somewhat by the low loan-to-value ratio of its mortgage loan portfolio and by strengthened prudential measures.
Sovereign risks are therefore primarily linked to the real economy. Income or interest rate shocks that undermine households’ debt-servicing capacity would likely weigh on consumption. Because household consumption has historically been an important growth driver (see Exhibit 2), this would dampen domestic demand and overall economic activity, and could cycle through to higher unemployment. Higher unemployment would take a toll on household income, further hitting the ability to service debt.
EXHIBIT 2
Percentage-Point Contributors to Korea’s Real GDP Growth
Sources: Bank of Korea and Moody’s Investors Service
In addition to income levels, asset price fluctuations can affect consumption behavior when consumers own real estate or financial assets. These wealth effects are statistically significant in Korea, and could add additional downside risks to consumption and economic growth should a shock trim financial asset valuations. In such a scenario, policymakers have fiscal and monetary policy means to buffer such a shock and absorb contingent liabilities. However, should indebted households retrench consumption significantly, the spillover effects on the broader economy, and thereby the sovereign and banks, would be more material.
-4
-2
0
2
4
6
8
10
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Government Consumption Household Consumption Other Private ConsumptionInvestment Net Exports of Goods & Services Statistical DiscrepancyReal GDP Growth
NEWS & ANALYSIS Credit implications of current events
41 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Sub-sovereigns
German Laender’s Salary Pact with Public Employees Is Credit Positive On 17 February, German Laender and labor unions reached an agreement to increase salaries for around 800,000 public employees by 2% this year (effective retrospectively to the beginning of the year) and by 2.35% at the start of 2018. This agreement is credit positive because the salary increase is less than German Laender’s expected tax collection growth of 2.6% in 2017 and 3.8% in 2018 and sets guidance for salary increases for the Laender’s special status employees. Additionally, the agreement ends strikes at universities, kindergartens and other public offices.
Public employees’ salaries account for the largest expense in each Land’s budget, equaling an average of 45% of a Land’s tax collection and around 35% of its total expenses, because Laender are responsible for labor intensive public services such as schools, universities, police, court houses and tax offices. The agreement will result in personnel expenses for all German Laender increasing by a combined €870 million in 2017 and €1.9 billion in 2018, while Laender expect tax collections to increase by €8 billion in 2017 and €11 billion in 2018.
In general, West German Laender such as Bavaria (Aaa stable), Lower Saxony (unrated) and Nordrhein-Westfalen (Aa1 stable) should benefit from the agreement because personal costs constitute a much larger share of total expenses (around 40%) than East German peers such as Brandenburg (Aa1 stable) and Saxony-Anhalt (Aa1 stable), where it is around 30%. East Germany states have only existed since reunification in 1990, resulting in lower salaries, low numbers of retirees, and consequently lower pension payments.
The agreement with public employees normally serves as a role model for the salary negotiations between Laender and the remaining 2.2 million public special status employees and pensioners. Therefore, we expect the increase for the special status employees in several Laender to be finalized broadly in line with the terms of the recent agreement. In our view, the moderate increase of salaries below Laender’s expected increase of tax revenue is likely to contribute positively to balanced budgets and to result in declining debt ratios, as measured by the ratio of net direct and indirect debt to operating revenues, for most German Laender.
In addition to being below the Laender’s expected tax revenue growth rate, the salary increase is lower than what many Laender assumed in their budgets for 2017 and 2018. Nordrhein-Westfalen, the state with the highest number of public employees at around 293,000 in 2016, budgeted its personnel expenditures to increase by 5.0% in 2017 and 1.7% in 2018 from around €25.3 billion in 2016. Therefore, we expect that the agreement will result in additional annual savings in budgeted salaries for the state.
Janko Lukac Analyst +49.69.70730.925 [email protected]
NEWS & ANALYSIS Credit implications of current events
42 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
Australian Universities to Benefit from Growing International Student Enrollments Last Wednesday, Australia’s Department of Education and Training released data showing that international student enrollment16 at Australian universities grew by 12.6% in 2016, after growing 8.7% in 2015. This is credit positive for Australian universities because the fees paid by international students compensate for slower growth in grant funding from the Australian government, and overseas students pay universities almost 2.5x more per capita versus domestic students.
International enrollments are a leading indicator of the fees that Australian universities will derive from this demographic (see Exhibit 1). In 2015, international fees accounted for 18.7% of universities’ total revenues, up from 16.3% in 2013. We expect that the higher number of international enrollments in 2016 will translate into a higher growth rate in international student fees next year. The increase in this source of revenue will contribute to universities’ efforts to continue enhancing and expanding their infrastructure and research facilities, which, in turn, will attract more students.
EXHIBIT 1
Change in Australian Universities’ International Student Enrollments and Fees
Sources: Australia’s Department of Education and Training and Moody’s Investors Service
The Australian government contributed more than 57% of the universities’ revenue in 2015 (the latest available figures), but is facing its own fiscal challenges. Although the government will remain a strong supporter of the sector, given the importance of higher education to Australian exports, growth in grants has slowed significantly (see Exhibit 2) and we expect this trend to continue. Universities will become increasingly reliant on alternative sources of revenue, particularly international student fees, to fund capital plans and cover rising costs.
16 Enrollment data are based on actual course enrollments. Financial data for 2016 for the consolidated university sector are not yet
available.
-10%
-5%
0%
5%
10%
15%
20%
2009 2010 2011 2012 2013 2014 2015 2016
International Enrollments International Fees
Kristin Tan Associate Analyst +61.2.9270.1413 [email protected]
Debra Roane Vice President - Senior Credit Officer +61.2.9270.8145 [email protected]
NEWS & ANALYSIS Credit implications of current events
43 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
EXHIBIT 2
Change in Australian Universities’ Operating Expenditures Is Outpacing Change in Government Grants
Sources: Australia’s Department of Education and Training and Moody’s Investors Service
Australian universities will continue to face challenges in reducing the growth rate of their operating expenditures, given the need to compete on an international level to recruit academic staff and attract students. The sector is also facing increasing global competition, including from Canada, the US and the UK. However, we note that a less open attitude toward immigrant workers in the US, as well as tighter visa restrictions in the UK and its imminent departure from the European Union, could strengthen Australia’s competitive position.
Although international fees are an increasingly important source of revenues for universities, a growing reliance increases their exposure to adverse events such as visa restrictions or adverse publicity. The latter occurred in 2011-12, when a series of violent incidents against foreign students in Melbourne resulted in a drop in international student enrollments and fees.
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
2012 2013 2014 2015
Government Financial Assistance Operating Expenditures
NEWS & ANALYSIS Credit implications of current events
44 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
US Public Finance
Kansas Governor Vetoes Tax Hike, a Credit Negative Last Wednesday, the Kansas (Aa2 negative) state senate fell three votes shy of the two-thirds majority required to override Governor Sam Brownback’s credit-negative veto of legislation that would have increased income tax rates and gone a long way toward resolving Kansas’ fiscal troubles. With the state for now sticking with a lower-tax policy, Kansas will continue to struggle to balance its budget, consider deferring pension contributions again, and drain its highway fund of funding for crucial transportation projects.
The rollback of the tax cuts would have generated more than $450 million of additional revenues annually, or 8% of revenues (see exhibit), which would have closed the majority of the state’s structural imbalance. The state’s budget gap totals more than $600 million, evidenced by a 2017 revenue shortfall of $350 million, a planned highway fund raid of more than $250 million, and ongoing pension underfunding.
Kansas’ Estimated Incremental Revenues from Proposed Tax Increase
Source: State of Kansas and Kansas Department of Revenue
Kansas does have the ability to strengthen its finances. Its economic base is stable, and its long-term liabilities are moderate, although growing rapidly. The state has already taken some steps to preserve its fiscal profile, including raising sales taxes and cutting expenditures aggressively. Furthermore, the state may yet enact tax reform or find other solutions in this budget season. We still expect the state to resolve its fiscal problems eventually, although the longer its budget remains out of balance, the greater the risks to its credit quality.
Part of Kansas’ current fiscal predicament is traceable to legislation the state enacted in 2012 that slashed income tax rates by 29% for the top marginal tax bracket and repealed a tax on nonwage business income. The tax cuts immediately squeezed the state’s then-roughly $6.4 billion general fund tax revenues by $700 million. The state has responded to this gap in several ways, including drawing down reserves and raiding the state highway fund.
Kansas’ legislature earlier this month passed House Bill 2174, which would have raised the top income tax bracket in the state to 5.45% from 4.60% and reinstated the tax on nonwage business income. Although the incremental revenues from this bill might not have closed Kansas’ budget gap entirely – or addressed an embedded problem of chronic pension underfunding – it would have been an important step in a more
$590
$454 $459 $463 $468
0%
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4%
6%
8%
10%
12%
$0
$100
$200
$300
$400
$500
$600
2018 2019 2020 2021 2022
$ M
illio
ns
Fiscal Year
Amount - left axis Percent of Estimated 2017 Tax Revenues - right axis
Dan Seymour, CFA Vice President - Senior Analyst +1.212.553.4871 [email protected]
NEWS & ANALYSIS Credit implications of current events
45 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
positive direction following several years of credit deterioration. Following the veto, the fiscal 2018 (which ends 30 June 2018) budget season will be crucial. Continuing to resort to stop-gap measures that do not resolve, or may even worsen, the state’s long-term structural problems would intensify the pressure on Kansas’ credit quality.
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46 MOODY’S CREDIT OUTLOOK 27 FEBRUARY 2017
NEWS & ANALYSIS Corporates 2 » Hologic’s Planned Acquisition of Cynosure Is Credit Positive » Arconic’s Sale of Alcoa Shares Is Credit Positive » PSA's Acquisition of Opel Would Strengthen Its Market
Position, a Credit Positive » Danone's Scrip Dividend Proposal Is Credit Positive » Toshiba’s Delayed Results and ¥700 Billion US Nuclear
Impairment Add to Its Woes » Kirin's Planned Sale of Its Brazilian Business to Heineken Is
Credit Positive
Infrastructure 9 » Closure of NavaJo Generating Station Is Credit Positive for
Star West » NRG Activist Shareholders' Involvement Is Credit Negative
Banks 12 » Colombian Government's Takeover of Highway Project Is
Credit Negative for Banks » Russia’s Mortgage Lending Growth Is Credit Positive for
Banks » Czech Pre-election Proposal for Bank Tax Would Reduce
Profits and Capital Generation » Cypriot Banks Would Benefit from Continued Recovery in
Property Prices » Industrial Development Corporation of South Africa Will
Benefit from Takeover of National Empowerment Fund » Nigerian Banks' Foreign-Currency Liquidity Declines, a
Credit Negative » Bankrupt Hanjin Shipping's Creditor Banks Are Well-Reserved
Insurers 25 » US Hospitals and Insurers Would Benefit from Proposed
Rules to Stabilize Health Insurance Exchanges » AIG Takes Another Large Reserve Charge, a Credit Negative
US Public Finance 29 » States Make Progress on Bridge Repair Backlog, a
Credit Positive
Securitization 31 » Peugeot and GM Europe Merger Would Benefit Companies'
Auto ABS
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