Global Corporate Credit: Twin Debt Booms Pose...

Global Corporate Credit: Twin DebtBooms Pose Risks As Companies SeekUS$57 Trillion Through 2019

Primary Contact:

Jayan U Dhru, New York (1) 212-438-7276; [email protected]

Secondary Contacts:

Terry E Chan, CFA, Melbourne (61) 3-9631-2174; [email protected]

Diego H Ocampo, Sao Paulo (54) 114-891-2124; [email protected]

David C Tesher, New York (1) 212-438-2618; [email protected]

Paul Watters, CFA, London (44) 20-7176-3542; [email protected]

Table Of Contents

The Global Environment Is Of Moderate Concern

Corporate Credit Cycle And Intensity Drive Debt Demand

Key Credit Concerns

If Tail Risks Materialize

Related Criteria And Research

Appendix

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 15, 2015 1

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Global Corporate Credit: Twin Debt Booms PoseRisks As Companies Seek US$57 Trillion Through2019

The prospects of rising defaults in what is now the world's biggest corporate debt market—China—and the surge in

leveraged finance in the U.S. pose what Standard & Poor's Ratings Services sees as the two biggest risks to corporate

credit around the world.

Since the onset of low interest rates in the U.S. and eurozone over the past few years, investors in the West have been

chasing yield. This has contributed to credit booms in the emerging markets and in U.S. speculative-grade issuance.

With the lower credit growth rates of developing economies and the imminent rise of U.S.-dollar interest rates, we

have reached an inflexion point in the corporate credit cycle. As the U.S. economy picks up, will global corporate

credit quality improve? Or have latent (tail) risks built up over the five years since the Great Recession? (Watch the

related CreditMatters TV segment titled, "Global Corporate Credit: Debt Booms In China And The U.S. Pose Risks As

Companies Seek $57 Trillion Through 2019," dated July 16, 2015.)

Overview

• Debt demand is lower. We project global corporate debt demand to be $57 trillion from 2015 through 2019,

down 4% from last year's five-year projection, because of lower forecast global nominal GDP growth. Of this,

we expect $37 trillion of refinancing and $20 trillion of new debt.

• The lion's share outstanding will be China's. We expect outstanding corporate debt globally to grow by

two-fifths to $71 trillion by 2019. With 40% of the total, China will have the lion's share.

• Key tail risks. While we regard overall risk to global corporate credit as moderate, we remain concerned about

two key tail risks that could drag down credit performance and destabilize financial markets. First is China's

opaque and rising corporate debt. Second is the rapid rise of U.S. leveraged finance debt. Another tail risk,

though much smaller, is Latin American debt.

The different stages in the corporate credit growth cycle of countries are an important component in assessing credit

quality. Standard & Poor's has therefore focused on these stages in examining the global environment. We also analyze

the credit quality of more than 6,000 global companies based on sectors. Our studies showed that the risk of global

corporate credit quality worsening is moderate. We also see two key tail risks (possibility of more extreme outcomes

over time) to be wary of: China's corporate debt and U.S. leveraged finance.

The Chinese economy has expanded enormously over the past five years, although its growth rate has recently

stepped down. Corporate debt has escalated this growth. Indeed, the Chinese central government's "capitalism with

Chinese characteristics" has led to the corporate sector (including state-owned enterprises [SOE]) incurring more debt

than the sovereign. In fact, China's corporate debt is eight times the size of the government's and the largest in the

world. Our analysis of a sample of listed Chinese companies indicates that their financial risks have worsened by the

equivalent of about a notch since 2009. As China's corporate credit growth cycle slows, we expect defaults to pick up.


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While some form of government support for SOEs is likely, its scope and effectiveness are uncertain. The mixed result

of Chinese policymakers' intervention in the recent equity market turmoil is a case in point. Consequently, we view

China's corporate debt as tail risk number one.

In the U.S., it would appear that in terms of corporate credit not too much has happened following the Great

Recession. But this is not the case. Rather, there have been opposite swings at the two ends of the corporate credit

spectrum. At the investment-grade end (ratings of 'BBB-' or higher), U.S. companies have been hoarding cash (with the

majority for tax reasons remaining parked overseas), whereas at the speculative-grade end, issuers have taken

advantage of favorable borrowing conditions under the U.S. quantitative easing program to increase borrowing. Hence,

the oft-cited comment by observers that there has been little deleveraging by U.S. companies as a whole. Our analysis

of a sample of listed U.S. companies indicates that their financial risks have worsened by the equivalent of about half a

notch since 2009. While we regard the U.S. corporate credit growth cycle to be in the early peaking stage (that is,

credit growth is picking up), the likely rise in U.S.-dollar interest rates makes the high debt load of U.S. leveraged

finance borrowers tail risk number two.

Meanwhile, the downturn in commodity prices has hit Latin American countries whose economies rely on this. Brazil,

for example, is in recession. We therefore see Latin American corporate credit as the third tail risk, although

admittedly it is of a very different magnitude because of its relatively small size.

Elsewhere, we have lesser but mixed concerns about Asia-Pacific's corporate credit, with some countries relying more

on Chinese goods and services demand than others. We are also not overly concerned about Europe's corporate

credit, although risks to the currency union and effects from the incoming QE remain salient. Finally, we are relatively

sanguine about Japan's corporate credit cycle peaking, given its relatively low growth in credit.

• This fourth annual Global Corporate Credit report discusses our:

• Assessment of five factors shaping the economic and financial environment;

• Estimation of credit intensity and debt demand of corporate issuers by country

• of domicile; and

• Two key credit concerns–China and U.S. leveraged finance–over the five-year horizon.


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Global Corporate Credit: Twin Debt Booms Pose Risks As Companies Seek US$57 Trillion Through 2019

The Global Environment Is Of Moderate Concern

We rank our credit concerns qualitatively as "high," "moderately high," "moderate," and "low" (see appendix for

definition).

Uneven economic conditions

We regard global economic risk to credit as low to moderate. It is low for the improving U.S. economy and Japan's

recession recovery (see chart 1). For Europe, we have only moderate concerns, despite things looking up amid

persisting structural risks related to the currency union. In China, companies are still adapting to lower economic

growth, keeping risks moderately high. Other emerging markets too have moderately high risk with some facing

slowdowns partly because of commodity price declines. While disinflation risk is moderately high for producers, it is

low for consumers, so overall it is moderate.

Divergent funding capacity

The Federal Reserve's exit from quantitative easing (QE) means that U.S. interest rates are likely to rise, increasing

market liquidity and refinancing risks, especially for speculative-grade debt globally. But this is only a moderate

concern because we expect the Fed to carefully manage the rate increases. We consider Europe's funding capacity to

be of low concern given its very low interest rates and the European Central Bank's (ECB) extended and aggressive QE

program. Japan's funding capacity is also of low concern given the liquidity trap (cash injections are ineffective to spur


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economy amid low interest rates) it has endured. The emerging markets are a mixed bag. Some regulators, as in China,

have lowered interest rates and still have room to reduce them, but they fear stoking credit inflation. We see the

funding risk in China as low and in other emerging markets as moderate.

Shifting currency exchange rates

Market expectations of higher U.S. interest rates are boosting the U.S. dollar. This will test companies transacting

cross-border business and even domestic-focused entities. A strong dollar is a moderate risk to credit for U.S. debtors

given export headwinds and the greater competitiveness of imports. We are also moderately worried about emerging

markets companies, but for another reason. Weaker domestic currencies hurt those who borrow in U.S. dollars,

especially if the principal and interest are unhedged. For Europe, the euro's weakness against the greenback poses a

low concern and, in fact, benefits exporters. Japan's yen has fluctuated for some time but the impact has not been that

serious. Our concern is low about China's managed renminbi.

High collateral values

With easy money, investors have chased yield. The stock market has benefitted, and perhaps a correction is overdue.

But this poses only moderate risk to credit because it mainly affects companies using stock as collateral or needing to

raise equity. In real estate, values are just starting to pick up in the U.S., are mixed in Europe, and have suffered

negative real growth in Japan–thus property overvaluation risk is low. In contrast, despite price falls and banks

"haircutting" property collateral values (assuming collateral value is lower than market value in assessing loans), the

risk in China is still high. In some emerging markets, asset prices have risen faster than GDP growth, implying

moderate high risk. The end of the commodities super-cycle (the price boom associated with strong demand from

China) means that collateral risk is moderately high.

Variable credit cycle

Speculative-grade corporate issuers have taken advantage of the U.S. QE to increase debt faster than investment-grade

peers. In fact, four out of five new U.S. issuer ratings in 2012-2014 were 'B'. We see the tail risk from such debtors as

moderately high (see chart 2). For Europe, we see the inherent risk to credit from QE as moderate. For Japan, its credit

expansion is likely to be relatively subdued, so our concern there is low. Finally, we view China's corporate credit with

high concern. This is due to rapid growth that has pushed corporate debt up to 160% of GDP at end-2014 and the

likelihood that it will continue to rise faster than GDP growth in coming years. Bad debts are rising amid signs that the

Beijing authorities will allow some companies to default, as the recent default of state-related entity Baoding Tianwei

Group Co. Ltd. (not rated) shows.


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Corporate Credit Cycle And Intensity Drive Debt Demand

Our analysis of the corporate credit cycle underpins our assumptions of credit intensity that we use to project debt

demand. Credit intensity is corporate debt growth divided by nominal GDP growth. We estimate companies may seek

up to $57 trillion (2:1 refinancing to new) over 2015-2019 (see table 1). China could consume $23 trillion or 40% of

global demand; U.S., $12 trillion, 21%; and the eurozone, $7 trillion, 13%.

The corporate credit cycle stage influences credit growth as well as debt capacity. We assess a stage as "slowing,"

"adjusting," "climbing," or "peaking" (see appendix for definitions). To assess the stage, we examined credit growth

rates over the 15 years through 2014 for each country, converting these rates into an index. We indexed peak growth

at 100 or trough at 0, with the period average at 50 (see appendix for methodology). We used data spanning two years

to dampen noise from volatility (see chart 3).


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Table 1

Global Corporate Credit Demand

(a) (b) (c) (d)

(e) = 75% x

(a)

(f) =

f(a,c,d)‡

(g) =

(e)+(f) (h)

(i) =

(a)+(f)+(h)

Total

debt

o/s

2014

Total

debt o/s

over

GDP

2014

Nominal

GDP CAGR

2015-19¶

Average

intensity

multiple

Refinance

demand†

New debt

demand

2015-19

Total debt

demand

2015-19

Currency

gain/

(loss)

Projected

o/s debt

2019

(US$

tril.) (%) (%) (x)§ (US$ tril.) (US$ tril.) (US$ tril.) (US$ tril.) (US$ tril.)

Asia-Pacific 25.5 120% 6.9% 1.3 19.4 14.5 33.8 1.2 41.9

Australia 0.9 66% 4.8% 0.8 0.7 0.2 0.9 0.0 1.2

China 16.1 160% 8.2% 1.3 12.2 10.6 22.9 1.6 28.5

Hong

Kong

0.7 232% 5.4% 2.2 0.5 0.5 1.0 - 1.2

India 1.0 48% 12.6% 1.5 0.7 1.3 2.1 0.0 2.3

Indonesia 0.2 24% 10.8% 1.1 0.1 0.1 0.3 0.0 0.3

Japan 4.5 102% 1.4% 1.0 3.2 0.3 3.6 (0.5) 4.6

Korea 1.5 113% 5.5% 1.4 1.2 0.7 1.8 0.1 2.3

Malaysia 0.3 94% 8.2% 1.3 0.3 0.3 0.6 0.0 0.8

Singapore 0.2 84% 5.1% 2.8 0.2 0.2 0.4 0.0 0.5

Thailand 0.2 53% 6.1% 1.2 0.1 0.1 0.2 0.0 0.3

North

America

12.5 65% 4.4% 1.2 9.4 3.7 13.1 0.1 16.3

U.S. 11.5 65% 4.4% 1.2 8.6 3.4 12.0 - 14.8

Canada 1.1 63% 3.9% 1.3 0.8 0.3 1.1 0.1 1.5

Europe 11.2 78% 3.0% 1.0 7.3 1.6 8.9 (1.2) 11.5

Eurozone 9.6 83% 2.8% 1.0 6.3 1.2 7.5 (1.1) 9.7

U.K. 1.6 58% 4.0% 1.1 1.1 0.4 1.4 (0.1) 1.8

Latin

America

1.3 43% 7.1% 1.3 0.9 0.7 1.5 (0.2) 1.7

Brazil 0.9 46% 7.3% 1.0 0.5 0.3 0.9 (0.2) 1.0

Mexico 0.5 38% 6.7% 1.8 0.3 0.3 0.7 0.0 0.8

Total 50.5 87% 5.2% 1.2 37.0 20.4 57.4 (0.2) 71.4

¶Based on Standard & Poor’s projections of local currency GDP growth and foreign exchange rate against the U.S. dollar.

§Assumes debt grows over 2015-2019 at specific multiples of nominal GDP rate depending on a country's credit cycle stage. Total is debt

weighted.

†Assumes 75% of debt matures over five years. ‡Mathematical function. CAGR--Compound annual growth rate. N/A--Not applicable.

o/s–outstanding.


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Our calculations show that the eurozone, Japan, and U.S. hit troughs in 2009. In contrast, China's corporate credit

cycle peaked that same year before slowing. The eurozone has remained stuck in the adjustment phase. The U.S. index

rallied after 2009, and has recently transited from the climbing to peaking stage.

The index for Japan indicates the country is still peaking. However, we should qualify that the amplitude of Japan's

corporate credit cycle is small, making it fairly volatile. Our research also shows China is slowing, with Hong Kong

(HK) and Singapore close behind. Commodity-reliant Australia and Brazil are even further along, in the adjusting stage.

Europe and U.K. remain in a trough.

As the corporate credit cycle turns, weaker debtors in emerging markets and U.S. leveraged finance may struggle to

raise new debt or refinance.

Emerging markets show greater credit intensity

The higher credit-to-GDP intensity (see appendix for definition) of the emerging markets magnifies credit growth. We

expect the megatrend of emerging markets' debt overtaking that of developed markets to continue based on sheer

momentum. These markets' higher credit intensity, stronger nominal GDP growth, and large outstandings (primarily

China's) will propel the trend. While the credit cycles in the emerging markets (and Asian money centers of Hong Kong

and Singapore) are slowing, we expect their credit intensities to remain above those of advanced markets given their

stages of economic development.

To factor in a country's stage of corporate credit cycle, we applied specific intensity multiples in our projections (see


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table 1). We qualitatively assigned these after examining the historical credit intensity of each country. These multiples

substitute for the normalized 1 time (x) and 1.2x multiples we had applied in our reports of prior years.

Disinflation reduces new money demand

A lower inflation rate (such as due to commodity price falls) by definition dampens demand for additional debt

financing in nominal terms (not necessarily in real terms). We are assuming a nominal GDP compound annual growth

rate of 5.2% globally over the next five years, lower than last year's 6.1%.

We project refinancing demand to be $37 trillion for 2015-2019 (see table 1). Adding new debt of $20 trillion results in

total financing demand of $57 trillion through to 2019. Disinflation has caused the projection to be lower than last

year's $60 trillion (1.2x multiple). As before, we assumed 75% of outstanding debt will be refinanced over the five-year

period. Overall, we project total outstanding to reach $71 trillion by end 2019 (see chart 4).

China's risk to credit: high

Rapid debt growth, opacity of risk and pricing (partly due to bank loans dominating funding), very high debt to GDP,

and the moral hazard risk of the Chinese market make it a high risk to credit. While the cycle is in the slowing phase,

China's credit growth rate still remains faster than most (see chart 4).

Admittedly, these numbers include a material contribution from state-owned enterprises (SOEs), which are not

explicitly guaranteed. While some observers argue that we should presume implicit government support and therefore

exclude these SOEs from the count, such support remains uncertain. Even if we presume 50% of corporate debt relates


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to SOEs, halving the amount owed by Chinese companies, our debt projection for 2019 for China would still be

one-and-a-half times that of the eurozone and similar to that of the U.S.

Asia-Pacific's risk to credit: moderate

We regard the risk from Japan's corporate debt growth as low and other Asia-Pacific economies as a net moderate

(see chart 2). Japan's low nominal GDP growth and still-low credit intensity of 1x mean that debt would expand slowly

at the peaking stage. The extended period of secular stagnation (persistently low economic growth) has distorted the

normal credit cycle, so its low absolute level curbs the downside in our view.

For other Asian economies, the risk is mixed, although overall a net moderate. We expect fast growth to continue for

Hong Kong and Singapore due to their very high intensities (see table 1). We also project rapid growth for Indonesia as

its economy further develops. Further, India's corporate debt growth will outpace others because its forecast high

nominal GDP growth should boost demand. Naturally, such growth has its own risks.

Latin America's risk to credit: moderately high

We regard the risk from Latin American corporate debt growth as moderately high (see chart 2) as net exports and

foreign direct investment fall, currencies depreciate, and borrowers become overleveraged. This is particularly evident

in Brazil, where we assess the stage of the credit cycle as adjusting. As Brazil's economy contracts, its political

stalemate continues, and the currency depreciates, high borrowings and shrinking asset values are worsening credit

quality. We expect Brazil's corporate sector to not substantially increase its debt burden in U.S.-dollar terms because of

reduced investment.

In contrast, Mexican companies may have higher debt needs as stronger U.S. demand reinvigorates the economy.

Mexico's structural reforms may also bolster domestic growth, although the effectiveness of such measures is

uncertain. All in, Mexican corporate debt could come closer to Brazil's level by 2019.

North America's risk to credit: moderately high

We regard the risk from North American (U.S. and Canada) corporate debt growth as moderately high (see chart 2).

We expect these two economies to grow moderately in the next few years. However, we are projecting credit demand

from the region to remain fairly high, reflected in our assumption of the continent's credit-intensity of 1.2x–the highest

among large advanced economies. In the next five years, we expect North America's debt demand to be $13 trillion,

23% of global demand.

The U.S. credit cycle is at the peaking stage, with Canada further ahead in the same phase. In recent years,

QE-induced low interest rates have enabled companies across the credit spectrum to extend maturities at very

attractive pricing and terms. Investors have also been willing to accept the heightened risks associated with

speculative-grade debt in return for higher yield. However, the residual hangover from years of lenient credit could be

painful when the Fed raises its policy rate, which we expect to happen later this year. In general, rising rates will

increase borrowing costs and could dampen debt issuance, with lower quality borrowers bearing the brunt.

Europe's risk to credit: moderate

We regard the risk from corporate debt growth in Europe as moderate overall, albeit with some regional variation (see

chart 2). In the eurozone, companies have struggled to recover from the rapid accumulation of debt from 2004 to 2008,


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particularly because nominal growth has remained so low. Debt sustainability has improved because interest rates

have fallen, the share of fixed rate debt has increased, and debt maturities have been extended.

Nevertheless, we anticipate that a combination of low inflation, below-par real growth, and companies' continued

antipathy to debt may somewhat constrain new debt demand in coming years. The weaker prudential case for large

cash balances as banks' capital positions improve, along with negative deposit rates, would also reduce debt demand.

In contrast, U.K. companies are somewhat better positioned. Stronger nominal growth (reducing leverage ratios), a

recovery in collateral values, and a greater variety of funding sources suggest that debt availability can support some

normalization in the U.K. intensity measure to above 1x.

Evolution Of Risk

Since this series began, the risks facing global corporate credit have evolved. In 2012, market skittishness

tempered our projection to $46 trillion of refinancing and new debt for the following five years. Market

confidence crept up in 2013 though, partly boosting our projection to $53 trillion. We predicted China would

surpass the U.S. as the world's largest corporate borrower–which it did. Downside risks at that time were the

prospect of banks rationing credit and a sharp economic correction in China. As these concerns subsided in 2014,

we revised our forecast for demand to $60 trillion for 2014-2018, higher than our current projection of $57 trillion

for 2015-2019.

Key Credit Concerns

Following on from our economic and financial heatmap (see chart 1), several specific areas could show heightened

credit concerns over the next half decade.

Our main concerns relate to the scale and growth of corporate debt in China, the potential for a shakeout in the

leveraged finance market in the U.S. and, potentially a market liquidity drought developing in certain sectors and

countries such as in Latin America.

Our analysis of the financial risk of 6,238 listed companies globally illustrates the growing vulnerability of corporate

credit in these regions or markets. The results show that since 2009 financial risk has risen most in China, followed by

Latin America (see chart 5). We estimate such risk has worsened by the equivalent of about a notch in these regions,

half a notch globally and in North America, and almost none in Europe and other Asia-Pacific (note: this exercise does

not use actual credit ratings).


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Additionally, in the U.S., QE has allowed speculative-grade issuers to increase debt faster than their investment-grade

peers (see chart 6). These credit booms imply that the seeds of a crisis may have already been sown.

Global financial risk is trending upward

The financial risk scores of companies globally have worsened incrementally (see chart 5). China and Latin America

deteriorated at the same pace, while the global pool and North America expanded at an intermediate pace. Meanwhile,

the financial risk of companies in Europe and other Asia-Pacific economies were stable. These trends align with

observations on our global ratings pool and prior studies. Given the increased score differential between China and

others, contagion risk from China has increased. In this exercise, we sourced 2009-2014 data for listed (rated and

unrated) companies from S&P Capital IQ, weighted credit ratios, and applied a near-normal distribution over the 2014

sample on a 10-point scale (see appendix for methodology).


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China: Can Beijing manage rising risks?

China shows moderate to moderately high financial risk (see chart 5). The risk score average is only slightly worse than

the global level. But the score decline over 2009-2014 is a concern. From our other studies, SOEs tend to show credit

metrics about half as strong as those of their private-sector peers. Many SOEs rely on lenders, such as state-owned

commercial banks, giving them preference over other borrowers. Sectors such as real estate and infrastructure

development involve a number of SOEs. The opaque financials of numerous SOEs make it difficult to gauge the degree

to which underperforming debt is recognized as such. For China, this is a secular risk.

We do recognize, however, that the government is trying to address such risks. Besides recently lowering interest rates

to shore up economic growth, Beijing has begun a plan to swap at least RMB1 trillion ($160 billion) of local

government financing vehicle debt (a type of SOE) for municipal bonds (effectively moving the debt onto the

government's balance sheet). Future policy action would be critical in moderating or amplifying the impact from the

cycle's slowdown. The more Beijing prudently manages such risks, the less of a threat such risks are.

Asia-Pacific: Higher real estate valuations could be a problem

Asia-Pacific economies show moderate financial risk (see chart 5). The risk score average is slightly better than

average. But companies' financial risks have marginally worsened for some markets (albeit the sample sizes are small).

In addition, the risk of property overvaluation is moderately high for some. Residential prices in Hong Kong, India,

Indonesia, Malaysia, and Philippines have risen faster than GDP growth. Given the importance of real estate as loan

collateral and its economic contribution, any reversals here have repercussions for general credit risk.

Latin America: Sliding commodity prices are taking a toll

Latin America shows moderate to moderately high financial risk (see chart 5). The risk score average is slightly worse

than the global score. Not surprisingly, the commodity-reliant Latin American economies are decelerating fast as

money flows out, governments cut fiscal spending, and banks tighten. The effects are being felt across Argentina,


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Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. We see agribusiness sectors in Brazil and Argentina facing

moderately high risk. Steelmakers in Brazil are suffering from both poorer economic conditions and the threat of

imports. Oil and gas suppliers in Brazil and Mexico are facing cash flow pressure, and Brazil's homebuilders are

struggling with low demand and high refinancing risk.

North America: Leverage is still on the rise

North America shows moderate to moderately high risk (see chart 5). The risk score average is about the global level,

with high investment-grade issuers remaining strong. However, with QE tapering and more 'B' issuers borrowing (see

chart 6), fundamentals are leaning toward the market boiling over. The vast volume of institutional and retail money

flowing into speculative-grade bonds also suggests vulnerability. Prolonged low interest rates have allowed borrowers

to extend maturities and finance mergers and acquisitions (M&A) and shareholder-friendly activities (dividend

recapitalizations). Extending maturities, in turn, is lowering interest costs and generating efficiency gains. On the other

hand, recapitalizations are increasing leverage and less productive investing. The impact of M&A is mixed, depending

on the balance between gains from reduced capacity and heavier debt.

While the system's leverage is manageable, an interest rate spike could trigger refinancing problems for riskier issuers

as investors become cautious and capital-constrained banks shy away from debtor-friendly structures.

Europe: Will QE do the trick?

The European sample shows moderate financial risk (see chart 5). The risk score distribution at average is slightly

better than the global level and shows little net change between 2009 and 2014. However, while this reflects an

extended period of financial discipline, given significant prevailing political and economic uncertainties, it also masks

material differences between companies by size, sector, and country. Those most exposed to weak local markets in the

periphery typically have less financial flexibility and fewer funding options that will reinforce strict financial discipline.

Conversely, (often larger) companies operating in faster growing European and global markets have greater flexibility.

A key risk to monitor is to what extent the ECB's landmark QE encourages greater productive investment in the real

economy or reawakens the clamor for increased short-term shareholder rewards. Early signs do not bode well.

If Tail Risks Materialize

A key risk in 2014 was the huge shift in the balance of global credit toward China. The risk remains elevated even

though we expect lower credit growth rates for China. Other emerging markets are also posing high tail risks.

Additionally, the risks within U.S. leveraged finance have become moderately high as U.S. interest rates are poised to

rise. Further, many countries are in the slowing to adjusting credit-cycle stages, signaling that the tail risks could

materialize and trigger a destabilizing credit squeeze.

Obviously, the authorities in China, the U.S., or other countries would likely intervene if a material dislocation were to

occur. Still, market volatility and heightened uncertainty can often be difficult to contain despite the authorities' best

endeavors.

Today therefore could very well seem like the good old days if, down the road, the tail risks materialize.


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Related Criteria And Research

Related Criteria

• Corporate Methodology, Nov. 19, 2013

• Key Credit Factors For The Real Estate Industry, Nov. 19, 2013

Related Research

• U.S. Nonfinancial Corporate Cash: The Top 1% Hold 48% Of A Record $1.82 Trillion; The Rest Face Rising Debt,

June 11, 2015

• Credit Shift: As Global Corporate Borrowers Seek $60 Trillion, Asia-Pacific Debt Will Overtake U.S. And Europe

Combined, June 15, 2014

• The Credit Cloud: China Will Leapfrog The U.S. In The Race For $53 Trillion In Corporate Funding, May 14, 2013

• The Credit Overhang: Is A $46 Trillion Perfect Storm Brewing?, May 9, 2012

Appendix

Assumptions, data, and methodology

This appendix discusses the assumptions, data sources, and methodologies adopted in the article. The definitions used

in this article should be read in context. They may not necessarily align with those in our other publications.

Borrowing, credit, debt: Used interchangeably. Includes loans and debt securities (e.g., bonds) that are both short-term

and long-term.

Chart 1: See "concerns, risk-to-credit."

Chart 2: The data points for the y-axis of projected debt compound annual growth rate (CAGR) are computed from a

mathematical function of nominal GDP growth rate and credit intensity multiplier (see "credit intensity" below).

Chart 3: See "credit cycle stages" and "credit growth index" below.

Chart 4: This chart is based on table 1.

Chart 5: Charts were derived from our computations drawing on financial data, sourced from S&P capital IQ, for the

years 2009 to 2014 of 6,238 listed companies (both rated and unrated). See "Financial risk scores."

Chart 6: Data source is Standard & Poor's.

Commodity super-cycle: A cycle of commodity price movements that can span decades. In this article, it refers to the

commodity price boom of the 2000s and into the 2010s, which was associated with strong growth in demand from

China.

Concerns, risk-to-credit: We have classified five external high-level factors that may affect corporate credit: economic

conditions, funding capacity, currency exchange rates, collateral values, and credit cycle. We define the descriptors of

"high," "moderately high," "moderate," and "low" (used in chart 1) as per table 3 below.


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Table 2

The views on likelihood and impact are qualitative.

Risk-to-credit: This is our qualitative assessment of the likelihood that each credit factor could have a detrimental

impact on corporate credit portfolios over the next two years. For example, adverse economic conditions may

translate to a challenging business environment and therefore represent a risk to credit, although it is not intrinsically a

credit risk. Instead, we use the term "credit risk" here to refer to the probability of default and loss given default of an

issuer or credit portfolio.

Corporate: Nonfinancial private sector corporations. Although in China's case, figures may also include some

state-owned enterprises (see "Corporate debt figures, China" below).

Corporate debt figures, China: We sourced the corporate debt figures for China (and other Asia-Pacific countries) from

the Bank for International Settlements' (BIS) long series on credit to the private nonfinancial sector (March 2015).

• Local government financing vehicles. We expect the Chinese corporate debt figures to include state-owned

enterprises (SOE) that are not explicitly guaranteed by government. These include the so-called local government

financing vehicles (LGFV) set by local governments as a means to bypass central government borrowing restrictions

on local governments. Consequently, the likelihood of implicit government support is generally uncertain, although

it could specifically apply on a case-by-case basis.

• Reasonableness of China's debt figures. We suggest they are reasonable, based on a simplistic comparative analysis

of total gross indebtedness of general government, corporate, and household sectors of the U.S. and China. We

calculate the 2014 U.S. gross general government debt at 89% of GDP. We compute U.S. household (BIS data) and

corporate debt (Fed data) to be equivalent to 77% and 65% of GDP, giving a total indebtedness of 231% (see chart

7). For China, the ratios are: gross general government, 20%; household, 37%; and companies, 160%, for a total of

217%.


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• The U.S. at 231% is still higher than China's 217%. In China's case, our concern is more about the imbalance and

growth rate of corporate debt. Even if we presume 50% of companies are SOEs and reclassify half the debt as

government, the residual corporate debt-to-GDP ratio would still be a high 80%.

• Shadow banking. It is our understanding that such numbers include borrowings outside the formal banking system

(so-called "shadow banking"). We do not fully agree with the argument by some observers that the inclusion of

shadow banking would be double counting because some debt is inter-company lending. The degree and nature of

intercompany lending is not transparent (for example, are all the ultimate shareholders of the lender and borrower

actually the same?). In effect, the lender companies are credit creators, hence "shadow banking."

Credit cycle: The cycle of credit growth over time.

Credit cycle stages: The idealized stages of the credit cycle are:

• Climbing. Where the credit growth rate is climbing upward.

• Peaking. Where the credit growth rate continues increasing at a slowing rate until the rate reaches a peak point.

• Slowing. Where the credit growth rate begins to descend.

• Adjusting. Where the credit growth rate continues decreasing at a slowing rate until the rate reaches a trough point.

An example is shown in chart 8 below.


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Credit growth index: An index used for positioning the stage in which the corporate credit of a country or region sits

within the credit cycle. It is based on the annual history over 2000-2014 of the credit growth rates for that country or

region where:

• Either the peak growth rate is indexed at 100, or the trough indexed at 0, and

• The average growth rate for the period is indexed at 50.

We subjectively locate a country on the upward (left side) or downward (right side) on the index cycle based on the

direction of growth. As an example, we view that U.S. credit cycle as being in the "peaking" stage (see chart 9).


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Credit intensity: More fully "credit intensity of GDP." While the term typically refers to total private sector debt, in this

article we refer specifically to corporate debt. The ratio of corporate debt growth divided by nominal GDP growth per

annum is indicative of how fast corporate debt grows relative to the economy.

We qualitatively assign specific intensity multiples in our projections after examining each country's history of credit

intensity and the current stage of credit cycle. These multiples substitute for the normalized 1 time (x) and 1.2x

multiples we had applied in our reports of prior years.

Data sources and assumptions:

• Currency exchange rate: Standard & Poor's forecast.

• Debt data sources:

-- Asia-Pacific. Bank for International Settlements (BIS): Long series on total credit and domestic bank credit to the

private nonfinancial sector.

-- Brazil. Banco Central Do Brasil's table 1 on financial system credit.

-- Canada. Statistics Canada's Table 378-0122 National Balance Sheet.

-- Eurozone. The European Central Bank's statistics on nonfinancial corporations (on a consolidated basis).

-- Mexico. Banco de Mexico's total financing to the nonfinancial private sector.

-- U.S. The Federal Reserve's Flow of Funds Accounts of the U.S. (Z.1 release), Table L.102 Nonfinancial businesses


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(sum of lines 19, 21, 22, 23, 24).

-- U.K. The Office for National Statistics' private nonfinancial corporations: Financial balance sheet.

• GDP growth: Standard & Poor's forecast.

• Nominal GDP data source: The International Monetary Fund's World Economic Outlook database Oct. 2014.

• Refinancing and new financing demand. We assume that for the five-year period 2015-2019 (i) refinancing demand

is equal to three-quarters of outstanding debt at most recent year-end, and (ii) new financing demand equals specific

multiples of the compound annual growth rate of nominal local currency GDP multiplied by outstanding debt at

most recent year-end. The new financing demand is translated to U.S. dollars based on the forecast exchange rate

for the period.

Financial risk score: The discussion below pertains to chart 5 and its accompanying narrative.

Financial ratios. We computed cash flow and leverage ratios partly based on our corporate ratings criteria (see Related

Research). These ratios are:

• Funds from operations (FFO) divided by debt;

• Debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA);

• FFO plus interest divided by cash interest;

• EBITDA divided by interest;

• Cash flow from operations divided by debt;

• Free operating cash flow divided by debt; and

• Discretionary cash flow divided by debt.

The ratios are computed as described in section E of our Criteria/Corporates/General/Corporate Methodology, Nov.

19, 2013. However, the treatment of the ratios does not follow the relevant criteria given that this is not a full credit

rating exercise.

• Financial risk score. Using weighted financial ratios (see below), we calculated the financial risk score on a ten-point

scale for each company.

• Near-normal distribution. By iteration, we selected an exponential function to set thresholds for the ratios over a

ten-point scale such that the 2014 global sample returned a near-normal distribution.

• Nonfinancial risk. In this exercise, nonfinancial risk (e.g., country risk, industry risk) is assumed to be constant.

Consequently changes in financial risk would be indicative of changes in credit risk (which is a function of financial

and nonfinancial risks).

• Sample selection. We selected a sample of nonfinancial companies from S&P Capital IQ's database with the

following characteristics:

-- Market capitalization as of April 21, 2015, of equal to or more than US$150 million;

-- Geographic locations: U.S., Canada, Mexico, Brazil, Ireland, U.K., Italy, Belgium, France, Germany, Luxembourg,

Netherlands, Portugal, Spain, Slovenia, Estonia, Austria, Slovakia, Finland, Greece, Cyprus, Malta, Vietnam, Hong

Kong, China, Indonesia, Japan, Korea, South, Malaysia, Philippines, Singapore, Taiwan, Thailand, Australia, New

Zealand, and India.

-- Industry sectors: energy equipment and services, integrated oil and gas, oil and gas exploration and production, oil


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and gas refining and marketing, chemicals, construction materials, containers and packaging, aluminum, diversified

metals and mining, coal and consumable fuels, gold, precious metals and minerals, steel, paper and forest products,

aerospace and defense, building products, construction and engineering, electrical equipment, industrial

conglomerates, machinery, trading companies and distributors, commercial and professional services, air freight and

logistics, airlines, marine, road and rail, airport services, highways and railtracks, marine ports and services,

automobiles and components, household durables, leisure products, textiles, apparel and luxury goods, consumer

services, media, retailing, consumer staples, healthcare equipment and services, pharmaceuticals, biotechnology and

life sciences, real estate investment trusts (REITS), diversified real estate activities, software and services, technology

hardware and equipment, semiconductors and semiconductor equipment, telecommunication services, utilities, oil and

gas storage and transportation, real estate operating companies, real estate development, real estate services, and

silver.

-- Period: Years 2009 to 2014 inclusive.

• Weighting of ratios. We weighted the first two ratios ("core ratios") one-third each and distributed the other third

among the remaining depending on a company's industry sector.

Haircutting: A banking practice of assuming collateral value that is much lower than market value for the purpose of

loan assessment.

Liquidity trap: A situation where a central bank's policy interest rate has been reduced to zero, and it is therefore

unable to lower nominal (and hence real) interest rates further to stimulate aggregate demand in the economy.

Secular stagnation: A situation where economic growth is persistently low.

Table 1: See "data sources" and "credit intensity" above.

Tail risk: In the study of portfolio risk, "tails" refer to the end portions of a statistical distribution curve. Tail risk refers

to the risk of the less likely and more extreme outcomes, implicitly indicated at the ends of the curve, occurring.

Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change,

affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject

of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.


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