Rise In Funding Cost Poses Risks To Auto Sector Players

BMI View : Should the recent rise in funding costs due to the Chinese banking sector's woes flare up once more, small dealerships which already need to grapple with tight cash flows will come under greater pressure, potentially forcing many of them to shutter. Domestic carmakers which have seen a surge in accounts receivables would also see a detrimental impact to their balance sheets and should they shelve expansion plans due to more expensive financing, auto sales would be indirectly hurt.

The recent turbulence in the Chinese banking system saw overnight interbank borrowing rates soaring beyond 30% ( see 'Beijing's Credit Crunch Conundrum', June 20). While rates have fallen since then as the central bank stepped in to ease the credit crunch in the banking system, they still remain elevated compared with the more benign environment before the liquidity squeeze. The accompanying chart highlights the rise in interest rates, showcasing the upward shift of the swap curve from May 1 2013 (before the banking sector crunch) and July 8 2013 (today).

Moreover, the risk of a further flare-up remains ever-present given the precarious health of the banking system. In this article, we look at such a scenario and examine the impact to the auto sector supply chain.

Market Re-pricing Yield Curve
China Onshore CNY IRS Curve, %

Rise In Funding Cost Poses Risks To Auto Sector Players

BMI View : Should the recent rise in funding costs due to the Chinese banking sector's woes flare up once more, small dealerships which already need to grapple with tight cash flows will come under greater pressure, potentially forcing many of them to shutter. Domestic carmakers which have seen a surge in accounts receivables would also see a detrimental impact to their balance sheets and should they shelve expansion plans due to more expensive financing, auto sales would be indirectly hurt.

The recent turbulence in the Chinese banking system saw overnight interbank borrowing rates soaring beyond 30% ( see 'Beijing's Credit Crunch Conundrum', June 20). While rates have fallen since then as the central bank stepped in to ease the credit crunch in the banking system, they still remain elevated compared with the more benign environment before the liquidity squeeze. The accompanying chart highlights the rise in interest rates, showcasing the upward shift of the swap curve from May 1 2013 (before the banking sector crunch) and July 8 2013 (today).

Moreover, the risk of a further flare-up remains ever-present given the precarious health of the banking system. In this article, we look at such a scenario and examine the impact to the auto sector supply chain.

Market Re-pricing Yield Curve
China Onshore CNY IRS Curve, %

With 86% of all receivables in the Chinese auto industry funded by bankers' acceptance bills (usually ranging from 30-180 days), short-term financing costs would inevitably rise should we see another round of financial markets volatility. Discount bills remain an important lubricant for transactions, allowing automakers to extend generous payment terms to dealers, and suppliers to extend credit to carmakers.

Dealerships Will Bear The Brunt Of Higher Interest Rates...

Small dealerships have tight cash flows and depend on bankers' acceptance bills to pay carmakers for inventory purchases. Furthermore, they do not enjoy access to long-term financing and are unable to borrow funds at attractive low interest rates, a privilege which state-owned enterprises enjoy. This makes this mode of funding even more vital to them.

The rise in note yields would mean that dealerships which cannot afford the higher interest rates would cut their inventory levels. This could, in turn, impinge upon potential car sales if the requisite stocks were not on hand to meet demand.

In the worst case scenario, we see already struggling dealerships being dealt a fatal blow in an elevated interest rate environment. With inventory costs rising and our view for auto sales to experience slower growth in H213, smaller dealers will be forced out of business.

...But Surge In Carmakers' Accounts Receivables Is Worrying

We acknowledge that carmakers remain diversified as they supply vehicles to different dealers and have balance sheets which are generally well-capitalised. Their cash balances are healthy and average long-term debt/equity ratios are below 15%. However, we have observed a trend of a surge in accounts/note receivables for many of the private Chinese automakers and this becomes a source of concern with a rise in financing costs. Since it is not easy to extract data on total vehicle sales made on credit, we find it reasonable to look at accounts receivables as a percentage of total revenues to get an idea of dependency on deferred payments among carmakers.

As the accompanying chart shows, the rise in accounts receivables in the past few years for China's largest SUV maker, Great Wall Motors, is not commensurate with a similar increase in revenues (in millions of CNY). The percentage of revenues as account receivables at the firm surged from 10.5% in 2006, to 37.2% in 2012. For Geely, since its takeover of Volvo in 2008, its account receivables have formed a big percentage of total revenues, with average receivable days hitting 172 in 2012.

Dependency On Receivables Evident
Select Financial Metrics Of Private Chinese Automakers - Great Wall Motors (LHS); Geely (RHS)

While state-run automakers have lower average receivable days which are more in line with global norms (around 30 days), the rise in yields of short-term discount bills puts every carmaker on the hook for sales made on credit. With small dealers potentially going bust, a significant share of these account receivables could go bad, with private carmakers being the most vulnerable. Although firms such as Great Wall have the cash on their balance sheet to take the necessary write-downs, we caution the negative impact to the bottom line of carmakers in the coming quarters should this trend continue.

Suppliers May Shorten Duration Of Credit Terms

Meanwhile, should the hike in short-term borrowing costs persist, suppliers to car manufacturers may no longer find it worthwhile to extend long payment terms, which is currently the case. This would then have the effect of increasing the working capital requirements of automakers in an already tighter credit environment.

Higher Yields May Hurt Investment

Companies have reportedly cancelled bond issuances amid the volatile market. Big auto dealerships rely on the bond market to fund their investments for new dealerships. While demand for cars remains robust, should more auto dealerships shelve capital-raising plans, we could see a slowdown in the inland expansion of automakers. This detrimental impact on the supply side of the industry will then indirectly hurt auto sales.

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