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Trading  | May 31, 2017

Less than a week after Moody’s downgraded China’s sovereign credit rating, prompting an unprecedented currency response by the PBOC which as noted earlier resumed its crusade against Yuan shorts by sending CNH overnight deposit rates as high as 65%, on Wednesday another rating agency, Fitch, took aim at what many consider the weakest link in China’s financial system: the nearly $9 trillion in shadow banking “assets”, of which roughly $4 billion are Wealth Management Products.

Just as surprising was the target of Fitch’s wrath: none other than China’s tech giant Baidu, which Fitch put on “negative watch” warning that the company’s financial services division faced increased risk of default as a result of its growing reliance on shadow banking in general and Wealth Management Products (WMPs) in particlar. As reported previously, China’s popular WMPs offer a higher yielding alternative to conventional financial instruments by bundling together investments into money market bonds, corporate loans and many other products, all of which are usually a mystery to the buyer. As of 2016, China had nearly 30 trillion yuan outstanding in WMPs.

Baidu, China’s dominant search engine, has not been immune to the scramble for funding optionality provided by shadow banking alternatives, and has been getting into the WMP game by rapidly expanding its Financial Services Group, which Fitch says is increasing Baidu’s overall business risk.

While Baidu is not under obligation to pay the returned target on these products, a failure could be potentially damaging to Baidu’s reputation, Fitch warned.

“As with Chinese banks, Baidu does not need to set aside large capital against potential defaults on its WMPs … WMPs have become an alternative form of financing for projects or investments that would not qualify for bank loans,” Fitch said.

This could lead to an increased risk of default or “shadow bank run”, since many of the bundled assets are of poor quality and would not qualify for bank loans. The WMP warning from Fitch came less than two weeks after Moody’s also put Baidu’s corporate debt on watch for a potential downgrade. WMPs have been behind the staggering surge in total assets of Baidu’s Financial Services Group, which have more than doubled to CNY25 billion in the period ended April 2017.

Fitch also cautioned that while Baidu’s credit risk compared well with western internet peers such as eBay and Expedia, it was worse than its domestic competitors in China’s tech trinity, Alibaba and Tencent.

Meanwhile, as a result of declining operating metrics and growing leverage, Baidu profits have continued to slide at the technology company in recent quarters. It has struggled with making the transition to the world of mobile internet, and as the FT reports, suffered a highly publicised scandal last year as a result of its reliance on revenues from medical advertising — some of which comes from dubious medical outfits.

Key highlights from the Fitch report:

Fitch Ratings has placed China-based Baidu, Inc.’s (Baidu) ‘A’ Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) and ‘A’ foreign-currency senior unsecured rating on Rating Watch Negative (RWN).


The RWN reflects Fitch’s belief that the rapid growth in Baidu’s financial services activities under its wholly owned Financial Services Group (FSG) has increased Baidu’s overall business risk.


The risk profile of the financial services activities is significantly higher than the risk profile of Baidu’s core internet services, such as search services, online video and transaction services.


The RWN will be resolved when management has provided further information on FSG’s expansion plans, risk control policies and procedures, and capital structure.


We may affirm the ratings at their current levels or downgrade the ratings, although any downgrade is likely to be a single notch. Our review will take into account Baidu’s strong net cash position, which provides a cushion to fund potential losses in the FSG.




Elevated Business Risk: The FSG sells wealth management products (WMPs), which are mostly fixed-income products with short tenors of up to 12 months, and operates a micro-lending business.


Baidu’s wealth management business is similar to that of many Chinese banks and WMPs are part of the shadow banking system in China. As with Chinese banks, Baidu does not need to set aside large capital against potential defaults on its WMPs.


Baidu sells WMPs to retail investors and reinvests most of the funds via a third-party trust company into money market investments, other fixed-income investments and corporate borrowers.


Although we understand that Baidu is not legally bound to pay the target return on the WMPs to investors, we believe that the potential damage to the company’s reputation – should the WMPs fail to achieve the target returns or have enough liquidity to meet maturities – is large enough that Baidu will honour the obligations under the WMPs.


We also believe that the risk profile of the micro-lending business is also much higher than Baidu’s core business, as its loans and cash credits to consumers are unsecured.


Rapidly Growth in WMPs: Baidu’s FSG business has grown from assets of CNY12 billion at end-2016 to CNY25 billion at end-March 2017, and we expect both FSG’s WMP assets and micro-loan book to continue to expanding very rapidly at least in the short-term. WMPs continue to proliferate in China as there is abundant liquidity, but a scarcity of high-yielding assets in which to invest.


WMPs have become an alternative form of financing for projects or investments that would not qualify for bank loans.


A large exposure to WMPs may make Baidu vulnerable to asset-quality shocks, especially as loss events rise.


Contingent Loss-absorption Capacity: Our review will address Baidu’s capacity to absorb losses in the FSG operations, to ensure that if FSG underperformed, the additional funding required would not be a big enough drain on cash from Baidu’s core operations to threaten the ‘A’ rating.


We believe that Baidu’s net cash position will be increasingly important as it will be the primary source of contingent loss-absorption capacity. At end-2016, Baidu’s net cash totalled CNY23 billion, excluding payables to WMP customers of CNY7 billion, which were funds from retail investors entrusted to Baidu to invest in WMPs.

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