DBRS Assigns A (high) Rating to the People’s Republic of China, Stable Trend

DBRS, Inc. has assigned issuer ratings of A (high) to the long-term foreign and local currency debt of the People’s Republic of China, and issuer ratings of R-1 (middle) to its short-term foreign and local currency debt. The trend on all ratings is Stable.

The ratings reflect China’s large and diversified economic structure, and DBRS’s assessment that China’s centralized system provides government authorities with powerful tools to adjust to shocks and to continue market liberalization reforms. China’s strong external balance sheet, abundant domestic savings, and high international reserves further support the ratings. Despite these strengths, China’s economic growth model – dependent on the extension of investment-oriented credit to achieve GDP growth targets – has begun to result in lower GDP growth. To reach future growth targets, authorities plan to rebalance the economy toward more domestic consumption. A successful transition without significant economic or social disruption could be challenging. Financial sector vulnerabilities are a second risk to growth. Private sector and local government borrowing has increased at an alarming rate since 2008 and particularly from less-transparent lending entities.

The Stable trend reflects DBRS’s view that China has sufficient space to manage near-term domestic and external economic shocks. A Positive trend could be assigned to the ratings if progress on reducing fiscal imbalances and financial sector vulnerabilities result in a more stable and transparent debt profile. Conversely, a sharp downward economic adjustment combined with a higher fiscal deficit – possibly as a result of financial sector deterioration or realized contingent liabilities – could place downward pressure on the ratings.

Economic reforms beginning in 1980 helped foster three and a half decades of rapid growth. The Chinese economy grew by an annual average of 10% between 1980 and 2010. Such a consistently high three-decade growth rate increased the economy to the second largest and helped lift roughly 600 million people out of poverty. Although real GDP growth decelerated to 7.7% in 2013 and is expected at 7.5% this year, IMF growth potential estimates around 7.5% are well above the 4-5% median growth among other developing countries.

DBRS believes public sector debt ratios are manageable. A recent audit performed by the National Audit Office (NAO) reported gross government debt at 53% of GDP in mid-2013, including implicit and explicit guarantees of off-budget borrowing. The audit shows local governments are responsible for RMB 17.9 trillion (30% of GDP) of explicit borrowing and implicit debt guarantees to local government financing vehicles that finance long-term infrastructure projects. The NAO notes that local governments have directed only a fraction of fiscal spending to repay government guaranteed debt issued by financing vehicles. No more than 19.1% of guaranteed debt was repaid by fiscal capital in each year since 2007. Once adjusted, gross debt was closer to 40% of GDP in 2013, and is expected to rise to 45% by 2018. DBRS uses this adjusted gross debt ratio as its baseline.

China’s external position supports the ratings. As of 2Q14, international reserves rose to $3.9 trillion (42% of GDP), and more than cover negligible public sector external debt. This makes China a large net external creditor. The current account surplus is expected to remain around 2% of GDP as domestic savings remain higher than investment. At 21% of GDP, the net international investment position is strong relative to peers at similar income levels, and the country’s abundant reserves and broad export base provide ample external liquidity.

Strong political commitment to reform also supports the ratings. The Third Plenum meetings in November 2013 established an ambitious reform agenda with the aim of transitioning to a more inclusive, market oriented, and sustainable economic model. Financial sector reform that removes implicit bank and corporate guarantees and allows for greater market determination of interest rates is considered a priority. State-owned enterprise reform that increases competition among non-strategic service sectors, and fiscal reform of local government finances, were also emphasized. Implementation of key Third Plenum reforms could direct resources more efficiently, further open-up the service sector, promote labor intensive growth, and support household income and consumption. Authorities view domestic economic rebalancing as key to sustainable long-term growth.

Despite high output growth and the reform blueprint, continued reliance on investment and credit to reach growth targets increases vulnerabilities. Investments are producing diminishing returns due to the economy’s declining ability to absorb additional fixed capital. In 2013, investment was 48% of GDP, while consumption accounted for only 36%. Unless tempered, overreliance on credit and investment as stimulus to support growth increases corporate and local government leverage and the likelihood of a costly economic correction. This domestic imbalance exists in a context of changing labor market dynamics, due to a shrinking working age population and rising wages. This weakens China’s competitive position as a center for cheap manufacturing.

Rapid credit growth, some of which has been misallocated toward unproductive investments, has increased financial sector risks. Including non-traditional, or off-balance sheet banking, the stock of credit increased by 71.4% of GDP from 2008 to 2013, surpassing 200% of GDP. Nearly two-thirds of the increase came from off-balance sheet lending. This rapid growth of credit raises concerns over the adequacy of supervision and regulation, the quality of underwriting standards, and the non-traditional market pricing of risk. Distortions are exacerbated by widespread implicit financial sector guarantees and control over deposit interest rates, which contribute to the misallocation of savings.

High local government deficits are another cause for concern. Once quasi-fiscal local government expenditures are included, China’s fiscal position is significantly weaker than the official 10-year median deficit of 1.3% of GDP. Including local government off-budget items, the augmented general government deficit averaged 5.6% of GDP since 2004, and was 7.4% in 2013. Local government revenues depend, in large part, on land sales and leases. Therefore, high off-budget spending combined with declining property transactions and real estate prices could result in even weaker local government finances. Moreover, opaque transparency has created incentives for the misallocation of public resources and the undermining of fiscal discipline. Recent amendments to the Budget Law, however, attempt to create a more unified and transparent budget regime by allowing local governments to issue bonds. The new law may result in less local government dependence on off-budget revenue and greater disclosure of fiscal activity.

Notes:
All figures are in Renminbi [RMB] unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales.

The sources of information used for this rating include Ministry of Finance of the People's Republic of China, the People’s Bank of China, China National Bureau of Statistics, State Administration of Foreign Exchange, National Audit Office, Haver Analytics, IMF, BIS. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer and did not include participation by the issuer or any related third party.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Jason Graffam
Rating Committee Chair: Alan G. Reid
Initial Rating Date: NA
Most Recent Rating Update: NA