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

DBRS, Inc. has confirmed 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 economy, strong external balance sheet, and abundant domestic savings. Despite these strengths, China’s economic model has begun to result in lower GDP growth. To ensure stable growth, authorities are attempting to rotate the economy away from investment in oversupplied areas towards more domestic consumption. While there is evidence of progress, a successful transition without steeper economic deceleration is a key challenge. Financial sector vulnerabilities are a second risk to growth. Private sector and local government borrowing, particularly from less-transparent lending entities, has increased at a rapid rate since 2008.

The Stable trend reflects DBRS’s assessment that while recent market developments have cast uncertainty over policy intentions and levels of aggregate demand, the economy is resilient and authorities appear committed to the broad reform agenda. A Positive trend could be assigned to the ratings if progress is made on increasing the transparency of the public debt profile and reducing economic and fiscal imbalances. Material progress on deleveraging corporate sector debt in an orderly manner would also be credit positive. Conversely, a Negative trend would likely be assigned if a sharp and persistent downward economic adjustment results in large realized contingent liabilities and a rapid increase in public debt. An inadequate policy response to a domestic or external shock could also pressure the ratings.

Recent developments illustrate the tension policymakers face between medium-term market adjustments and short-term economic stability. The rapid rise in domestic equity indices from November 2014 to June 2015 was encouraged by the easing of rules on initial public offerings and margin transactions. The 40% correction since the peak, as of September 2015, persisted despite a series of uneven intervening price-support measures that have raised questions about the pace of market reforms. Meanwhile, the government changed its currency policy by allowing market conditions to influence the daily exchange rate fix. Yet, central bank interventions in the foreign exchange spot market prevent accelerating capital outflows from a sharper yuan depreciation. Furthermore, weak economic results in investment, exports, and industrial production show GDP growth could underperform the official 7% target.

Despite the slowdown, expansionary policies are likely to support the economy. For now, policymakers have buffers to offset sharp declines in economic activity via targeted fiscal spending and accommodative monetary policy. Real interest rates remain positive and bank reserve requirements are historically high. Recent cuts to both rates, along with the easing of regulation of housing purchases, stabilized the property market. However, policy levers have limitations. Despite improvements to market-based policy instruments, incomplete financial liberalization limits the effectiveness of monetary transmission. Furthermore, public debt is expected to continue its increase as economic imbalances are unwound and growth slows. Private sector measures of output show GDP underperforming the 2015 target, with estimates ranging between 4-7%.

Debt ratios appear manageable, despite a public sector debt profile that is not transparent. Central government debt outstanding was 15% of GDP in 2014. Including local government implicit and explicit guarantees, the IMF reports augmented gross government debt at 57% of GDP. This figure perhaps overstates gross debt, as governments historically directs less than a fifth of fiscal spending to repay government guaranteed debt issued by commercial financing vehicles. Adjusting for this, gross debt was 41% of GDP in 2014 and contained by high growth and favorable interest rates. In the absence of a shock, DBRS’s expects this adjusted gross debt stock to remain below 50% of GDP through 2020.

China’s resilient external position supports the ratings. International reserves have declined by $438 billion since peaking in June 2014 due to currency intervention, valuation losses, and capital support to development banks. Despite this, China remains a large net external creditor. Reserves were $3.6 trillion (35% of GDP) in August 2015 and more than cover negligible external debt. The 2.8% of GDP current account surplus in 2Q15 reflects a positive trade balance and high domestic savings. At 13.5% of GDP in 1Q15, the net international investment position – though weakened due to a rise in investment liabilities and a decline in reserves and other investments – remained strong relative to peers at similar income levels.

The government’s broad reform agenda also supports the ratings. Third Plenum meetings in November 2013 established the framework for transitioning towards a more inclusive, market oriented, and sustainable economic model. Whether the government has weakened the pace of implementing its ambitious reform agenda remains an open question. On one hand, the stock market episode of 2015 and mixed signals from the announcement to open state-owned enterprises (SOE) suggest this commitment may be slower than anticipated. SOE reform calls for both greater market forces and stronger party control over state entities. On the other hand, DBRS believes moderate market advances in the fiscal framework and the financial sector illustrate the government’s commitment to changing the economic model over the long-term.

Rebalancing of the Chinese economy is a primary challenge. The long-run objective of rebalancing is to moderate the high investment and savings rates by reducing government interventions and the role of the industrial sector. Offsetting this decline, authorities expect strong wage growth to increase consumption and financial sector liberalization to boost the service sector. Although the adjustment slowly progresses, the economy’s ability to absorb additional fixed capital is declining. This is in a context of marginal labor and productivity contributions to growth. Unless tempered, overreliance on credit and investment increases corporate leverage ratios and the risk of a steeper deceleration in economic activity.

Rapid credit growth has also increased financial sector risks. The stock of credit increased by 77% of GDP from 2008 to 2014 to surpass 200% of GDP. Nearly two-thirds of the increase came from off-balance sheet lending, raising concerns over the adequacy of supervision and regulation, the quality of underwriting standards, and the non-traditional market pricing of risk. Implicit financial sector guarantees and control over deposit interest rates have increased distortions. However, the pace and quality of total credit extension have improved in recent years. Growth of total financing declined to 14% in 2014, from 34% in 2009. Likewise, the share of shadow lending decreased to 32% in 2014 from 40% in 2013 due to stricter regulation.

High local government deficits are another cause for concern. Once quasi-fiscal local government expenditures are included, China’s fiscal position is weaker than the central government deficit of 1.8% in 2014. Including implicit and explicit guaranteed off budget liabilities, the IMF forecasts the augmented general deficit at 7.3% of GDP, net of revenue from local government land sales and leases. While recent amendments to the Budget Law create a more transparent budget regime, reform to the fiscal framework remains incomplete. Further progress is expected on tax reform that improves the revenue generating capacity of local governments.

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.

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Lead Analyst: Jason Graffam
Rating Committee Chair: Roger Lister
Initial Rating Date: 23 September 2014
Most Recent Rating Update: 23 September 2014