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

DBRS, Inc. has confirmed issuer ratings of A (high) for the long-term foreign and local currency debt of the People’s Republic of China, and issuer ratings of R-1 (middle) for 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, moderate public debt and high domestic savings. Despite these strengths, China’s economic model that is reliant on high levels of investment and debt, has begun to result in lower GDP growth. China’s main policy challenges consist of containing high corporate leverage, reducing government deficits, and sustaining GDP growth by transitioning towards domestic consumption and away from credit and investment.

The ratings are supported by several strengths, including the economy’s size and diversity. China is the world’s top merchandise trader and with GDP at US$ 10.9 trillion, is the second largest economy, contributing one-third of global growth. However, after averaging a GDP growth rate of 10% during 1980-2010, growth has slowed to 6.9% in 2015. Nonetheless, decades of income growth have created a large middle class, and as urbanization continues and demographic pressures maintain positive wage growth, China is likely to remain the largest middle class, consumer market in the world.

China’s public sector debt ratios are relatively low. Central government debt is only 15.3% of GDP in 2015. Once local government debt and implicit and explicit guarantees are included, however, general government debt is 42.9% of GDP. This is still well below the public debt to GDP ratio of other industrialized economies. Overall general government debt servicing appears manageable, with the baseline scenario for debt projected to modestly increase over the forecast period rising to 52.4% in 2020.

Despite a dramatic decline in foreign exchange reserves in 2015, China’s strong external balance sheet supports the ratings. Total reserves declined by US$808 billion from a peak of US$4.0 trillion in June 2014. The drop is due to capital outflows, principally the repayment of foreign liabilities, the acquisition of overseas assets, currency intervention and valuation losses. Nonetheless China remains a large net external creditor with high domestic savings, currently at 46% of GDP. Reserves of US$ 3.2 trillion more than cover external debt. The current account surplus of 3.0% reflects a positive trade balance and high savings. The net international investment position, though weaker than in the past, is positive at 14.6% of GDP.

Despite its economic resilience, China faces several challenges. Rebalancing the Chinese economy is a primary challenge. Policy makers are attempting a shift in China’s growth model from an over-reliance on infrastructure and property investment, towards domestic consumption and services. Although the adjustment is slowly progressing, the economy’s ability to absorb additional fixed capital is declining. The economy requires increasingly more capital to produce each additional unit of output, while demographic changes and wage pressures are eroding its labor advantages. These developments are occurring in a context of decelerating 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.

A key concern in China is the rapid increase in aggregate debt. Total social financing, which includes credit from the formal banking sector and from less regulated institutions, has risen from 129% of GDP in 2010 to 215% in 2015. A substantial part of this increase has been directed to inefficient state owned enterprises and the over supplied real estate sector. Real estate and construction account for a quarter of investments, 20% of banks loans, and 15% of GDP. While official estimates of non performing loans are at 5%, private sector estimates are higher, with the IMF estimates of ‘potential debt at risk’ at 15.5%. Moreover, due to bank investments in shadow products, banks total assets have risen more than deposits. This has resulted in a rapid increase in wholesale funding, from 15% of total funding in 2013 to 34% in 2015. However, in addition to state control of the banking system, banks are predominantly funded by domestic deposits. Key issues that DBRS is monitoring are capital outflows from China, the increasing reliance of banks on wholesale funding, and the potential erosion of liquidity buffers.

High local government deficits are another cause for concern. While the central government’s fiscal deficit has averaged 1.4% of GDP during the last decade, local government deficits as reflected by high levels of off-balance sheet liabilities, are significantly higher. However, there is limited transparency, as most local government financing is off-budget via local government financing vehicles. The IMF estimates an ‘augmented’ deficit, which includes off-budget activities at 9.5% of GDP, or 7.8% net of land sales. While recent amendments to the Budget Law create a more transparent budget regime, reform to the fiscal framework remains incomplete.

RATING DRIVERS

The Stable trend reflects DBRS’s assessment that while China’s long-term growth prospects are challenged by a number of structural imbalances, China has the economic and policy buffers to manage an abrupt near-term adjustment. A Positive trend could be assigned to the ratings, if progress is made on reducing domestic imbalances, deleveraging corporate sector debt in an orderly manner, and increasing the transparency of the public debt profile. Conversely, a Negative trend could be assigned, if China continues to prioritize near-term growth objectives over the reduction in the pace of credit growth and the resulting increases in financial risk exposure among the corporate and local government sectors. A sharp deterioration in economic performance, the realization of substantial contingent liabilities and a continued buildup in public debt could also pressure the ratings.

Notes:
All figures are in US Dollars 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. These can be found at http://www.dbrs.com/about/methodologies.

The sources of information used for this rating include Chinese Ministry of Finance, China National Bureau of Statistics, People's Bank of China, State Administration of Foreign Exchange, Bank for International Settlements, IMF World Economic Outlook, Haver Analytics, DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating was not initiated at the request of the rated entity.

The rated entity or its related entities did not participate in the rating process. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities.

This is an unsolicited credit rating.

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: Rohini Malkani
Rating Committee Chair: Roger Lister
Initial Rating Date: 29 September 2014
Most Recent Rating Update: 7 October 2015