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

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

The A (high) 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 has begun to result in lower GDP growth. China’s main policy challenge is the need to shift its growth model from an over-reliance of debt-fueled infrastructure and property investment towards domestic consumption and services. While there is evidence of some progress, financial vulnerabilities have risen, warranting measures for containing high corporate leverage, reducing local government deficits, and improving transparency.

China’s 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$ 11.2 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 6.7% in 2016. 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 16.2% of GDP in 2016. Once local government debt and explicit guarantees are included, general government debt is 46.2% of GDP. (The IMF’s definition of ‘augmented debt’ which includes off-budget liabilities to local government financing vehicles (LGFVs) estimates debt at ~60% of GDP). This is still well below the public debt to GDP ratio of other industrialized economies. With China’s debt largely domestic, debt servicing appears manageable, with the baseline scenario for debt projected to increase to 57.7% in 2021.

China’s resilient external position also supports the ratings. Since peaking at $4 trillion in June 2014, reserves have declined by $940 billion due to capital outflows, principally the repayment of foreign liabilities, the acquisition of overseas assets, currency intervention and valuation losses. Nonetheless China remains a large net external creditor with high domestic savings (46% of GDP), and reserves ($ 3.0 trillion) more than covering its external debt. The current account surplus (1.7% of GDP) 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. The RMB inclusion in the SDR basket effective October 2016 adds to the external buffers.

Despite its strengths, China faces many challenges with rebalancing the economy being the primary challenge. Policy makers are attempting to shift China’s growth model from an over-reliance on investment, towards more domestic consumption and services. While the adjustment is slowly progressing, the economy’s ability to absorb fixed capital is declining. China requires increasingly more capital to produce each additional unit of output, while demographic changes and wage pressures are eroding its labor advantages, depressing productivity gains. Reforms are underway, but not uniformly. External imbalances have declined but investments and savings remain high, with limited progress on reining in credit growth and imposing hard budget constraints on SOEs.

A key concern is the rapid increase in aggregate debt in China that is resulting in rising financial sector risks. 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 220% in 2016. A substantial part of this increase has been directed to inefficient SOE’s and the over supplied real estate sector. In addition to weak asset quality, an added concern is the sharp rise in bank investments in shadow products. Consequently, banks total assets have risen more than their deposits, resulting in growing recourse to wholesale funding. However, due to state control of the banking system and banks being largely funded by domestic deposits, risks of a crisis are low. Moreover, recent policy initiative’s towards ‘financial deleveraging via regulatory tightening’ if continued, bodes well for long-term financial stability. Nonetheless, key issues that DBRS is monitoring are capital outflows, the increasing reliance of banks on wholesale funding, property market developments and the potential erosion of liquidity buffers.

High local government deficits are another cause for concern. While the central government’s deficit came in at 3.0% in 2016, local government deficits as reflected by high levels of off-balance sheet liabilities, are higher. However, there is limited transparency, as most local government financing is off-budget via local government financing vehicles. The IMF estimates of the ‘augmented’ deficit, which includes off-budget activities have ranged between 7%-10% of GDP over the past few years. Recent amendments to the Budget Law are commendable, but, it remains unclear whether the tightening of LGFV financing mechanisms have improved the allocation of capital investments at the local level due to the rise in ‘Public Private Partnerships’ and special funds such as the ‘government guidance funds’ and ‘venture funds’ that are funded by the fiscal budgets.

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. Policy action following the upcoming 19th Party Congress to address concerns on excess capacity and excess leverage, coupled with the continuation of ‘regulatory tightening’ would be key to maintain the Stable trend. 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 and the realization of substantial contingent liabilities could also pressure the ratings. Conversely, a Positive trend could be assigned 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.

Notes:
All figures are in U.S 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, UNDP, and 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, Senior Vice President
Rating Committee Chair: Roger Lister, Chief Credit Officer, Global Financial Institutions Group and Sovereign Ratings
Initial Rating Date: 29 September 2014
Most Recent Rating Update: 26 September 2016