DBRS Confirms China at A (high), Stable Trend

DBRS Inc. has confirmed China’s Long-Term Foreign and Local Currency – Issuer Ratings at A (high). The Short-Term Foreign and Local Currency – Issuer Ratings have been confirmed at R-1 (middle). The trend on all ratings is Stable.

The rating confirmation reflects DBRS’s assessment that risks to growth and financial stability remain sufficiently counterbalanced by China’s economic and policy buffers, which limit the risk of an abrupt near-term adjustment. China’s rebalancing towards consumption and services coupled with strengthening external demand have enabled continued strong growth. Although credit growth has seen a modest deceleration, financial vulnerabilities remain, warranting continued efforts to contain high leverage and reduce local government deficits. While the Trump administration’s proposal to impose steel and aluminum tariffs may have a limited direct impact on China, a global escalation in protectionist and retaliatory measures could negatively impact China’s growth. Over the long-term, the removal of the two-term limit for the Party President could lead to a deterioration in policies and transparency.

The A (high) ratings reflect China’s large and diversified economy, strong external balance sheet, moderate public debt, and high domestic savings. China is the world’s top merchandise trader, is the second largest economy with GDP at US$ 12.2 trillion, and contributes one-third of global growth. Moreover, decades of rapid income growth have created one of the largest consumer markets in the world. Authorities’ emphasis on R&D has contributed to China’s strong competitive position in high-speed rail, fintech, big data, AI and 5G. China’s external position is another core credit strength. Its current account surplus reflects a positive trade balance and high domestic savings (46% of GDP). China is a net creditor, holding US$ 3.1 trillion of reserves that more than cover its external debt obligations. China’s public-sector debt ratios are relatively low, and debt servicing appears manageable. Central government debt is 16.1% of GDP and general government debt, which includes explicit local government debt, is 44.3% of GDP.

Despite these strengths, China’s ratings are constrained by structural credit challenges. 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 the adjustment is slowly progressing, the economy’s ability to absorb fixed capital is declining. A key concern is the rapid increase in aggregate debt in China and the resulting increase in financial sector risks. BIS estimates of China’s combined gross debt (general government, households, and corporates) have risen from 140% of GDP in 2006 to 256% of GDP in 2016. High local government deficits may prove to be highly procyclical and are another cause for concern. While the central government’s deficit is estimated at 3.7% of GDP in 2016, local government deficits are higher. There is limited transparency, as most local government financing is off-budget. Moreover, the consolidation of top leadership could also mean a greater risk of reduced ‘checks and balances’ and of policy errors that could exacerbate imbalances in the future.

LEVERAGE LEVELS ARE WORRISOME, BUT BUFFERS EXIST TO MANAGE NEAR-TERM ADJUSTMENT

A key concern in China is the rapid increase in leverage. Credit growth averaged 19.8% during 2008-2016, higher than nominal GDP growth. This resulted in the BIS’s measure of gross debt to GDP ratio rising from 140% in 2006 to 256% in 2016, and a credit gap of 20-25%. A large part of the credit is via the less regulated institutions or shadow banks which not only increase financial system risks, but could also compromise financial support for the real economy. This rapid pace of debt accumulation raises concerns both on the assets and liabilities side of the banking system’s balance sheet. Much of the increase in credit has been directed to inefficient state-owned enterprises (SOEs) and the real estate sector. While official estimates of NPLs and special-mention loans are at 5.5% of GDP, private sector estimates are higher. On the liability side, the increase in banks’ investments in shadow products has resulted in banks’ total assets rising more than deposits. Consequently, wholesale funding has risen to 31% currently, from 15% in 2011.

Authorities have enacted ‘financial stability/regulatory tightening’ measures to engineer financial deleveraging. Endorsed by President Xi, the PBOC has strengthened the supervision of the macroprudential assessment mechanism and enforced tighter regulatory control covering banks, insurance companies, and security firms. The consequent rise in short-term interest rates has partially reined in credit growth with the BIS’s credit gap declining from a high of 28.1% in 2Q 2016 to 18.1% currently.

Given China’s buffers, near-term risks of a financial crisis are low, but long-term risks remain. China’s low external funding risks, state ownership of banks, adequate capitalization (CAR at 13.1%; Tier 1 at 11.1%), loan-deposit ratios below 80%, high reserve requirements, high domestic savings, and a large sovereign wealth fund help mitigate near term risks and give the government time to address risks. Nonetheless, with the state directly controlling most of the banking system, there could be fiscal implications if banks are unable to absorb losses in case of defaults. DBRS continues to monitor (1) potential capital outflows, (2) erosion of liquidity buffers, and (3) property sector developments.

DESPITE STRONG CENTRAL GOVERNMENT FINANCES, OFF BUDGET CONCERNS REMAIN

China’s central government finances appear strong but contingent liability risks are a key concern. Transparency at the local government level is particularly limited, and until recently most of the local government financing was off-budget via local government financing vehicles (LGFVs). Since the 2014 fiscal reforms, progress has been made in reducing the existing sources of off-budget spending. However, new sources such as Public Private Partnerships (PPP) and Special Funds have emerged. Consequently, while the central government’s deficit averaged 2.75% during 2014-2016, the IMF estimates of the ‘augmented’ deficit (which includes off-budget items), rose from 9.8% in 2014 to 12.4% in 2016. The government could also be compelled to support SOEs and other private companies for financial stability reasons.

The central government debt is currently 16.1% of GDP and general government debt (which includes explicit local government debt) is 44.3% of GDP. The IMF’s definition of ‘augmented debt’ (which includes explicit and implicit off-budget liabilities to LGFVs) pegs debt at 62% of GDP in 2016. However, this overstates public sector debt, as less than one-fifth of guaranteed debt was repaid since 2007 and some of the LGFV borrowing is on a commercial basis. Adjusting for this, the gross public debt ratio is estimated at 49.3% of GDP and was used in the debt sustainability analysis. In DBRS’s baseline scenario, China’s public debt ratio is likely to rise to 62.2% of GDP by 2022. As China’s public debt is largely domestic, overall general government debt servicing appears manageable even as the baseline scenario for debt is projected to increase over the forecast period. Moreover, China’s high savings, low foreign debt, and debt maturities averaging 7.65 years, help mitigate near term risks of a disorderly adjustment.

ECONOMIC REBALANCING PROGRESSES SLOWLY

China’s growth rate, which averaged 10% for three decades (1980-2010), has slowed to 6.9% in 2017 due to a slowdown in productivity growth as the economy reaches middle income levels. The economy faces two large interacting imbalances: excessive leverage and excess capacity. Policy makers are attempting to shift China’s growth model from an over-reliance of debt-fueled investment towards 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, and a more rapid slowdown might be needed to limit financial risks. Meanwhile demographic changes and wage pressures are eroding its labor advantages and depressing productivity gains.

Reforms are underway, though 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. While there has been some recent progress in reversing the trend with consumption rising and contributing to over 60% of growth and service sector growth higher than industry, China still has the highest investment to GDP ratio (44% of GDP). China also has the lowest share of private consumption to GDP, at 38% as compared with peers at similar levels of income. Nonetheless, with GDP at US$12.2 trillion, China is the second largest economy and has one of the largest consumer markets in the world.

EXTERNAL POSITION REMAINS A CREDIT STRENGTH

China has a strong external balance sheet, and its external rebalancing has been substantial. China’s current account surplus has narrowed from 10% of GDP in 2008 to 1.4% currently. Though the authorities have made adjustments to the capital account and to the currency regime to introduce more market flexibility, the capital account remains relatively closed. China’s strong external balance sheet is reflected in high forex reserves, low external debt, and the RMB inclusion in the SDR basket (effective October 2016). However, financial market volatility and sizeable capital outflows in mid-2015 and early 2016 are reminders of the challenges associated with transitioning to a more market-driven economy. Moreover, while the proposal to impose tariffs on steel and aluminum may have a limited impact on China, a global escalation in protectionist and retaliatory measures could negatively impact China’s prospects.

REMOVAL OF TWO-TERM LIMIT COULD IMPACT INSTITUTIONAL QUALITY

The leadership under Xi Jinping is taking measures to address China’s structural imbalances. On the domestic front, measures include fiscal reform, financial sector liberalization, regulatory tightening, partial relaxation of the one-child policy, and pilot programs to restructure SOEs. On the external front, measures are linked to the ‘One Belt, One Road.’ At the same time, the government appears to desire to retain its command of the economy. The anti-corruption campaign initiated after Xi Jinping took over in 2012 has continued unabated for the last five years. The crackdown on the media and academia is another concern. These trends are reflected in China’s low ranking in World Bank Governance Indicators such as “Rule of Law” and “Voice and Accountability.”

Further, following the 19th Party Congress in 2017, President Xi Jinping has cemented his role as the most powerful leader in China since President Deng Xiaoping. This is reflected in the removal of the two-term limit for the State President and the amendment of the Party Constitution to enshrine “Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era,” The appointment of like-minded members in the Politburo Standing Committee makes it easier for the Party to carry out reforms. However, the consolidation of top leadership could also mean a greater risk of reduced ‘checks and balances’ and of policy errors that could exacerbate imbalances in the future.

RATING DRIVERS

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 potentially triggered by a global escalation in protectionist and retaliatory trade measures could negatively impact China’s macro economy. Evidence of a deterioration in institutional quality and policy management could also pressure the ratings. A global escalation in protectionist and retaliatory trade measures could negatively impact China’s macro economy. Conversely, a Positive trend could be assigned if progress is made on (1) reducing domestic imbalances, (2) deleveraging corporate sector debt, and (3) increasing the transparency of the public debt profile.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A – BBB (high) range. Additional considerations factoring into the Rating Committee decision included: (1) China’s robust economic performance and overall resilience; and (2) China's strong external balance sheet. The main points discussed during the Rating Committee include China’s overall debt situation, progress in economic rebalancing, and vulnerabilities that could arise in the financial system.

KEY INDICATORS

Fiscal Balance (% GDP): -3.7 (2016); -3.7 (2017F); -3.7 (2018F)
Gross Debt (% GDP): 44.5 (2016); 46.8 (2017F); 50.8 (2018F)
Nominal GDP (USD billions): 11,178 (2016); 12,222 (2017F); 13,119 (2018F)
GDP per Capita (USD): 8,084 (2016); 8,006 (2017F); 8,469 (2018F)
Real GDP growth (%): 6.7 (2016); 6.9 (2017); 6.5 (2018F)
Consumer Price Inflation (%): 2.0 (2016); 1.6 (2017); 2.4 (2018F)
Domestic Credit (% GDP): 145.3 (2016); 147.2 (Sept-2017)
Current Account (% GDP): 1.7 (2016); 1.4 (2017); 1.2 (2018F)
International Investment Position (% GDP): 16.0 (2016); 14.3 (Sept-2017)
Gross External Debt (% GDP): 11.5 (2016); 13.2 (Sept-2017)
Governance Indicator (percentile rank): 67.8 (2016)
Human Development Index: 0.74 (2015)

Notes:
All figures are in USD unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/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 at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

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, World Bank, UNDP and DBRS. DBRS considers the information available to it for the purposes of providing this rating to be 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 for this rating action. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

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, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Co-Head of Sovereign Ratings – Global Sovereign Ratings
Initial Rating Date: September 29, 2014
Last Rating Date: July 14, 2017

Information regarding DBRS ratings, including definitions, policies and methodologies, is available on www.dbrs.com.