DBRS Confirms China at A (high), Trend Changed to Negative

DBRS, Inc. (DBRS) confirmed the People’s Republic of China’s Long-Term Foreign and Local Currency – Issuer Ratings at A (high). At the same time, DBRS confirmed the Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (middle). DBRS changed the trend on all ratings from Stable to Negative.

KEY RATING CONSIDERATIONS

The Negative trend reflects DBRS’s view that downside risks are growing as China prioritizes near-term growth objectives over the need to curb credit growth. Since the last review, amid a domestic slowdown and a deterioration in U.S.-China relations, Chinese authorities seem to have paused deleveraging efforts as they look at ways to maintain growth in line with policy targets. Continued build up in leverage may increase risks of a decline in private sector demand and in financial stability. In spite of China’s extensive policy levers and ample resources, its buffers are eroding. If faced with a mix of capital flight and weaker domestic demand, it is unclear whether the effectiveness of existing policy levers will be maintained. Furthermore, while a trade deal with the U.S. is forthcoming, recent developments have changed dynamics between the two nations and both countries must now grapple with new approaches to competition and cooperation.

China’s current ratings reflect its large and diversified economy, strong external balance sheet, moderate public debt, and high domestic savings. China is the world’s top merchandise trader, the second largest economy with GDP at US$ 13.6 trillion, and accounts for roughly one-third of global growth. Decades of rapid income growth have created one of the largest consumer markets in the world. China’s A (high) ratings are nonetheless hindered by structural credit challenges. China’s main policy challenge is the need to shift its growth model from an over-reliance of credit intensive investment towards domestic consumption and services. While there is evidence of some progress towards deleveraging especially in curbing shadow lending, financial vulnerabilities remain elevated, warranting additional measures for containing high leverage, reducing local government deficits, and improving transparency. BIS estimates of China’s gross debt have risen from 140% of GDP in 2007 to 255% in Q3 2018. The IMF estimates of the ‘augmented’ deficit (which includes off-budget items) averaged 7.7% during 2013-2015, but rose to 10.6% during 2016-2018. Moreover, the consolidation of power and the reduction of checks at the top level of the central government increases the risk of policy errors that could exacerbate imbalances in the future.

RATING DRIVERS

Downward pressure on the rating could emerge if: (1) China continues to prioritize near-term growth objectives over reducing the pace of credit growth, which results in increased financial risk exposure among corporate and local government sectors; (2) there is a sharp deterioration in economic performance, potentially triggered by a global escalation in protectionist and retaliatory trade measures; or (3) evidence of a deterioration in institutional quality and policy management materializes. Conversely, the trend could be changed back to Stable if progress is made on: (1) reducing domestic imbalances, and (2) increasing the transparency and sustainability of local government finances.

RATING RATIONALE

China’s Overall Fiscal Situation Sees A Steady Deterioration

China’s fiscal framework is characterized by strong central government finances, but weak local government finances. Local governments face structural revenue shortfalls relative to their spending needs; they account for half of general government revenues, but make up over 80% of general government expenditure. Budget transparency at the local government level is limited and, until 2015, most of the local government financing was off-budget via local government financing vehicles (LGFVs). Following the 2015 fiscal reforms, there has been some progress in reducing the existing sources of off-budget spending by allowing local governments to issue their own bonds subject to an annual cap. However, in addition to bond financing, local governments have been using new sources such as public private partnerships and Special Funds to achieve growth targets.

China’s fiscal position has seen a steady deterioration. The central government’s deficit, which averaged 1.7% during 2012-2014, rose to 3.7% during 2015-2017. The IMF estimates of the ‘augmented’ deficit (which includes off-budget items), which averaged 6.6% during 2012-2014 rose to 10.6% during 2016-2018. In response to the slowdown emanating from to the global trade dispute, the recently released 2019 Government Work Report targets both a higher fiscal deficit and higher local government bond quota, which could result in the augmented deficit being closer to 11% of GDP. However, unlike the government response to the global financial crisis in 2008, the government’s recent efforts to shore up the economy will impose a lower fiscal cost.

Central government debt for 2018 is estimated at 17.3% of GDP. General government debt (which includes explicit local government debt) is 38.1% of GDP. The IMF under its definition of ‘augmented debt’ (which includes explicit and implicit off-budget liabilities to LGFVs) estimates debt at 72.4% of GDP in 2018. However, some of the LGFV borrowing is on a commercial basis. Adjusting for this, the gross debt is estimated at 50.3% and is used in the debt sustainability analysis. In DBRS’s baseline scenario, China’s public debt ratio is likely to rise to 65.1% of GDP by 2023. Given the interlinkages between the state and quasi-government institutions, the government could also be compelled to support SOEs and other private companies for financial stability reasons. Nonetheless, 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.

Concerns on Leverage Remain as Deleveraging Campaign Pauses and Disinflation Risks Return

Beijing’s stimulus following the global financial crisis resulted in a rapid increase in China’s leverage, with the BIS’s measure of gross debt to GDP ratio rising from 140% in 2007 to 255% in Q3 2018. The stimulus was not financed by the central government but through the local governments, banks and other less regulated institutions (shadow banks). Although the level of gross debt is like those of the U.S., U.K., and lower than Japan, the pace of growth and concentration are a concern. Deleveraging efforts and tightened supervision that were initiated in 2016 helped stabilize the debt ratio, lower shadow financing, and reduce the BIS’s credit-gap from a high of 22.8% in Q1 2016 to 3.0% in Q3 2018. However, authorities have become concerned about slowing domestic growth, combined with uncertainty from the on-going trade and investment tensions with the US, and deleveraging efforts appear to have paused. China’s debt is likely to rise again as monetary policy eases and disinflation risks return.

This rapid pace of debt accumulation has raised 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 state-owned enterprises (SOEs), some of which are inefficient, and the real estate sector. While official estimates of NPLs and special-mention loans are at 5.5% of GDP, private sector estimates are significantly higher. The interlinkages between the government and quasi-government institutions have led to an increase China’s contingent liabilities. Moreover, 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. Due to the interlinkages between corporates, non-bank financial institutions, and banks, defaults could put to the test the extent of China’s willingness to backstop the financial system. On the liability side, banks’ investments in shadow products has resulted in banks’ total assets rising more than their deposits, and increasing banks’ wholesale funding. This coupled with lower external surpluses has resulted in the Chinese financial system at the margin being funded by non-deposit liabilities, a riskier source of funding.

China’s many buffers such as low external funding risks, implicit government support to the banking sector, adequate capitalization (CAR at 13.1%; Tier 1 at 11.1%), high reserve requirements, high domestic savings, and a large sovereign wealth fund are positive. However, buffers are eroding, and risks are beginning to rise. Despite capital controls, foreign exchange reserves, at US $3.1 trillion, are below the US$ 4 trillion peak seen in June 2014. Its current account surpluses have narrowed to less than 1% of GDP. While in aggregate, China’s high saving of 46% of GDP is a buffer against financial shocks, studies indicate that Chinese savings are largely concentrated in wealthy households and private firms, which do not correspond to where debts are accumulating. DBRS continues to monitor potential capital outflows and property sector developments.

Reform Initiatives Face Setbacks Due to a Deterioration in the U.S.-China Relationship
The central government has taken measures to address China’s structural imbalances, but recently these efforts have been hindered by the domestic slowdown and changing dynamics in the U.S.-China relationship. The domestic reform agenda has included fiscal reform, financial sector liberalization, regulatory tightening, partial relaxation of the one-child policy, and pilot programs to restructure SOEs. External efforts include Xi’s One Belt One Road (OBOR) initiative to develop Southeast Asian markets and export surplus capacity. Some of these reform initiatives now face geopolitical headwinds.

Since the start of 2018, the United States has taken an increasingly aggressive stance on China’s economic policies, first threatening, then imposing 5-25% tariffs on US$250 billion Chinese exports (see: U.S.-China Relations: Dialogue With a Deadline and U.S. China Relations: Taking a Turn for the Worse). Further deterioration in the U.S.-China relationship could harm key industries in China and increase risks of a hard landing. Furthermore, OBOR has faced political backlash from partner governments opaque deals made with previous administrations. Several infrastructure projects have been paused, pending further review. While China has near-term policy buffers to cushion itself from shocks, its room for policy easing may be further constrained by its declining current account surplus, relatively lower FX reserves, and rising debt.

Sustaining Growth Becomes Difficult as Economic Rebalancing Slows

China’s growth rate averaged 10% for three decades (1980-2010). Since then, the growth rate has been steadily slowing coming in at 6.6% in 2018. Recognizing the impact of the trade headwinds, the government has lowered the 2019 growth target to a range of 6.0-6.5%. 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 gradually progressing, the economy’s ability to absorb fixed capital is declining and productivity growth is slowing. China requires increasingly more capital to produce each additional unit of output, and a more rapid slowdown might be needed to limit financial risks. At the same time, to maintain unemployment at an acceptable level and to complete the government’s objective to double 2010 GDP by 2020, the government must maintain GDP growth above the 6.2% level. Demographic changes and wage pressures are eroding its labor advantages and depressing productivity gains, complicating these efforts.

Reforms are underway, though not uniformly. External imbalances have declined but high savings have been directed into some less efficient forms of domestic investment, with limited progress on reining in credit growth and 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) among large economies. China also has the lowest share of private consumption to GDP (39%) compared with peers at similar levels of income. Fears that bilateral trade tensions will exacerbate a growth slowdown have led to increasingly expansionary monetary and fiscal policies. These have resulted in faster credit growth, thus temporarily reversing the progress on deleveraging.

China’s External Balance Sheet is Relatively Strong

While a global escalation in protectionist and retaliatory measures could negatively impact China’s prospects, China’s external balance sheet is relatively strong, and its external rebalancing has been substantial. The current account surplus narrowed from 10% of GDP in 2008 to 0.3% in 2018. China’s relatively strong external balance sheet is reflected in high forex reserves (US$3.1 trillion) and low external debt (14.2% of GDP). Despite a relatively closed capital account, 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.

While China’s capital account is dominated by FDI, authorities have been taking various measures towards its calibrated opening by allowing both inflows and outflows of portfolio investments, subject to quotas and approvals. Authorities have also permitted two-way flows via the Stock Connect Scheme, which allows mainland Chinese investors to purchase shares listed in Hong Kong and allows foreigners to buy Chinese A shares listed in the Shanghai and the Shenzhen stock exchanges. Foreign participation in China’s domestic market is low, at less than 3% of bonds and less than 2% of equities. Capital flows increased in 2018 following China’s much awaited inclusion in the MSCI Index and the opening of the Bond Connect, which allows investors from Mainland China and Hong Kong to trade bonds. Flows could increase further in 2019 with both the MSCI and FTSE likely to include A-shares at a substantially faster pace and the Bloomberg Barclays Global Aggregate confirming that it would include Chinese bonds from April 2019.

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 economic performance and overall resilience; and (2) China's strong external balance sheet. The main points discussed during the Rating Committee include U.S.-China trade tensions, China’s overall debt situation, progress in economic rebalancing, and vulnerabilities that could arise in the financial system.

KEY INDICATORS

Fiscal Balance (% GDP): -3.9 (2017); -4.1 (2018E); -4.4 (2019F)
Gross Debt (% GDP): 46.5 (2017); 50.1 (2018E); 53.9 (2019F)
Augmented Gross Debt (IMF) (% GDP): 67.5 (2017); 72.4 (2018E); 77.1 (2019F)
Nominal GDP (USD billions): 12,014 (2017); 13,457 (2018E); 14,172 (2019F)
GDP per Capita (USD): 8,524 (2017); 9,510 (2018E); 9,980 (2019F)
Real GDP growth (%): 6.9 (2017); 6.6 (2018E); 6.2 (2019F)
Consumer Price Inflation (%): 1.6 (2017); 2.2 (2018E); 2.4 (2019F)
Domestic Credit (% GDP): 205.3 (2017); 204.4 (Sept-2018)
Current Account (% GDP): 1.4 (2017); 0.7 (2018)
International Investment Position (% GDP): 14.9 (2017); 12.6 (Sept-2018)
Gross External Debt (% GDP): 12.2 (2017); 14.2 (Sept-2018)
Foreign Exchange Reserves (% short-term external debt + current account deficit): 327.5 (2017); 271.9 (Sept-2018)
Governance Indicator (percentile rank): 68.3 (2017)
Human Development Index: 0.75 (2017)

Notes:

All figures are in Chinese yuan (CNY) 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 primary 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 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 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.

DBRS, Inc.
140 Broadway, 43rd Floor
New York, NY 10005 USA