DBRS Morningstar Confirms China at A (high), Trend Remains Negative

DBRS, Inc. (DBRS Morningstar) confirmed China’s Long-Term Foreign and Local Currency – Issuer Ratings at A (high). At the same time, DBRS Morningstar confirmed China’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (middle). The trend on all ratings remains Negative.

KEY RATING CONSIDERATIONS

DBRS Morningstar continues to assess the Negative trend assigned to China in March 2019 when the Chinese authorities paused deleveraging efforts amid a domestic slowdown and a deterioration in U.S.- China relations. Since then, credit growth has been contained and the U.S. and China have signed a Phase One deal. Tensions with the U.S. and new tariffs could resurface, particularly following the U.S. elections in November. At the time of this review, China is suffering from the coronavirus outbreak that has triggered a supply and demand shock, that authorities are attempting to manage through expansionary monetary and fiscal policies to mitigate any lasting impact on growth.

DBRS Morningstar’s baseline assumption remains that the economic impact of the coronavirus should be relatively short-lived (1-2 quarters). However, the spread of the virus has not yet been fully contained, and a surge of new cases could pose additional challenges to growth, which in turn would likely generate additional pressures on the corporate and public sectors. If the coronavirus shock is worse than the baseline assumption, or if authorities respond with measures that significantly increase leverage, this could result in a more immediate review of the rating.

China’s A (high) 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, is the second largest economy with GDP at $14.3 trillion, accounts for roughly one-third of global growth, and is a net creditor to the world. Decades of rapid income growth have created one of the largest consumer markets in the world.

China’s 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. Although the government made some progress towards deleveraging, financial vulnerabilities remain elevated. On the governance front, consolidation of power could increase the risk of policy errors, while recent protests in Hong Kong Special Administrative Region (SAR), coupled with coronavirus containment, could test the dynamics of China’s single-party system. 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.

RATING DRIVERS

Downward pressure on the rating could emerge if: (1) there is a sharp deterioration in economic performance, potentially triggered by a significant acceleration in the spread of coronavirus or a global escalation in protectionist and retaliatory trade measures; (2) 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; 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

Coronavirus Outbreak, Trade Tensions Add to China’s Growth Woes

China’s economic growth slowed to 6.0% in 2019 from 6.6% in 2018. The deceleration was largely driven by the escalation in the U.S.-China trade tensions, which impacted trade and business sentiment. The tentative stabilization following the signing of the Phase One trade deal was shaken by the coronavirus outbreak. Chinese authorities have adopted stimulus measures (see Coronavirus: Growing Policy Efforts But No Respite Yet) designed to minimize the economic impact. The IMF’s current baseline scenario is based on the WHO’s assessment that the strong and coordinated measures could help contain the virus. Even under these assumptions, the IMF expects the coronavirus to shave off 0.4% of China’s 2020 growth to 5.6% from its earlier estimate of 6.0%. DBRS Morningstar sees risks as tilted toward the downside.

Aside from trade tensions and the coronavirus, China’s economic growth model has been facing increasing challenges over the last several years. Growth is slower than it has been in the past but remains strong at 6.0% in 2019. However, much of China’s growth over the past decade has been accompanied by a sustained increase in debt. The economy faces two large interacting imbalances: excessive leverage and excess capacity. Policy makers have been attempting to shift China’s growth model from an over-reliance of debt-fueled investment towards domestic consumption and services. Reforms are underway, though not uniformly. External imbalances have declined but high savings continue to be directed into some less efficient forms of domestic investment, with limited progress on reining in hard budget constraints on SOEs. There has been some recent progress in reversing the trend: consumption has risen and contributes nearly 60% of growth, while service sector growth is now higher than industry. However, China still has the highest investment to GDP ratio (44% of GDP) among large economies. Moreover, despite the gradual adjustment, 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, while demographic changes and wage pressures are eroding its labor advantages and depressing productivity gains.

Nonetheless, with GDP at $14.3 trillion, China is the second largest economy, is the world’s largest merchandise trader, and contributes one-third of global growth. Decades of income growth have created one of the largest consumer markets in the world. Furthermore, China has near-term policy buffers to manage an abrupt adjustment and cushion itself from shocks. These buffers include its moderate public debt, high domestic savings, low inflation, and high foreign exchange reserves. As a result, DBRS Morningstar applies a positive qualitative assessment for China’s growth prospects and balance of risks in the “Economic Structure and Performance” building block.

Overall Fiscal Position Sees A Steady Deterioration, But Public Debt Remains Domestically Financed

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 85% of general government expenditure. Budget transparency at the local government level is limited. Until 2015, most of the local government financing was off-budget via local government financing vehicles (LGFVs) due to a ban on official local government borrowing. The 2015 fiscal reforms allowed local governments to borrow officially (subject to an annual cap), and brought on-budget a large amount of LGFV debt. While the fiscal reforms are positive, in addition to bond financing, local governments have been using new sources such as public private partnerships and special funds to achieve growth targets and thus off-budget debt continues to rise.

On the whole, China’s general government’s deficit, which averaged 2.9% during 2016-2019 is expected to surpass 3% in 2020 as the government responds to the slowdown caused by the coronavirus. The IMF estimates of the ‘augmented’ deficit (which includes off-budget items), which averaged 11.3% during 2016-2019 is expected to exceed 12%. Central government debt for 2019 is estimated at 21.6% of GDP. Including explicit local government debt, China’s general government debt is 40.2% of GDP. The IMF, under its definition of ‘augmented debt’ (which includes explicit and implicit off-budget liabilities to LGFVs), estimates debt at 80.2% of GDP in 2019. However, this augmented ratio perhaps overstates public debt, as governments do not incur all guarantees onto the public balance sheet. Less than one-fifth of guaranteed debt was repaid by fiscal capital in each year since 2007. Moreover, some of the LGFV borrowing is on a commercial basis. Adjusting for this, the gross debt is estimated at a more moderate 55.6% and in DBRS Morningstar’s baseline scenario, China’s public debt ratio is likely to rise to 76.6% of GDP by 2024.

Despite the steady rise in public debt, China has fiscal space as indicated by its high domestic savings, low borrowing costs and large assets which include state-owned assets, foreign reserve assets held by the government, social security fund and government deposits with the central bank. Moreover, as debt is largely domestic, overall general government debt servicing is manageable even as baseline projections for debt show a considerable increase over the forecast period.

Extended Pause in the Deleveraging Campaign Could See Debt Levels Rise
Fears that bilateral trade tensions, and now coronavirus-related shutdowns, will exacerbate a growth slowdown are leading to increasingly expansionary monetary and fiscal policies. These could result in faster credit growth, thus reversing the progress of deleveraging. To put things in perspective, 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 (general government, households and corporates) to GDP ratio rising from 140% in 2007 to 261% in Q2 2019. The stimulus was not financed by the central government but through the local governments, banks, and other less regulated institutions. Although the level of gross debt is comparable to those of the U.S., UK, and lower than Japan, the pace of growth and concentration are a concern.

Following the financial deleveraging and tightened supervision measures initiated in 2017, overall total social financing (TSF) growth (consisting of bank loans, shadow credit, and capital market financing) declined from a peak of 16.6% in December 2016 to a low of 10.3% in December 2018. These deleveraging measures resulted in a sharp contraction in shadow credit. Low interest rates have also aided capital market financing , whereas loan growth has been relatively stable at 11.9%. Though authorities have shifted their focus from deleveraging to supporting growth, credit trends have been restrained with TSF growth stable at 10.7% in January 2020.

The deleveraging process could see an extended pause in the face of external and domestic shocks. Thus far, similar to policy actions taken to offset the effects from trade tensions with the U.S., China's monetary response to the economic fallout from the coronavirus has thus far been restrained and measured. The PBOC has cut various policy rates by a range of 15 to 26 basis points, relatively less than other central banks in the region and provided moderate levels of liquidity to support banks and businesses which were negatively affected.

However, China’s rapid pace of debt accumulation over the last decade 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 (corporates, banks, and non-bank financial institutions) have led to an increase China’s contingent liabilities, and defaults could test China’s willingness to backstop the financial system. So far, recent bank failures indicate authorities preference to consolidation rather than bankruptcy. This was reflected in PBOC’s takeover of Baoshang Bank, ICBC’s acquisition of Jinzhou Bank and Central Huijin’s stake in HengFeng Bank. On the liability side, during the last few years, Chinese banks have been lending well in excess of deposit growth by 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. Consequently, DBRS Morningstar applies a negative qualitative assessment for China’s financial risks in the “Monetary Policy and Financial Stability” building block.

Nonetheless, China’s many buffers such as low external funding risks, implicit government support to the banking sector, adequate capitalization (CAR at 14.2%; Tier 1 at 11.6%), 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 $3.1 trillion, are below the $4 trillion peak seen in June 2014. Its current account surpluses have narrowed to 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.

Strong External Balance Sheet Softens Protectionist Trade Policies and Virus Outbreak

Since the start of 2018, the United States has taken an increasingly aggressive stance on China’s economic policies, first threatening, then imposing tariffs Chinese exports. After nearly 19 months of negotiations, the U.S. and China signed a Phase One trade deal on January 15, 2020. As part of the deal, both countries agreed to halt additional tariff hikes and reduce tariffs for certain commodities. However, a 25% tariff on $250 billion worth of Chinese goods remains in place. In addition to commitments to uphold intellectual property rights, transparency on currency issues, and the financial sector liberalization, the Phase One deal commits China to an additional $200 billion worth of imports over the next two years. This equates to a 70% increase from 2017 levels, when Chinese imports of U.S. goods and services totaled $211 billion. The coronavirus outbreak could make it difficult for China to adhere to these commitments, at least in the near term. In addition, the virus could accelerate outward migration of supply chains that was provoked by trade tensions. As a result, more permanent negative effects on FDI and global trade with China may remain beyond the short term.

While a continued escalation in protectionist 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 1.0% in 2019, largely driven by a lower goods balance and widening services balance as China’s growth model is moving from exports to consumption. However, China remains a net lender to the rest of the world with a positive net investment position of 15% of GDP. Its relatively strong external balance sheet is reflected in high foreign exchange reserves ($3.1 trillion) and low external debt (14.2% of GDP). Nonetheless, 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.

Although 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. Authorities have also permitted two-way flows via the Shanghai and Shenzhen Stock Connect Schemes, as well as the Bond Connect. Foreign participation in China’s domestic market has historically been low, at less than 3% of bonds and less than 2% of equities, but have been steadily increasing with China’s inclusion in the MSCI Index (2018) and the Bloomberg Barclays Global Aggregate (2019). Over the last year, due to technical changes made by the three major index providers – MSCI, FTSE Russell and S&P Dow Jones – the weight of Chinese companies within emerging market allocations has risen to over 30%, which could result in increased inflows.

Centralized Political Structure Comes With Challenges

China has a centralized political and economic structure where decisions are made and executed via a network of Chinese Communist Party (CCP) authorities, with Xi Jinping as the State President, the Party General Secretary, and the Chairman of the Central Military Commission. Reforms undertaken since the 2012 leadership transition to Xi Jinping include measures to improve accountability on the fiscal front, liberalization of interest rates, opening of capital markets, and policy initiatives towards financial deleveraging via regulatory tightening. These reforms signal a greater role for market forces in the economy to help China address its economic challenges. DBRS Morningstar applies a positive qualitative assessment for China’s capacity to address economic challenges in the “Political Environment” building block.

At the same time, the government appears to desire to retain its command of the economy. The removal of the two-term limit for the State President and the amendment of the Party Constitution to enshrine ‘Xi Jinping Thought’ both serve to make Xi into China’s most powerful leader since Mao Zedong. While the concentration of power at the top of the political structure makes it easier for the CCP to carry out reforms, removal of checks and balances of policy errors could exacerbate imbalances in the future. Recent protests in Hong Kong SAR coupled with coronavirus containment could test the dynamics of China’s single party system.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/357696/.

Notes:
All figures are in US dollars unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments, which can be found on the DBRS Morningstar 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, China Index Academy, Bank for International Settlements, IMF World Economic Outlook, Haver Analytics, World Bank, UNDP and DBRS Morningstar. DBRS Morningstar 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.

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The rated entity or its related entities did not participate in the rating process for this rating action. DBRS Morningstar 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.

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