DBRS Morningstar Confirms China at A (high), Stable Trend

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 is Stable.

KEY RATING CONSIDERATIONS

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. Following a strong recovery post the pandemic, China’s growth momentum in H2 2021 has started to wane, driven by both demand and supply shocks. These include recurring waves of the pandemic and China’s ‘zero tolerance COVID’ strategy, weakness in China’s property markets, enforcement of policies to cut carbon emissions and the recent power outages. The IMF expects the Chinese economy to grow 8% in 2021 before slowing to 5.6% in 2022. While COVID-19 has resulted in a pause in China’s deleveraging efforts, credit growth has been measured rising 10% YoY in September, with the contraction in the stock of shadow loans seen since June 2018 continuing down 12.8% YoY in September 2021.

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 USD 14.7 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 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$ 3.2 trillion of reserves that more than cover its external debt obligations.

China’s ratings are nonetheless hindered by structural credit challenges. China’s main policy challenge remains the need to shift its growth model from an over-reliance of credit intensive investment towards domestic consumption and services. China’s rapid increase in debt is a key concern. BIS estimates of China’s combined gross debt (general government, households, and corporates) have risen from 140% of GDP in 2006 to 287% of GDP in 1Q 2021. High local government deficits are another cause for concern. While the central government’s deficit is estimated at 3.7% of GDP in 2021, local government deficits are higher. There is limited transparency, as a large part of local government financing is off-budget. While the government has made some progress on rebalancing and deleveraging, financial vulnerabilities remain warranting continued efforts to contain leverage and reduce local government deficits. On the governance front, in addition to consolidation of power increasing the risk of policy errors, there are growing concerns on China’s relationships with its neighbors becoming increasingly hostile.

RATING DRIVERS

China’s ratings could be upgraded if China (1) markedly reduces its domestic imbalances, through deleveraging and stronger domestic consumption; and (2) further increases the transparency of local government finances with a declining trajectory in the overall deficits. Conversely, the ratings could be downgraded if: (1) there is a sharp sustained 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) the pace of credit growth accelerates, increasing imbalances and financial risk exposure among corporate and local government sectors; or (3) evidence of a significant deterioration in institutional quality and policy management materializes.

RATING RATIONALE

Recovery Hits Speed Bumps As China Doubles Down on Structural Issues

China was the only major economy with positive growth during the pandemic, growing 2.3% in 2020 due to effective COVID-19 containment measures. As restrictions eased and the economy reopened, pent up domestic demand and increased external demand for medical supplies and electronics aided economic growth through the first half of 2021. However, the growth momentum has started to wane, driven by both demand and supply shocks. On the demand side, successive waves of the virus in 2021 and China’s zero tolerance approach to COVID-19 is resulting in a lagging domestic consumption recovery. Beijing’s targeted property tightening measures have started to weigh on industrial production, fixed asset investment and domestic demand within the real estate sector, which account for nearly 15% of GDP. Additionally, the successful, ongoing rollout of the vaccine globally and re-opening of economies is resulting in an upturn in service activities, and could result export demand peaking. On the supply side, to meet commitments to meet its peak CO2 emissions target by 2030 and reach carbon neutrality by 2060, authorities have begun to implement measures to cut energy use and CO2 emissions. Restrictions on energy intensive and high polluting industries such as iron and steel, aluminum and textiles have started taking their toll on growth. Consequently, China’s growth decelerated to 4.9% in Q3, following the 13.2% growth in the first half of 2021. The IMF in its latest WEO expects the Chinese economy to grow 8% in 2021 before slowing to 5.6% in 2022.

Nonetheless, China is the second largest economy with GDP at $14.7 trillion, 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. China’s relatively strong growth prospects and balance of risks contribute to a positive adjustment in the Economic Structure and Performance building block.

China’s Fiscal Position Continues to Deteriorate, But Debt is Domestically Financed

China is on track to meet its official government budgetary estimates in 2021 amid tighter expenditure control. China ended 2020 with a deficit of 3.7% of GDP, in line with expectations given the relatively small official fiscal response to the pandemic. For 2021, the government targeted a fiscal deficit of 3.2%, withdrawing some discretionary fiscal measures which supported employment and businesses. While the first eight months of fiscal results in 2021 indicate that the government has been keeping a tight hold on expenses, given the weaker than expected growth in the second half of 2021, the government might call on additional fiscal spending to support the economy.

However, China’s overall fiscal situation is significantly weaker than the official headline number. This is due to China’s fiscal framework which is characterized by strong central government finances, but weak local government finances. With local governments responsible for nearly 85% of total expenditure but collecting just 50% of total revenues, local governments face structural revenue shortfalls relative to their spending needs. Prior to 2015, this was financed via local government financing vehicles (LGFVs) and land sales as there was a ban on official local government borrowing. While China’s on-going fiscal reforms have brought on-budget a large amount of LGFV debt and also enabled local governments to issue debt, 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. Consequently, the IMF’s broader measure of the fiscal deficit (the augmented deficit, which includes off-budget items financed by LGFVs, special construction funds, and government-guided funds) averaged 11.3% of GDP during 2016-2019 as compared to the official government deficit of 3%. The pandemic which resulted in the IMF’s augmented deficit rising to 18.2% in 2020 is expected to decline to 13.8% by 2025. The IMF also has a narrower measure of the fiscal deficit which includes SOE operations, land sales but excludes LGFV + special funds. This deficit measure which averaged 5% during 2017-2019 rose to 11.9% during the pandemic and is expected to decline to 7.5% in 2025. Risks associated with these quasi-fiscal activities contribute to a negative adjustment to the building block assessment for Fiscal Management and Policy.

Higher deficits and lower nominal GDP growth are likely to result in China’s general government debt (official definition) rising to 47.2% of GDP in 2021, up from 38.1% in 2019 prior to the pandemic. This includes central government debt, explicit local government debt and some of the explicit liabilities to local government financing vehicles (LGFVs). Under a more expansive measure, the IMF estimates ‘augmented debt’ (which includes explicit and implicit off-budget liabilities to LGFVs), at 96.4% in 2021 as compared to the pre-pandemic level of 80.5% in 2019. However, this augmented ratio perhaps overstates public debt, as guarantees do not always wind up on the public balance sheet, and thus the IMF’s more conservative definition of debt reflects a rise of public debt to 68.9% of GDP in 2021, up from 56.5% in 2019. 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, 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.

China’s Balancing Act – Managing Leverage and Preserving Financial Stability

China has been among the world’s fastest growing economies but its two-decade debt-fueled expansion has generated economic imbalances and financial fragilities in certain sectors, including property. While authorities have been cognizant of these risks, it was only after April 2017 when President Xi referred to elevated leverage as "an issue of national security, ” that authorities have tried to reduce the economy’s reliance on debt for growth through tighter regulatory and supervisory measures. These measures helped stabilize the BIS estimates of overall debt levels (households; non-financial corporates and government) at 255% of GDP during 2017-2019 and contain the growth of shadow credit. However, the deleveraging efforts were paused in mid-2019 due to US China tensions and then the Coronavirus Disease (COVID-19) pandemic resulting in the debt ratio rising to 287% of GDP in 1Q 2021. Nonetheless, China’s efforts at deleveraging have resulted in the BIS’s credit gap declining from a high of 28.1% in 2Q 2016 to 3.1% in 1Q 2021. Moreover, overall total social financing (TSF) growth (consisting of bank loans, shadow credit, and capital market financing) has been measured, rising 10% in September from 13% in January, while the contraction in the stock of shadow loans seen since June 2018 continued in September 2021 down 12.8%.

Regulatory tightening measures, along with slowing property sales, have resulted in a downturn in the property sector and brought Evergrande Group, China’s largest property developer, to the brink of default. The Evergrande crisis embodies the delicate balance for authorities between containing leverage in the economy while preserving financial stability (see China's Balancing Act: Containing Property Sector Leverage While Preserving Financial Stability). While Chinese corporate bond defaults have been rising over the past three years, with even some state-owned enterprises defaulting on their obligations, authorities have bailed out several financial institutions and successfully contained isolated bank failures, thus preventing sector-wide contagion. This was first reflected in PBOC’s takeover of Baoshang Bank in May 2019. In subsequent months, authorities intervened to varying degrees in six other banks (Bank of Jilin, Bank of Jinzhou, Hengfeng Bank, Harbin Bank, Chengdu Rural Commercial Bank, and Bank of Gansu) by acquiring strategic stakes and assembling bailout coalitions. Other interventions include the equity injection by the China Insurance Security Fund to Anbang Insurance, bailouts of HNA Group and China Huarong Asset Management Company.

For now, while authorities have not signaled a reversal in the property tightening measures, in its latest policy statement on October 2015, PBOC has stated that spillovers from the Evergrande issue are controllable with authorities and local governments resolving the issue through market oriented and rule of law principles. In addition to Evergrande, several other developers are also finding it increasingly difficult to raise funding. But, while developer loans are potentially a risk, nearly 75% of the banking sector exposure to the property sector is via mortgages. Macro prudential guidelines including loan-to-value ratio requirements coupled with cultural factors have so far contributed to low delinquency rates. While official estimates of non-performing loans and special-mention loans are at 5.5% of GDP, private sector estimates are significantly higher. That said, China has 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.

Nonetheless, taking into account both asset and liability side issues, where 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 factor for China’s financial risks in the Monetary Policy and Financial Stability building block. DBRS Morningstar continues to monitor potential capital outflows and property sector developments.

US China Relations Remain Fraught, But China’s External Balance Sheet Is Strong

The U.S.-China relationship looks broadly unchanged in spite of the changeover in the U.S. presidential administration. There has been little action to reverse the main policies of the previous administration toward China: the tariffs on over USD 350 billion in Chinese exports, the sanctions on Chinese tech companies, and the tighter restrictions on Chinese businesses buying American technology remain in place. However, the U.S. strategy toward China has nonetheless undergone a meaningful shift from a bilateral and transactions-based approach under the Trump administration to a multilateral, values-based approach under the Biden administration. On one hand, this implies some shift in emphasis toward issues that require cooperation with China, specifically climate change. China is not only the largest emitter of carbon, but through its Belt and Road Initiative, it is also the major financier of coal-fired plants throughout the developing world. On the other hand, it also implies increased U.S. coordination with other major countries that may share similar concerns regarding China's policies regarding the passage of the National Security Law in Hong Kong, political suppression in Xinjiang, and developments in the East Pacific.

The shift in the U.S.-China relationship adds to China's existing challenges. While both countries have strong incentives for continued collaboration, prospects have increased for a more overt rivalry in economic matters (see U.S.-China Relations: Resuming Integration or Globalization in Reverse?). That said, China’s external balance sheet is strong, and its external rebalancing has been substantial. The current account surplus narrowed from 10% of GDP in 2008 to 0.7% in 2019 before rising to 1.8% in 2020. While the rise last year was largely due to pandemic related exports (medical equipment, electronics), the trend decline has been driven by a lower goods balance and widening services balance as China’s growth model is moving from exports to consumption. China’s relatively strong external balance sheet is reflected in high foreign exchange reserves (USD 3.2 trillion) and low external debt (16% of GDP). China remains a net lender to the rest of the world with a net asset position of 14.5% of GDP. 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, permitting two-way flows via the Shanghai and Shenzhen Stock Connect Schemes, and the Bond Connect and approving the inclusion of Chinese companies in global indices. China’s onshore bond market is now estimated at USD 14 trillion overtaking Japan to become the second largest after the US.

Increasing Role of the State Runs the Risks of Policy Errors

China has a centralized political and economic structure where decisions are made and executed via a network of Chinese Communist Party (CCP) authorities. Over the last few years, Chinese authorities have undertaken several reforms to tackle structural issues, which include increasing fiscal accountability and passing the budget law, liberalizing interest rates, opening of capital markets, and instituting regulatory measures to address domestic leverage. Thus, DBRS Morningstar has applied a positive qualitative adjustment due to China’s capacity to address economic challenges in the “Political Environment” building block.

That said, the role of the state in both the economy and society has increased over the last several years. The anti-corruption campaign initiated after Xi Jinping took over in 2012 may have addressed genuine corruption issues, but it may also have cemented the President’s authority and limited competing voices. Further, the removal of the two-term limit for the State President and the amendment of the Party Constitution in 2017 to enshrine ‘Xi Jinping Thought’ served to establish President Xi on the same level as paramount leaders of the past. Recent policy changes aimed at reducing economic inequality (‘common prosperity’) and regulating industries in the education, fintech and gaming space also serve to demonstrate an increased level of government intervention. However, while the concentration of power at the top of the political structure makes it easier for the CCP to carry out reforms, insufficient checks and balances could heighten the risk of policy errors and test the dynamics of China’s single party system. Extensive restrictions on the media and academia and issues on human rights are another concern. These trends are reflected in China’s low ranking in Worldwide Governance Indicators such as “Voice and Accountability.”

ESG CONSIDERATIONS

The ESG subfactors Human Capital and Human Rights (S) and Institutional Strength, Governance, and Transparency (G) were among the key drivers behind this rating action. China’s per capita GDP is low at USD 11,891, partially reflecting relatively low levels of productivity. China’s risks associated with one party rule, a lack of independent institutions, and the limited transparency and accountability associated with government actions which partially contribute to problems with corruption. DBRS Morningstar has taken these considerations into account within the ‘Economic Structure and Performance’, ‘Fiscal Management and Policy’ and ‘Political Environment’ building blocks.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/387985.

Notes:

All figures are in USD 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 https://www.dbrsmorningstar.com/research/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021). Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).

Generally, the conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are monitored.

The primary sources of information used for this rating include Ministry of Finance, Bank of International Settlements, International Monetary Fund, World Bank, UN, and Haver Analytics. 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.

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.

This is an unsolicited credit rating.

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