DBRS Morningstar Changes Trend on China to Negative From Stable, Confirms Rating at A (high)

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

KEY RATING CONSIDERATIONS
The Negative trend reflects DBRS Morningstar’s expectation of a weaker macroeconomic performance for the Chinese economy in the medium term, due to (1) continued property sector weakness, (2) China’s ageing demographics, and (3) heightened U.S.-China tensions. These factors might have structural implications for the country’s economic prospects, weighing on government finances. In 2022, China’s zero COVID policy, property sector weakness and weak external demand is likely to result in China’s growth coming in at a little over 3% versus the government’s target of 5.5%. Headwinds to China’s economy could result in sustained underperformance through the IMF’s forecast horizon till 2026. The rating action reflects the deterioration in the ‘Economic Structure’, ‘Fiscal Management and Policy’, and ‘Debt and Liquidity’ building blocks.

China’s ratings are hindered by structural challenges such as its investment-led growth model, opaque public finances at the local level, high debt levels across sectors, and growing governance concerns. 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. While China’s shadow banking sector continues to contract, and recent trends in credit growth remain measured, China’s overall debt levels are 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 291.5% of GDP in Q1 2022. High local government deficits are another cause for concern and are estimated to be much higher than the central government’s deficit, which is estimated at 3.2% of GDP in 2021. There is limited transparency, as a large part of local government financing is off-budget. While the government has made some progress on deleveraging, financial vulnerabilities remain, warranting continued efforts to contain leverage and reduce local government deficits. On the governance front, the risk of policy errors are increasing as power consolidates, and there are growing concerns on China’s relationships with its neighbors becoming increasingly tense.

That said, DBRS Morningstar considers that China’s economic and policy buffers remain sufficient to limit the risk of an abrupt near-term adjustment. China’s A (high) ratings reflects its large and diversified economy, strong external balance sheet, moderate public debt, comparatively very low inflation rate, and high domestic savings. China is the world’s top merchandise trader, is the second largest economy with GDP at USD 17.5 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.

RATING DRIVERS
An upgrade of the ratings is unlikely in the near term. However, DBRS Morningstar could upgrade the ratings if China 1) markedly reduces its domestic imbalances, through deleveraging and increasing domestic consumption; and (2) significantly reduces the overall level of deficits while improving the transparency of local government finances. The trend could be changed to Stable if current economic headwinds dissipate and the general government fiscal balance improves more than expected.

Ratings could be downgraded due to one or a combination of the following factors: (1) sustained deterioration in economic performance, potentially triggered by continued COVID-19 outbreaks and the associated mobility restrictions; (2) lack of progress on reducing imbalances and financial risk exposure among corporate and local government sectors; or (3) increased evidence of a material deterioration in institutional quality and policy management.

RATING RATIONALE

Cyclical and Structural Factors Are Taking A Toll on China’s Growth Engines

China is likely to miss its official 2022 GDP growth target of 5.5% by a wide margin due to the combination of an intensification of headwinds in the property sector, China’s zero COVID strategy, and growing strains on external demand. China’s economy grew 8.1% in 2021 after the pandemic shock reduced growth to 2.2% in 2020. However, growth has begun to wane towards the end of 2021 due to both demand- and supply-side factors. While annualized growth in the first quarter came in at 4.8%, Omicron-linked disruptions coupled with strong lockdowns resulted in Q2 GDP growth slowing to 0.3% YoY. Although growth is likely to recover over the second half of 2022, authorities’ measures to reduce speculative property development have resulted in prolonged housing market weakness weighing on industrial production and fixed asset investment. The mortgage boycotts in July hurt the confidence of potential homebuyers, further impacting domestic demand. China’s external demand is also facing headwinds as the pace of rate hikes in advanced economies has reduced export growth. In addition, tighter regulations in the technology space and measures to curb CO2 emissions have added to growth pressures. In the latest World Economic Outlook, the IMF reduced China’s growth forecasts to 3.2% in 2022 and 4.4% in 2023, the lowest in the last 38 years.

In addition to the cyclical factors, developments over the last few years are impacting China’s structural growth drivers. First, in light of the deterioration in U.S.-China relations and rising geopolitical tensions, multinational companies (MNCs) have been revisiting their China strategy, with a greater emphasis on supply chain resiliency rather than efficiency. While a total outward migration of supply chains is unlikely given the availability of labor and large domestic market access within China, MNCs are increasingly following a China+1 strategy. More importantly, the intensification of U.S. restrictions on advanced technology industries are likely to impact productivity. Secondly, growth in China remains accompanied by a sustained increase in debt and growing income inequalities. Policymakers have been attempting to shift China’s growth model from an over-reliance of debt-fueled investment (including housing) towards domestic consumption and services. There has been some progress in reversing the trend but progress is slow. Private consumption is low at 38% of GDP and China still has the highest investment to GDP ratio (43% of GDP) among large economies. Third, in addition to China’s ageing demographics, as noted by the IMF, policy efforts to strengthen the social safety net and reduce income inequality are needed to reduce savings further and boost consumption.

Nonetheless, China is the second largest economy with GDP at USD 17.5 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.

Property Sector Woes Raise Macro and Financial Stability Risks in China

The key source of downward pressure on the economy is China’s property sector. Regulatory tightening measures announced in August 2020, along with slowing property sales, have resulted in a downturn in the property sector resulting in several large developers defaulting on their bond payments. The downturn is a major drag on the economy as China's property sector has been a key engine of growth for two decades, contributing to nearly 15% of GDP and 25% of total fixed investment. The slowdown also has implications for public finances as land sales to property developers account for nearly 25% of local government tax revenues. As the sector begins to downsize, it could take a toll on employment and consumption given that housing accounts for 70% of Chinese household assets. The real estate sector currently accounts for 30% of bank loans. With nearly 75% of the banking sector exposure to the property sector via mortgages, macroprudential guidelines including loan-to-value ratio requirements, have so far contributed to low delinquency rates. While banks’ direct exposure to the property sector appears manageable, the high-indebtedness of property developers suggests that the spillovers could go beyond the banking sector, affecting households, upstream and downstream industries, and non-bank funding channels. Thus, while official estimates of non-performing loans and special-mention loans are low at 5.5% of GDP, private sector estimates are significantly higher. This coupled with liability side issues reflected in increasing recourse to non-deposit liabilities results in DBRS Morningstar applying a negative qualitative factor in the ‘Monetary Policy and Financial Stability’ building block. DBRS Morningstar continues to monitor potential capital outflows and property sector developments.

While China’s property sector woes have deepened and is resulting in high macro risks and financial stability risks, authorities are aware of the risks and are taking several measures to address the property downturn. These include initiatives to help complete abandoned projects as well as building low cost public housing. In addition, with inflation at 2.4% (August 2022), China has slightly reduced its 1-year loan prime rate from 3.7% to 3.65% and its 5 year loan prime rate from 4.45% to 4.3%. Moreover, China has many buffers such as low external funding needs, adequate capitalization (CAR at 14.2%; Tier 1 capital ratio at 11.6%), high reserve requirements, high domestic savings, and a large sovereign wealth fund, all of which lend assurance to the government’s capacity to support the financial system.

China’s Fiscal Position Continues to Deteriorate, But Debt is Domestically Financed
China’s general government deficit, which averaged 2.9% during 2016-2019, rose to 3.7% in 2020 following the stimulus to offset the impact of COVID-19. Policy support for the housing sector and on-going COVID relief measures will likely result in the deficit averaging 3% through the IMF’s projected horizon of 2026. However, China’s overall fiscal situation is significantly weaker than the official headline number. China’s fiscal framework is characterized by relatively strong central government finances, but local government finances are weak. 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. 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. China’s on-going fiscal reforms have brought on-budget a large amount of local government financing vehicles (LGFV) debt and also enabled local governments to issue debt. However continued higher expenditure at the local government level have resulted in local governments using new sources of funding such as special funds and public private partnerships to fund growth. Given the implicit state support for these new sources of local government funding, China’s fiscal and debt metrics are weaker than the headline figures.

Consequently, as compared to the official government deficit of 3.2% in 2021, 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) came at 16.5% in 2021, compared to a pre-pandemic average of 11.3% of GDP during 2016-2019. 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 stood at 7.9% from a pre-pandemic average of 5% during 2017-2019. On-going expenditures and lower growth are likely to result in the deficit averaging 7.6% through the IMF’s forecast horizon of 2026. 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 expected to result in China’s general government debt (official definition) rising to 50.6% of GDP in 2022, 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 that public debt increased to 78.5% of GDP in 2022, up from 57.1% in 2019. The IMF also publishes an ‘augmented debt’ figure (which includes explicit and implicit off-budget liabilities to LGFVs), which reached an estimated 101.7% in 2022 as compared to the pre-pandemic level of 81.4% in 2019. This augmented ratio likely overstates public debt, as guarantees do not always wind up on the public balance sheet. However, 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.

Despite the steady rise in public debt and sizeable contingent liabilities, China has fiscal space as indicated by its high domestic savings, low borrowing costs, and substantial liquid assets, including foreign reserve assets held by the government, 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.

U.S.-China Tensions Increase, But China’s External Balance Sheet Is Strong

China’s external balance sheet is strong, and its external rebalancing has been substantial. The current account surplus narrowed from an average of 5.2% between 2001 and 2010 to stand at 1.7% in 2021. The overall decline has been driven by a lower goods balance and widening services balance as China’s growth model transitions from exports to consumption. China’s relatively strong external balance sheet is reflected in high foreign exchange reserves (USD 3.2 trillion, or 17% of GDP) and low external debt (16% of GDP). China remains a net lender to the rest of the world with a net asset position of 11.5% 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, 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 United States.

The shift in the U.S.-China relationship since 2017 nonetheless adds to China's existing challenges. Tariffs imposed by the previous U.S. administration on over USD 350 billion in Chinese exports and sanctions on Chinese tech companies remain in place, and the Biden administration has further tightened restrictions on Chinese purchases of American technology. The relationship has experienced added strains in the wake of rising Western concerns over the centralization of power within China and perceived repression of dissidents and minority populations, and Chinese concerns over foreign intervention into Taiwan and other domestic affairs. (See DBRS Morningstar Commentary: Taiwan-China: An Outright Invasion Would Be A Serious Threat To The Global Economy). DBRS Morningstar maintains its view that this evolving relationship between the largest economies in the world remains important to the overall global outlook and may have implications far beyond their own borders.

20th Party Congress Cements Xi’s Authority
China has a centralized political and economic structure where decisions are made and executed via a network of Chinese Communist Party (CCP) authorities. Reforms made over the last few years include increasing fiscal accountability and the passage of the budget law, liberalizing interest rates, opening of capital markets, and instituting regulatory measures to address domestic leverage. The predictability and general pragmatism of China’s economic policymaking have led to a positive qualitative adjustment in the ‘Political Environment’ building block.

That said, the role of the state in both the economy and society has increased over the last few Party Congress meetings - China’s most important political event every five years. Xi Jinping took over as Party General Secretary after the 18th Party Congress in 2012 and concurrently serves as the Chairman of the Central Military Commission and as the State President. Moreover, while the anti-corruption campaign initiated after Xi Jinping took office may have addressed genuine corruption issues, it may also have cemented the President’s authority and limited competing voices. The removal of the two-term limit for the State President in the 19th Party Congress in 2017 and the revised definition of China’s principal problem being “insufficient and imbalanced development” further enhanced the role of the state. Thus while growth remained a priority, authorities said that they would accept lower but better quality growth with other objectives such as financial stability and clean energy policies rising in importance.

The recently concluded 20th Party Congress in 2022 further cemented Xi Jinping’s leadership role in the CCP with Xi entering an unprecedented third five-year term as party general secretary and with the seven-member Politburo Standing Committee now dominated by allies of Xi Jinping. While China’s main economic policies will be released later this year, in his opening remarks at the Congress, President Xi reiterated plans to grow China into a ‘medium-level developed country’ by 2035 with a focus on developing industrial technology in areas of quantum computing, aerospace and satellite navigation. Xi’s ‘dual circulation’ policy remains the party’s key economic priority, which includes expanding domestic demand and improving the resilience of the domestic supply chain, while remaining open to trade. Xi has also continued to emphasize the role of recent policy changes aimed at reducing economic inequality (‘common prosperity’). Recent regulation of industries in the education, fintech and gaming space demonstrate an increased level of government intervention. 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 challenges are reflected in China’s low ranking in Worldwide Governance Indicators, particularly ‘Voice and Accountability.’

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors
The Human Capital and Human Rights factor affects the ratings assigned to China. China’s per capita GDP is low at USD 12,561, reflecting relatively low levels of productivity. Concerns over individual and human rights are a source of tension with some domestic populations and international peers. China’s hukou system (a household registry that ties health, education, housing and other government services to the parents’ status, whether urban or rural) limits economic mobility and human capital accumulation for migrant workers from rural areas. Recent hukou reforms have eased the barriers to converting a rural hukou to an urban one, but urban registrations remain low relative to urban-rural migrants. These factors have been taken into account in the ‘Economic Structure and Performance’ and in the ‘Political Environment’ building blocks.

Governance (G) Factors
The Institutional Strength, Governance and Transparency factor has an impact on China’s ratings. In addition, Bribery, Corruption, and Political Risks and Peace and Security are relevant considerations. China ranks in the 4th percentile in the Worldwide Governance Indicators on Voice and Accountability. All political institutions are dominated by the Chinese Communist Party, which limits press freedoms and other independent voices. The government has conducted regular anti-corruption campaigns since President Xi Jinping took office to root out corruption and graft in the military, in the central and local governments, and in state-owned enterprises, though investigations are opaque and due process appears to be disregarded. Additionally, ongoing tensions on the India-China border, in the South China Sea, and around the Taiwan Straits occasionally flare up. These factors have been taken into consideration in the ‘Fiscal Management and Policy’ and ‘Political Environment’ building blocks.

There were no Environmental factors that had a significant or relevant effect on the credit analysis.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings. (May 17, 2022).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/405262.

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/401817/global-methodology-for-rating-sovereign-governments (August 29, 2022).
In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings. (May 17, 2022) in its consideration of ESG factors.

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, People’s Bank of China, 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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