Morningstar DBRS Confirms China at "A", Stable Trend

DBRS, Inc. (Morningstar DBRS) confirmed China's Long-Term Foreign and Local Currency - Issuer Ratings at "A". At the same time, Morningstar DBRS confirmed China's Short-Term Foreign and Local Currency - Issuer Ratings at R-1 (low). The trend on all ratings is Stable.

KEY CREDIT RATING CONSIDERATIONS

The rating confirmation reflects Morningstar DBRS's assessment that risks to growth and financial stability remain sufficiently counterbalanced by China's economic and policy buffers. Morningstar DBRS expects the weakness in the property sector, the challenges of China's ageing demographics, and heightened U.S.-China tensions will translate into lower economic growth over the medium term. These factors have structural implications for the country's economic prospects, weighing on government finances. The ratings are also hindered by opaque public finances at the local level, high debt levels across sectors, and growing governance concerns. While the general government's deficit is estimated at 3.1% of GDP in 2023, the IMF's augmented deficit which includes off-budget items financed by local government financing vehicles (LGFV's) and various special funds is significantly higher at 13.2% of GDP, while a narrower definition estimates it at 7.4% of GDP. China's overall debt levels have risen with the BIS estimates of China's combined gross debt (general government, households, and corporates) rising from 138% of GDP in 2008 to 290% of GDP in Q1 2024. The IMF projects China's debt-to-GDP ratio to trend higher through its forecast horizon due to headwinds to the economy.

That said, Morningstar DBRS considers that China's economic and policy buffers remain sufficient to limit the risk of an abrupt near-term adjustment. China's A ratings reflect its large and diversified economy, strong external balance sheet, moderate public debt, comparatively low inflation rate, and high domestic savings. China is the world's top merchandise trader and is the second largest economy with GDP at USD 18.2 trillion accounting for roughly one-fifth of global growth. 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 (43.4% of GDP). China is a net creditor, holding USD 3.2 trillion of reserves that more than cover its external debt obligations.

CREDIT RATING DRIVERS

Morningstar DBRS could upgrade the credit 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.

Alternately, credit ratings could be downgraded due to one or a combination of the following factors: (1) a deeper and sustained deterioration in economic performance; (2) a lack of progress on reducing fiscal 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.

CREDIT RATING RATIONALE

Policy Measures Help Near term Resilience, But Headwinds to China's Growth Story Continue

Following the COVID led sub-par 3% growth in 2022, China's economy recovered in 2023 with real GDP coming in at 5.2% in 2023. With 9M growth at 4.8%, GDP growth in 2024 is expected to come in close to the government's 5% target with consumption and public investment offsetting the weakness in the property sector. The latest round of coordinated policy measures encompassing monetary easing, fiscal support and measures to stabilize the equity and property markets are encouraging, but unlikely to offset drags from China's structural challenges which include its high and rising debt, demographics with geo-political challenges. In the latest World Economic Outlook, the IMF estimates that the Chinese economy will grow at 4.8% in 2024. The IMF also expects growth to moderate in the medium term, averaging 3.7% through its forecast horizon (2025-2029).

Developments over the last few years are impacting China's structural growth drivers. First, growth in China remains accompanied by a sustained increase in debt and growing income inequalities. China's combined gross debt (general government, households, and corporates) has more than doubled from 138% of GDP in Q1 2008 to 290% of GDP in Q1 2024. Policymakers have been attempting to shift China's growth model from an over-reliance of debt-fueled investment (including housing) towards consumption and services. There has been some progress in reversing the trend, but progress is slow. Private consumption is low at 39% of GDP and China still has the highest investment to GDP ratio (42% of GDP) among large economies.

Second, China's ageing population is likely to shrink its productive capacity. With a population of 1.4 billion, China is the second most populous country in the world. However, thanks to its one-child policy that was in place from 1979 to 2015, China's working-age population is expected to decline by 22% from 2022 to 2050. Consequently, labor's negative contribution will persistently weigh on China's potential growth. Further, the UN expects China's old age dependency ratio to rise from 19% currently to 50% by 2050. This will require higher government spending on social services, which could have a significant impact on public finances.

Third, the shift in the U.S.-China relationship since 2017 has increasingly added to China's domestic challenges of debt and demographics. Tariffs on Chinese exports, sanctions on Chinese tech companies and restrictions on Chinese purchases of American technology on both exports of semi-conductor chips and design software are taking on a toll. Furthermore, the controls are not limited to U.S. companies; they also apply to foreign companies that create products that incorporate American technology. The intensification of U.S. restrictions on advanced technology industries are likely to impact productivity. In addition, rising geopolitical tensions, have resulted in multinational companies revisiting their China strategy, with a greater emphasis on supply chain resiliency rather than efficiency, resulting in another headwind to Chinese growth.

Despite these challenges, China is the second largest economy with GDP at USD 18.2 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 And Debt Metrics Deteriorate Further

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 75% of general government expenditure. Budget transparency at the local government level remains limited. Prior to 2015, as local governments were banned from borrowing, higher local government expenditure was financed via local government financing vehicles (LGFVs) and proceeds from land sales. China's ongoing fiscal reforms have enabled local governments to issue debt subject to a cap and brought on-budget a large amount of off-balance sheet activity. However, continued higher expenditure at the local government level and lower land sales have resulted in local governments using new sources of funding such as special funds and public private partnerships to fund growth.

Consequently, as compared to the general government deficit which has averaged of 3.1% since 2018-2024, 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) is much higher. The augmented deficit currently stands at 13.2% in 2024 as it expected to remain at 12-13% through the IMF's forecast horizon of 2028. 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.

China's public debt ratios have seen a steady rise since the pandemic and the downturn in the property market. The official definition for general government debt (which includes explicit local government debt) has risen from a pre-pandemic level of 38.5% of GDP in 2019 to 60.5% in 2024. The IMF under its definition of `augmented debt' (which includes explicit and implicit off-budget liabilities to LGFVs) estimates debt to have risen from a pre-pandemic level of 86% of GDP in 2019 to 124% of GDP in 2024. This augmented ratio likely overstates public debt, as some of the LGFV borrowing is on a commercial basis and not all guarantees wind up on the public balance sheet. Higher deficits and lower nominal GDP growth are likely to result in China's debt-to-GDP ratio trending higher from 60.5% currently to 79% of GDP in 2029 under the official government definition and from 124% of GDP in 2024 to 148% of GDP in 2029 as per the IMF estimates for augmented debt. 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.

That said, 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.

Policy Moves to Support the Property Sector Unlikely To Reverse Downward Pressure on the Economy and Financial Stability Risks

China's property sector correction which began in 2021 remains the key source of downward pressure on the economy. China's property sector was a key engine of growth for two decades, contributing to nearly 15% of GDP and 25% of total fixed investment. The rapid rise in house prices coupled with the buildup of leverage among property developers led to the commencement of regulatory tightening by the authorities. This in turn exposed vulnerabilities among many developers leading to several defaults endangering the completion of pre-sold homes. While authorities are taking measures to support the sector, inventories pending completion remain high thereby undermining confidence and resulting in weak housing demand. 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.

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. 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. But given the interlinkages of the property sector in the economy, 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 Morningstar DBRS applying a negative qualitative factor in the `Monetary Policy and Financial Stability' building block. Morningstar DBRS continues to monitor potential capital outflows and property sector developments.

The government recently announced a host of new measures to stabilize the housing sector. These include a 50bp reduction for existing mortgages, lowering the minimum downpayment ratio for second home mortgages from 25% to 10%, increasing the PBOC's funding support towards housing destocking. These are in addition to initiatives taken in 2023 to help complete abandoned projects, build low-cost public housing and measures to stabilize prices through the introduction of price caps on new home sales to keep new home prices lower than secondary market prices. In addition to weak housing prices, China has been facing downward price pressures. CPI averaged 0.2% in 2023 and 0.3% during January 2024 to September 2024. PPI which averaged -3.1% in 2023 remained deflationary averaging 2.1% during January 2024 to September 2024. Despite low inflation, consumption growth has been weak in China reflecting falling asset prices, low job and wage growth. With inflation remaining subdued at near zero levels since April 2023, China lowered its 1-year loan prime rate from 3.70% in July 2022 to 3.10% currently and its 5-year loan prime rate from 4.45% to 3.6% in the same period. However, downward price pressure coupled with low nominal GDP growth have impacted profit margins and profitability.

While the new measures to support demand and correct housing inventory are positive, they are unlikely to address China's ageing demographics, weak income expectations and concerns on the property sector - both prices and delivery. Although financial stability risks are rising, 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.

U.S.-China Relationship Remains Fraught; But China's External Balance Sheet Is Strong

The shift in the U.S.-China relationship since 2017 adds to China's existing challenges. Tariffs remain on over USD 350 billion in Chinese exports and sanctions on Chinese tech companies have been progressively tightened with restrictions on Chinese purchases of U.S. technology. The relationship continues to experience added strains on advanced economy 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. Morningstar DBRS 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.

A more confrontational stance on trade by US or European officials generate further headwinds via tariffs could slow the export growth that has buoyed China's economy in 1H24. The tariff threat could generate significant uncertainty for key trading partners and the global economy. As regards investments, the U.S. may seek to further restrict China's access to cutting-edge technologies, such as semiconductors and chip-making equipment, while trying to build non-China technology supply chains in the U.S. and among allies.

Nonetheless, despite the growing challenges, 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 1.4% in 2024. 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 3.3 trillion, or 13% 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 14.1% 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.

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. Reforms made over the last decade 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 general pragmatism of China's economic policymaking has led to a positive qualitative adjustment in the `Political Environment' building block.

However, a growing concern is the role of the state in both the economy and society, which 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 has cemented the President's authority and also appears to have limited competing voices. Further, the removal of the two-term limit for the State President in the 19th Party Congress in 2017 and the appointment of Xi as party general secretary in the 20th Party Congress in 2022 for an unprecedented third five-year term has further cemented Xi Jinping's leadership role. Moreover, the seven-member Politburo Standing Committee is now dominated by President Xi's allies. 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 are another concern. These challenges are reflected in China's low ranking in Worldwide Governance Indicators, particularly `Voice and Accountability.'

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

ESG Considerations had a significant effect on the credit analysis.

Social (S) Factors

The following Social factor had a significant effect on the credit analysis: Human Capital and Human Rights. China's per capita GDP is low at USD 12,669, 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 thePolitical Environment' building blocks.

Governance (G) Factors

The following Governance factors had a significant effect on the credit analysis: Institutional Strength, Governance and Transparency. The following Governance factors had a relevant effect on the credit analysis: Bribery, Corruption, and Political Risks and Peace and Security. 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' andPolitical Environment' building blocks.

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

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (August 13, 2024) https://dbrs.morningstar.com/research/437781

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/442670.

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 (July 15, 2024) https://dbrs.morningstar.com/research/436000. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/437781 in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS' outlooks and credit ratings are monitored.

The primary sources of information used for these credit ratings include Ministry of Finance, People's Bank of China, Bank of International Settlements, International Monetary Fund, World Bank, UN, and Macrobond..

Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings was of satisfactory quality.

The credit rating was not initiated at the request of the rated entity.

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

Morningstar DBRS did not have access to the accounts, management and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is an unsolicited credit rating.

The last credit rating action on this issuer took place on November 09, 2023.

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