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 R1 (middle). The trend on all ratings have been revised to Stable from Negative.
KEY RATING CONSIDERATIONS
The return to a Stable trend reflects DBRS Morningstar’s view of the willingness, capacity and relative effectiveness of the Chinese authorities to manage risks associated with moderately rising leverage, trade tensions and more recently managing the economy through the turbulence caused by the COVID-19 pandemic. DBRS Morningstar considers 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.
China’s effectiveness in containing COVID-19 and its stimulus is enabling China to return to its pre-virus levels far earlier than any other major economy with the IMF estimating real GDP growth at 1.8% in 2020 and 8.3% in 2021. Although China is likely to be the only major economy with an expansion in its 2020 GDP, lower growth and higher deficits will result in China’s public debt ratio rising from 52.6% in 2019 to 61.7% in 2020. DBRS Morningstar considers however that unlike the stimulus following the 2008 global financial crisis which resulted in a rapid expansion of credit (up 33% YoY), loan growth has been measured increasing from 11.9% in January to 13.7% in October. Moreover, financing has shifted away from shadow lending with capital market financing and loans being the major components. On the external front, despite a fairly smooth review of the Phase One trade deal in September 2020, tensions on U.S.-China relations remain elevated in the technological, financial, and geopolitical front. Nonetheless, DBRS Morningstar expects China’s extensive buffers to be sufficient to cushion itself from shocks. These buffers include its moderate public debt, high domestic savings, low inflation, and high foreign exchange reserves.
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 14.3 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 remains the need to shift its growth model from an over-reliance of credit intensive investment towards domestic consumption and services. 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.
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.
China Emerges Strongly From the Pandemic, But Underlying Challenges Remain
China was the first epicenter of the COVID-19 pandemic in January 2020, and is also among the first to control the spread of the pandemic. That said, the pandemic, containment measures, and a disruption in supply chains led to a severe downturn in economic activity with Q1 GDP contracting -6.9% YoY, the most severe downturn since the end of the Cultural Revolution in 1976. The Chinese economy has staged an impressive comeback since mid-March. The containment of the virus, stimulus measures, and the subsequent opening up of the economy have led to a surge in pent up demand and catch-up in production with GDP growth in the second and third quarter of 2020 rising 3.2% YoY and 4.9% YoY.
While high frequency data indicates that recovery is currently progressing well, the outlook remains uncertain. Although activities such as domestic tourism, have returned to normal, consumption continues to lag behind production. Public sector investments are likely to remain strong, but private sector investments are dependent on the global investment climate and the possibility of supply chain diversification. Exports have held up due to increased demand for medical supplies and computer hardware, but the trade outlook is clouded by considerable uncertainty on the severity and duration of the global recession. Despite this uncertainty, China is outperforming expectations in terms of the speed and extent of the recovery and will be one of the few countries with a positive headline GDP growth number for 2020. The IMF’s October WEO estimates growth at 1.8% in 2020 and 8.2% in 2021.
Chinese policymakers implemented several measures to mitigate the impact of COVID-19, but its policy response has been gradual and responsive. For the first time in its history, China abandoned numeric growth targets and emphasized stable labor market conditions and other social objectives. In addition to increased spending on containing the pandemic and producing medical equipment, China's fiscal package estimated at RMB 4.6 trillion (4.5% of GDP, IMF estimates) includes support for affected corporates (tax reductions and regulatory forbearance) and public investment (infrastructure, 5G and economic digitalization, and public health). On the monetary policy front, the People’s Bank of China (PBOC) has provided substantial monetary accommodation via open market operations, reserve ratio reductions, and interest rate cuts.
While China’s recovery following the pandemic is advancing, growth remains unbalanced. Much of China’s growth over the past decade has been 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 towards domestic consumption and services. 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 construction and manufacturing. However, China still has the highest investment to GDP ratio (44% of GDP) among large economies. Further, as the IMF has pointed out, policy efforts to strengthen the social safety net and reduce income inequality are needed to reduce savings further and boost consumption.
Following the rebound in growth to 8.2% in 2021, the IMF estimates growth to average 5.7% during 2022-25 – among the highest growth rates in the world. While there are downside risks, stemming from rising financial vulnerabilities and the increasingly challenging external environment, with GDP at USD 14.4 trillion, China is the second largest economy. Moreover, it is the world’s largest merchandise trader, and contributes to one-third of global growth. Decades of income growth have created one of the largest consumer markets in the world. As a result, DBRS Morningstar applies a positive adjustment from the qualitative factors to reflect China’s growth prospects and balance of risks in the Economic Structure and Performance building block.
Targeted Expansionary Fiscal Policy Supports the Economy, and Public Debt Remains Domestically Financed
In contrast to 2008’s massive infrastructure stimulus plan following the global financial crisis, authorities’ response to the pandemic has been cautious and targeted at stress relief and liquidity provision to the corporate sector. Chinese authorities have so far announced a series of discretionary fiscal measures aimed at supporting employment and helping businesses, particularly medium and small enterprises (MSMEs), affected by the pandemic. Fiscal support from the central and local governments include additional healthcare spending, accelerated disbursement of unemployment insurance and its extension to migrant workers, tax relief and waiver of social security contributions, wage subsidies, and financial guarantees for SMEs.
As a result of the COVID stimulus, the government increased its 2020 budgetary deficit target to 3.6% of GDP (RMB 3.76 trillion) in May, up from 2019’s target of 2.8%. Beyond the budget deficit, the government also issued special COVID-19 government bonds (totaling RMB 1 trillion) and increased the quota of special local government bonds (to RMB 3.75 trillion, 3.6% of GDP), to be transferred directly to local government. The State Council also increased re-lending and re-discounting quotas for small and medium banks to support SME lending. Consequently, the IMF’s latest October 2020 estimates the general government deficit (which includes social security, SOE, and land sales-related transactions) rising to 11.8% in 2020 from 6.3% in 2019. The IMF’s secondary, broader measure of the fiscal deficit (the augmented deficit, which includes off-budget items financed by local government financing vehicles (LGFVs), special construction funds, and government-guided funds) is now expected to exceed 15% of GDP, up from a 2016-2019 average of 11.3%. Risks associated with these quasi-fiscal activities contribute to a negative adjustment to our 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 rising to 61.7% of GDP in 2020 from 52.6% in 2019. This includes central government debt, explicit local government debt and some of the explicit liabilities to local government financing vehicles (LGFVs). While 2020 estimates are currently available, the IMF, under its definition of ‘augmented debt’ (which includes explicit and implicit off-budget liabilities to LGFVs), had estimated debt at 80.2% in 2019. However, this augmented ratio perhaps overstates public debt, as guarantees do not always wind up on the public balance sheet. Less than one-fifth of guaranteed debt was repaid by fiscal capital in each year since 2007. Nonetheless, despite the 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.
Credit Growth Is Measured But Overall Leverage Levels to Rise
On the monetary front, in light of the economic slowdown caused by trade tensions and coronavirus-related shutdowns, authorities have shifted course from deleveraging the economy to supporting growth. In its H2 2020 policy outlook and in line with the Politburo policy statement, the PBOC has emphasized that the monetary policy will continue to be more flexible and precisely targeted. In addition to liquidity injection via open market operations, reduction in interest rates and targeted reserve ratio requirements (RRR) cuts, the PBOC has also taken several steps to limit tightening in financial conditions and prevent systemic risks.
However, unlike the 2008 stimulus, overall total social financing (TSF) growth (consisting of bank loans, shadow credit, and capital market financing) has been measured, rising 13.7% in October from 10.7% in January. Despite the pause in deleveraging, financing has shifted away from shadow lending to capital market financing and bank credit. The contraction in the stock of shadow loans seen since June 2018 continued in October down 2.8%, while bank credit rose from 11.9% in January to 13.3% in October. Increased lending has primarily been channeled to public health infrastructure, 5G and economic digitalization. Growth in capital market instruments continues with the stock of corporate bonds and equity financing rising 18.1% YoY.
While the response measures have been more moderate relative to the stimulus post-global financial crisis, the sharp fall in nominal GDP has resulted in domestic debt levels are rising across all sectors. The BIS’s measure of gross debt (general government, households and corporates) to GDP ratio rising from 142.5% in 2007 to 258.7% in 2019, but that figure rose to 274.4% in the first quarter of 2020. The buildup in debt represents a key risk on the asset side of banks’ balance sheet, particularly as the central bank eases support measures. While official estimates of NPLs and special-mention loans are at 5.5% of GDP, private sector estimates are significantly higher. Corporate bond defaults have been rising over the past three years and may increase if the PBOC rolls back financial support and refinancing becomes more costly and as bonds approach maturity at the end of the year. Risks within the real estate sector are also rising: the liquidity crunch facing China’s largest property developer Evergrande Group is emblematic of the problems within the sector. Real estate and construction account for a quarter of fixed asset investment, 20% of banks loans and 15% of GDP.
The government’s implicit support to the property sector, and to the financial system as a whole, could once again test China’s willingness to backstop the financial system. Recent bailouts by central and regional authorities in 2019 clearly demonstrate that the PBOC and the CCP leadership remain committed to ensuring stability. So far, authorities have successfully contained isolated bank failures and prevented 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. 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.
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. Moreover, the deleveraging and regulatory tightening measures which include supervision of the macroprudential assessment mechanism and tighter regulatory control covering banks, insurance companies, and security firms have resulted in BIS’s credit gap declining from a high of 28.1% in 2Q 2016 to 7.5% in 1Q 2020. DBRS continues to monitor potential capital outflows and property sector developments.
Re-escalation in US-China Tensions, But China’s External Balance Sheet Is Strong
Despite the signing of the Phase 1 trade deal in January 2020 where the U.S. and China agreed to halt additional tariff hikes and China committed to purchase an additional USD 200 billion of goods, U.S.-China relations have remained tense. COVID-19 and U.S. export restrictions on high-tech exports have made it difficult for China to adhere to the purchase commitments. Moreover, the U.S. and China are currently engaged in a multi-faceted and wide-ranging confrontation ranging from intellectual property disputes to human rights. As a result, policymakers in Beijing are shifting their focus from a cyclical stimulus to addressing secular challenges, as the virus could accelerate outward migration of supply chains that was provoked by trade tensions.
Although supply chains in China have proved resilient in the near term, they could go through some reorganization in the medium term. Multinational companies (MNCs) have been revisiting their China strategy in light of rising trade tensions and higher costs, with a greater emphasis on supply chain resiliency rather than efficiency. A total outward migration of supply chains is unlikely though, given the availability of labor and large domestic market access within China. Earlier this year, the government announced a renewed emphasis on reducing reliance on both external supply and demand. The new focus also known as the ‘dual circulation theory’ aims to cut its dependence on overseas markets and technology in its long-term development. Policy makers are attempting to shift investment to advanced manufacturing, increasing domestic capacity for agriculture and energy production, and reducing its dependence to achieve growth sustainability.
While diversification of supply chains coupled with increasing U.S.-China tensions could negatively impact China’s prospects, 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 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. The current account surplus could edge higher in 2020 as China’s economy has been the first to emerge from the pandemic resulting in relatively robust manufacturing and exports. Despite prevailing tariffs and supply-chain diversification concerns, there has been broad-based strength in exports across products and export destinations, while the pandemic has curtailed outward tourism.
China’s relatively strong external balance sheet is reflected in high foreign exchange reserves (USD 3.1 trillion) and low external debt (14.2% of GDP). China remains a net lender to the rest of the world with a net asset position of 15% 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.
Thanks to the opening up of the financial sector leading to more balanced capital flows, coupled with lower economic imbalances on the back of supply-side reform and the ongoing cleanup in the financial sector, RMB internationalization is regaining momentum. Though still low, RMB is the sixth most used currency in the global payments system and the third-most-active currency in trade finance. This could rise in the coming years as ASEAN is now China’s largest trading partner and this has created an opportunity to enhance the use of the RMB in cross-border trade. Given the rising U.S.-China tensions, greater use of the Chinese yuan internationally could remain a priority for Chinese policy makers.
Centralized Political Structure Enabled A Deft Handling of the Pandemic, But Comes With Challenges
China’s centralized political and economic structure has enabled the country to effectively manage the outbreak of the virus and its impact on the economy thus far. One of the strictest lockdowns put in place worldwide, combined with a comprehensive testing and tracing strategy, has kept the virus at bay after the initial wave in China. Subsequent easing of lockdown measures and moderate stimulus measures have resulted in one of the fastest economic recoveries among major economies. More broadly, reforms undertaken over the last few years signal a greater role for market forces in the economy. These reforms 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. DBRS Morningstar applies a positive qualitative factor for China’s capacity to address economic challenges in the “Political Environment” building block.
While the concentration of power at the top of the political structure makes it easier for the government to carry out reforms, removal of checks and balances could exacerbate the risk of policy errors in the future. China’s anti-corruption campaign may have addressed genuine corruption issues, but the results are unclear. Meanwhile, the removal of two-term limits for the State President appear to have cemented the president’s authority and limited competing voices. 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 World Bank Governance Indicators such as “Voice and Accountability.”
Human Capital & Human Rights (S), Bribery, Corruption & Political Risks (G), and Institutional Strength, Governance & Transparency (G) were among key drivers behind this rating action. China’s per capita GDP was relatively low at USD 10,286 in 2019 (USD 16,708 on a PPP basis), lower than other similarly rated peers. According to World Bank Governance Indicators, China ranks in the 43rd percentile for Control of Corruption, the 6th percentile for Voice & Accountability, the 45th percentile for Rule of Law, and the 72nd percentile for Government Effectiveness. These considerations have been taken into account within the following Building Blocks: Fiscal Management and Policy, Economic Structure and Performance, and Political Environment.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/370015.
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 (July 27, 2020).
For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.
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.
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