Scope affirms China’s sovereign rating at A+ and maintains the Outlook at Negative
|A large and diversified economy, strong external sector, and capacity to reform support the rating. Rising public and non-financial sector debt and significant policy easing exacerbating long-term imbalances underscore the Negative Outlook.|
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Scope Ratings GmbH has today affirmed the People’s Republic of China's long-term local- and foreign-currency issuer and senior unsecured debt ratings at A+ and maintained the Outlook at Negative. The agency has also affirmed the short-term issuer ratings at S-1+ in both local and foreign currency and maintained the Outlook at Negative.
Summary and Outlook
The affirmation of China’s ratings at A+ is supported by the economy’s significant external resilience underpinned by high foreign-exchange reserves, low external debt and the internationalisation of the renminbi. Moreover, despite the economic slowdown, trend growth within China’s large and diversified economy remains very high compared with that of similarly-rated sovereign peers. The government retains moreover significant scope to facilitate effective reforms and capacity to maintain economic and financial stability when dealing with longer-term as well as new economic challenges.
The maintenance of the Negative Outlook represents Scope’s view that risks to the sovereign ratings are skewed to the downside over the forthcoming 12-18 months, reflecting: 1) significant public-sector deficits as well as a growing public-sector debt stock, exacerbated by fiscal easing adopted to cushion China’s slowing economy; and 2) high and rising levels of total non-financial sector debt since 2008. Although the trajectory of the increase was eased before via significant policymaker efforts, the ongoing economic slowdown and sequential macro-economic threats have pressured additional policy accommodation, leading to renewed rises in non-financial debt.
The ratings could be downgraded if, individually or collectively: i) fiscal deficits remain large and public-sector debt ratios continue to rise, raising near- and longer-term economic risks; ii) non-financial sector debt ratios continue on a significant rising path, threatening financial stability; and/or iii) capital outflows accelerate, and/or China’s current account weakens more than anticipated, cutting China’s reserves and external resilience. Conversely, the rating Outlook could be revised to Stable if: i) economic and financial reforms accelerate significantly, including moves away from ‘hard’ growth targets, improving productivity growth and accelerating economy-wide deleveraging; ii) significant consolidation of the fiscal deficit restrains rising public-sector debt; and/or iii) the renminbi makes substantive gains as a reserve currency.
The Negative Outlook takes into account China’s sizeable budget deficit and growing public-sector debt stock. In response to the Covid-19 virus outbreak as well as over the run of China’s trade dispute with the United States, authorities have responded to threats to economic growth with significant monetary and fiscal loosening. Excluding transfers to the general budget from a budget stabilisation fund, China’s general government deficit increased to about 4.9% of GDP in 2019, from 4.1% in 2018, and compared with 1.8% of GDP as of 2014. In 2020, in the face of the deep economic slowdown expected in H1-2020, Scope expects the general government deficit to rise to around 6% of GDP (before stabilisation fund transfers).
In addition, the IMF calculates an ‘augmented net lending/borrowing’ metric for China, including infrastructure spending financed by off-balance-sheet local government financing vehicle (LGFV) debt. The augmented deficit was estimated by the IMF at a very elevated 12.7% of GDP in 2019, an increase on an augmented deficit of 11.2% of GDP in 2018 and 7.2% of GDP as of 2014. Authorities have taken steps to cut links between local governments and LGFVs and argue that LGFV spending should not be included in general government metrics. However, Scope considers both the augmented and the non-augmented general government net lending/borrowing metrics in its rating assessment to account for liabilities that may migrate to the general government balance sheet under stressed scenarios. While there have been isolated (though rising) examples of LGFVs missing debt payments since 2018, unmet coupon or principal payments were frequently made whole shortly after default events with the support of regional and local governments. Moreover, in Scope’s opinion, the government’s tolerance for allowing a more widespread bankruptcy event in the LGFV sector remains low, owing to the systemic consequences for financial stability and economic development.
Under a narrow definition, China’s general government debt totalled an estimated 40.2% of GDP in 2019. In view of primary deficits expected over the medium term, offset in part by a highly favourable growth-interest rate differential, China’s debt ratio under the general government definition is projected to increase to over 50% of GDP by 2024. However, including the debt of LGFVs and other off-budget entities, the IMF estimates the government’s ‘augmented debt’ stood at an elevated 80.1% of GDP in 2019. Augmented debt is projected to rise to 101.4% of GDP by 2024, according to the IMF. In view of rapidly rising debt ratios even under conditions of global economic expansion, Scope notes significant risks to China’s debt trajectory in the case of a more severe global economic downturn.
Risks also stem from high and rising levels of economy-wide debt. The non-financial sector debt ratio has resumed a rising trajectory since 2019, reaching 261.5% of GDP level as of Q2 2019, according to Bank for International Settlements data. This compares with a much lower 143% of GDP as of Q4 2008. The IMF foresees non-financial sector debt rising to 295% by 2024 from 266% of GDP at end-2019. Significant supervisory and regulatory actions have been taken by the authorities to address debt risks – especially in the corporate and financial sectors. However, Scope notes that China’s economic slowdown has led to significant policy easing by authorities, serving to counteract credit-positive financial reform initiatives being pursued simultaneously and exacerbate debt imbalances. Corporate debt dropped to 154.5% of GDP in Q2 2019, from 163% of GDP at a Q1 2016 peak (with much of this debt tied to state-owned enterprises (SOEs)), representing nonetheless the largest corporate debt stock in nominal terms in the world. However, debt has been rising in the general government and household sectors, with the latter having seen its debt ratio increase to 55% of GDP in Q2 2019, tripling on 18% of GDP as of 2008. Scope views elevated, above-potential economic growth precipitating credit and investment as credit negative, as the agency estimates that China’s potential rate of growth is easing down towards 5% over the medium run.
Real growth slowed to 6.1% in 2019, from 6.7% in 2018 (and from a recent peak at 10.6% in 2010), with 2019 growth representing the weakest annual rate since 1990. Scope expects the economy to slow in 2020 to about 5%, with a sharp economic slowdown foreseen in Q1 this year due to epidemic-linked interruptions to human movement and business operations prior to the beginnings of a potential recovery by Q2. Scope expects a recovery in the annual rate of economic growth to above 6% in 2021, however. The economic slowdown alongside regulatory crackdown on riskier forms of lending have accelerated private sector defaults. Onshore corporate defaults increased to over RMB 137bn in 2019 according to Bloomberg data, surpassing a previous annual record in 2018 of RMB 122bn and after only RMB 27bn in 2017. 2018 and 2019 moreover saw the first major SOE and LGFV defaults on dollar-denominated debt since 1998. Increasing defaults could risk a more systemic re-pricing of risk if not managed carefully – especially under conditions of the state being forced to be more selective in allocating resources for intervention due to already stretched spending priorities. Scope expects NPLs to increase significantly in 2020 (from a low non-performing loan ratio of 1.9% as of end-2019), with corporate defaults to exceed 2019 record amounts, reflecting non-payments from weaker corporate issuers, LGFVs as well as consumer-facing companies damaged by weakened demand due to the economic slowdown. However, bad loan rises will nonetheless be restrained by extraordinary steps taken to delay NPL recognition, offer borrowers forbearance and roll over maturing loans.
Economic risks also surround still unsettled trade disputes with the United States. Mid-January, the US and China signed the “Phase 1” trade deal. The US agreed not to proceed with 15% tariffs on USD 160bn worth of Chinese consumer goods and halved tariffs on USD 120bn of Chinese goods from 15% to 7.5%. However, the 25% tariffs on USD 250bn of Chinese imports remain in force, and additional tariff reductions will be linked to progress in future trade negotiations. In Scope’s view, the slowdown in China’s economy endangers goals of China purchasing an extra USD 200bn of US goods over the next two years – a core condition of the phase-one trade agreement – or may bring additional weakening in the renminbi, which is now trading at around 7 to the dollar. Such events could risk a future re-escalation of trade disputes by an unpredictable US government. While economic disruptions such as the Covid-19 virus outbreak and the trade dispute have weakened China’s growth outlook, their rating implications lie, however, more significantly in the triggering of policy responses that have aggravated long-term macro-financial risks.
China’s A+ ratings are supported by an economy that is the second largest in the world with a nominal GDP of USD 14.1trn in 2019 and a macroeconomic track record that has seen the transformation of its economy since market-oriented reforms began in 1978. China’s ratings are moreover underpinned by the economy’s resilience in the face of various financial crises. Important supervisory and regulatory actions have been taken to contain material financial sector risks; deleveraging has resulted in the size of the banking system being curtailed to its smallest as a share of the economy since 2015. The government’s commitment and ability to reform represent significant credit strengths, in Scope’s view. In addition, while augmented general government debt metrics are high and rising, central government debt – as rated by Scope – stood at only 16.4% of GDP as of Q3 2019 – roughly unchanged in recent years.
Scope is moreover mindful of China’s strong external sector. China’s current account surplus improved to 1.3% of GDP in 2019, from a 2018 balance of 0.4%. Nonetheless, the surplus has weakened in line with a rebalancing of the economy from manufacturing towards services from a peak surplus of 9.9% of GDP in 2007. Despite disputes with the United States, Scope notes that China has championed greater trade openness and multilateralism, including via the continued lowering of tariffs on consumer goods and autos and increasing of imports.
China’s foreign-exchange reserves stood at USD 3.12trn in January, representing a slight increase on an October 2018 trough at USD 3.05trn. China’s reserve stock, however, while still accounting for 26% of all global FX reserves, remains nonetheless weakened compared with a peak at USD 4trn in June 2014. While China’s still-sizeable reserve arsenal remains a significant credit strength, the lower outstanding level, alongside possible future drops should capital outflow pressures accelerate, weakens resilience.
China’s ratings benefit from the increased use of the renminbi in global markets, enhancing external resilience. The share of renminbi claims in total global foreign-exchange reserves stood at 2.0% in Q3 2019, doubling on 1.1% as of Q1 2017. Moreover, China’s still largely closed capital account, with domestic institutions constituting most of the investors in its bond market, increases resilience to global financial shocks, as moreover evidenced by low levels of external debt of 14% of GDP.
Sovereign rating scorecard (CVS) and Qualitative Scorecard (QS)
Scope’s Core Variable Scorecard (CVS), which is based on relative rankings of key sovereign credit fundamentals, signals an indicative ‘A’ (‘a’) rating range for the People’s Republic of China. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis.
For China, the following relative credit strengths are identified: i) growth potential of the economy; ii) market access and funding sources; iii) external debt sustainability; and iv) vulnerability to short-term external shocks. Relative credit weaknesses are signalled for: i) macro-economic stability and sustainability; ii) fiscal policy framework; iii) debt sustainability; iv) banking sector performance; v) financial imbalances and financial fragility; and vi) recent events and policy decisions.
The combined relative credit strengths and weaknesses generate a one-notch upward adjustment and signal a sovereign rating of A+ for China. A rating committee has discussed and confirmed these results.
Factoring of Environment, Social and Governance (ESG)
Scope considers environmental, social and governance issues during the rating process as reflected in its sovereign methodology. Governance-related factors are explicitly captured in Scope’s ‘Institutional and Political Risk’ assessment pillar of its methodology, under which China has traditionally scored weakly on the World Bank’s Worldwide Governance Indicators. The power consolidation achieved by President Xi Jinping, even if it bolsters reform momentum in the near term, has credit-negative implications over the longer run, in Scope’s view, potentially undermining the delicate collective leadership structure underpinning the decades of China’s economic miracle, and reducing the quality of governance and policymaking over the longer term. Qualitative governance-related assessments reflect Scope’s QS evaluation of ‘recent events and policy decisions’ as ‘poor’ and ‘geo-political risk’ as ‘neutral’ compared with China’s ‘a’-sovereign peers.
Socially-related factors are captured in Scope’s CVS via China’s middle-income economic status (GDP per capita of USD 10,099 as of 2019). In addition, the CVS accounts for the comparatively low level of unemployment and a healthier old-age dependency ratio compared with peers – although China’s rapid ageing means challenges are rising. Significant social progress has been achieved, including the lifting of over 850 million citizens out from absolute poverty and significant strides made in education and health. In addition, there have been positive policy shifts toward a greater focus on the quality of economic growth and citizens’ lives, including priorities on boosting social safety nets and reducing income inequality. 2020 milestone objectives include the doubling of GDP and household income compared with 2010 levels to reach a “moderately prosperous society” and the elimination of absolute poverty by 2020. However, the delayed early response to the virus outbreak shows residual gaps in China’s preparedness for major public health crises – as represented in average scores on the 2019 Global Health Security Index. Social considerations are taken into account in Scope’s QS evaluations of China’s ‘growth potential of the economy’, ‘economic policy framework’ and ‘macroeconomic stability and sustainability’.
China’s poor record on environmental issues has improved in recent years. This includes the introduction of the Air Pollution Action Plan, which has helped to dramatically reduce PM2.5 levels in major metropolitan areas. China is the world’s largest emitter of carbon dioxide; however, meaningful progress is also being made in cutting the carbon intensity of the economy with China pledging overall emissions will peak by around 2030. Beijing wants to cut the proportion of coal in its overall energy mix to under 58% by end-2020, from around 70% around a decade before – and prudently seeks one-fifth of its energy needs to be met via non-fossil fuel sources by 2030. In 2017, China launched a nationwide carbon emissions trading system for large industrial users. China’s move towards greener, more sustainable growth is considered during Scope’s rating process.
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Full namePeople's Republic of China