Scope Ratings AG has today downgraded the People’s Republic of China's long-term local-currency issuer rating to A+ from AA-, following the release of its revised sovereign rating methodology, and has converted its status from subscription to public. The agency has also assigned a long-term foreign-currency issuer rating of A+, along with a short-term issuer rating of S-1+ in both local and foreign currency. The sovereign’s senior unsecured debt in local and foreign currency was also rated at A+. The Outlooks are Stable.

Rating drivers

The downgrade of China’s long-term sovereign ratings to A+ is driven by weaknesses in the ‘public finance’ and ‘financial stability’ analysis categories under Scope’s revised sovereign rating methodology and reflects Scope’s view that China’s fundamentals are challenged by: i) significant and continued increases in non-financial sector debt since 2008, ii) large public sector deficits and a growing public sector debt stock as well as iii) weaker current account surpluses and international reserve levels. Going forward, a concentration of Scope’s ongoing assessment will focus on the extent to which a continued unfavourable debt trajectory is redressed through the proactive initiatives of authorities.

China maintains significant credit strengths, including strong external resilience vis-à-vis high forex reserves, low external debt and the internationalisation of the renminbi. Moreover, growth within China’s large and diversified economy remains high compared with that of sovereign peers, and the government retains significant scope to facilitate effective reforms and maintain economic and financial stability in the near term.

High and rising economy-wide debt is a primary driver of the rating downgrade. The debt of the non-financial sector rose to 257% of GDP as of Q4 2016, according to data from the Bank for International Settlements, having risen quickly from 141% of GDP as of Q4 2008. Alongside rising general government sector debt stocks, non-financial corporate debt rose sharply to 166% of GDP in 2016 from 96% of GDP in 2008. Increases in corporate leverage moderated over 2016 owing to increased policy attention ahead of October’s party congress. However, household debt has continued to increase rapidly to 44% of GDP in 2016, from 18% of GDP as of 2008. In the latest Article IV, the IMF estimated total non-financial sector debt (which under its definition stood at a lower 236% of GDP at end-2016) to continue its rise to 297% of GDP by 2022. Such significant debt increases over short periods have been associated in the past with growth slowdowns and, frequently, financial crises.

A second driver of the rating downgrade is China’s elevated budget deficit and growing public sector debt. China’s general government deficit increased significantly to 3.8% of GDP in 2016, from a deficit of 1.8% of GDP as of 2014. The higher deficit was driven by slowing revenue growth and an increase in expenditures since 2014 – partly to support economic activity. China’s official deficit statistics, however, exclude specific off-balance sheet activities of local governments. To address this, the IMF calculates an ‘augmented net lending/borrowing’ measure for China, including infrastructure spending financed by off-balance sheet local government financing vehicle (LGFV) debt. This augmented deficit estimate amounted to a significant 10.4% of GDP in 2016, an increase on 7.2% of GDP in 2014.

Under a narrower definition, China’s general government debt totalled 44% of GDP in 2016. However, including the debt of LGFVs and other off-budget entities, the IMF’s estimate of the government’s ‘augmented debt’ stood at 62% of GDP in 2016 (of which central government debt accounts for only 16% of GDP). Given continued primary deficits over the medium term, offset partly by a favourable growth-interest rate differential, China’s debt ratio under the general government definition is projected to rise gradually to 62% of GDP by 2022. However, augmented debt is projected to rise more significantly to 92% of GDP by 2022, according to the IMF.

A third rating driver of the downgrade is weaker current account surpluses and international reserve levels. China’s current account surplus fell to 1.7% of GDP in 2016, from 2.7% of GDP in 2015 (and from a peak surplus of 9.9% of GDP in 2007). In 2017, the current account surplus should further narrow to 1.4% of GDP, before edging gradually lower to 0.4% of GDP by 2022. Capital outflow pressures have moderated in 2017, after persistent pressures from 2014 to 2016. This easing in outflows has been attributed to the tighter enforcement of capital controls, a somewhat stronger growth outlook in 2017 than widely anticipated, and more stable exchange rate expectations amid dollar weakness.

Amid greater stability in the financial account, pressures on China’s foreign-exchange reserves have eased in 2017, standing at a total of USD 3.09trn in August, up from January 2017’s near six-year low of USD 3trn. China’s reserve stock, however, while still accounting for 28% of all global forex reserves, has declined substantively from a peak of USD 4trn (in June 2014), as the PBOC sold dollars aggressively to support the renminbi. While China’s still-sizeable reserves remain a significant credit strength, the lower level alongside possible further future drops weakens resilience.

China maintains significant credit strengths through its large and well-diversified economy (with a nominal GDP of USD 11.2trn in 2016, the second largest in the world). China’s ratings are, in addition, underpinned by a macroeconomic track record that has seen the transformation of China’s economy since market-oriented reforms began in 1978 and the economy’s resilience in the face of various financial crises. Important supervisory and regulatory actions have been taken to contain financial sector risks. The government’s commitment and ability to reform represents a continued credit strength, in Scope’s view.

Real growth slowed to 6.7% in 2016, from 6.9% in 2015 (and a recent peak of 10.6% in 2010), but was in line with the authorities’ 2016 target of 6.5-7.0%. Scope expects the government to meet its 2017 growth target of around 6.5% ‘or higher if possible in practice’. Looking ahead, growth will remain robust, though Scope expects the growth rate to gradually fall. Given the use of stimulus in recent years to meet economic targets, there remains the chance that the government will do enough, by maintaining an adequately expansionary macroeconomic policy, to enable a doubling of 2010 real GDP by 2020 as per objectives. This scenario was incorporated in the IMF’s upwardly revised baseline expectations for average growth over 2018-20 of 6.4%. Such growth rates would be higher than Scope’s estimate for China’s potential growth (which assumes potential growth edging down towards 5% over the medium term), meaning that government objectives necessitate continued support from policy accommodation. Elevated growth in coming years is a key risk due to the consequential requirement for further increases in private and public sector debt.

The ratings benefit from the increased use of the renminbi in global markets, enhancing China’s external resilience. According to the Bank for International Settlements, the renminbi was traded in 4% of global over-the-counter FX turnover in 2016, up from 0.9% in 2010. The internationalisation of the renminbi has, moreover, seen its inclusion in global official reserves; presently, the share of yuan claims in total global FX reserves stands at 1.1%. The renminbi’s greater stability since 2017 and the currency’s inclusion in the IMF’s Special Drawing Rights basket of currencies since October 2016 should support demand for renminbi-denominated assets.

China's twice-a-decade Party Congress next month (opening on 18 October) promises to be a critical moment that will shape the country’s political and economic outlook. With the potential retirement of as many as five of the seven members of the Politburo Standing Committee (China’s top decision-making body), far-reaching changes will come in the makeup of the top brass of the Communist Party. A key area of interest will be whether President Xi Jinping (who will be confirmed in October for a further five years) consolidates greater power. A strengthened leadership could push ahead with critical reforms resisted by vested interests, including measures to expand productivity-enhancing reforms and those to reduce China’s significant debt levels. In Scope’s view, the extent of such economic reform in the period after October would be critical in the determination of China’s future ratings path. However, significant consolidation of power by President Xi would hold credit-negative implications over the long term, in Scope’s view, potentially undermining the delicate collective leadership structure in place for the decades of China’s economic miracle, and reducing the quality of governance and economic policymaking over the longer term.

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: 1) growth potential of the economy, 2) economic policy framework, 3) market access and funding sources, 4) external debt sustainability, 5) low vulnerability to short-term external shocks, and 6) recent events and policy decisions. Relative credit weaknesses are signalled for: 1) macroeconomic stability and imbalances, 2) fiscal performance, 3) debt sustainability, 4) current-account vulnerabilities, and 5) macro-financial vulnerabilities and fragility. The combined relative credit strengths and weaknesses indicate a sovereign rating of A+ for China. A rating committee has discussed and confirmed these results.

For further details, please see Appendix 2 of the rating report.

Outlook and rating-change drivers

The Stable Outlook reflects Scope’s view that risks to the ratings are balanced, as we await greater clarity on policies moving ahead that address escalating debt concerns.

The ratings/outlooks could be downgraded if: i) the trajectory of rising non-financial-sector debt ratios is maintained, threatening financial stability; ii) fiscal deficits remain large and public sector debt ratios continue increasing, raising economic risks; and/or iii) renewed capital outflows take hold, cutting China’s reserves and external resilience.

The ratings/outlooks could be upgraded if: i) economic and financial reforms accelerate significantly, including moves away from ‘hard’ growth targets, improving productivity growth and breaking the current trajectory of rising debt ratios; ii) significant consolidation of the fiscal deficit restrains rising public sector debt; and/or iii) the renminbi makes substantive gains as a global reserve currency.

For the detailed research report, please click HERE.

Rating committee

The main points discussed by the rating committee were: 1) China’s economic outlook and growth potential, 2) fiscal performance and debt sustainability, 3) banking and financial sector performance, 4) fiscal and monetary frameworks, 5) risks from contingent liabilities, 6) recent and upcoming political developments, and 7) peers considerations.

Methodology

The methodology applicable for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on www.scoperatings.com.

The historical default rates used by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default and definitions of rating notations can be found in Scope’s public credit rating methodologies at www.scoperatings.com.

The rating outlook indicates the most likely direction in which a rating may change within the next 12 to 18 months. A rating change is, however, not automatically a certainty.

Regulatory disclosures

This credit rating and/or rating outlook is issued by Scope Ratings AG.
Rating prepared by Dennis Shen, Lead Analyst
Person responsible for approval of the rating: Dr Stefan Bund, Chief Analytical Officer
The ratings/outlook were first assigned by Scope as a subscription rating in January 2003. The subscription ratings/outlooks were last updated on 05.05.2017.
The senior unsecured debt ratings as well as the short-term issuer ratings were assigned by Scope for the first time.

As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on the United Kingdom are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Sovereign Ratings Calendar of 2017" published on 21.07.2017 on www.scoperatings.com). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case, the deviation was due to the recent revision of Scope’s Sovereign Rating Methodology and the subsequent placement of the ratings under review, in order to conclude the review and disclose ratings in a timely manner, as required by Article 10(1) of the CRA Regulation.

Solicitation, key sources and quality of information
The rating was initiated by Scope and was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the ratings process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.
The following material sources of information were used to prepare the credit rating: public domain and third parties. Key sources of information for the rating include: China National Bureau of Statistics, People’s Bank of China, Ministry of Finance of China, IMF, BIS, United Nations and Haver Analytics.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.
Prior to publication, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Conditions of use / exclusion of liability
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