Scope affirms China’s credit rating at A+ and revises the Outlook to Negative
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 revised the Outlook to Negative. The agency has also affirmed the short-term issuer rating at S-1+ in both local and foreign currency and revised the Outlook to Negative.
The revision of the Outlook to Negative from Stable on China’s A+ sovereign ratings reflects the following two drivers:
Significant public-sector deficits despite recent consolidation initiatives as well as a growing public-sector debt stock; and
- High levels of total non-financial sector debt, after increases since 2008. Although the trajectory has been improved via significant efforts on the part of the authorities, ongoing economic slowdown pressures, including those related to escalating trade conflicts with the United States, may pressure targeted policy easing and exacerbate pre-existing macroeconomic imbalances.
The assignment of a Negative Outlook reflects changes in Scope’s assessments in the ‘public finance risk’ and ‘domestic economic risk’ categories of its sovereign methodology. Going forward, Scope’s ongoing assessment will hinge on the interplay between conflicting forces on policy makers to: i) maintain, if not accelerate, significant economic reforms to redress macro-financial imbalances and those concurrently to ii) ease policy and delay reforms so as to counteract a slowing economy. The resolution of this underlying tension is fundamental to China’s public- and private-sector debt trajectories going forward and will be decisive in Scope’s decisions on China’s ratings.
The affirmation of China’s rating at the A+ level reflects the economy’s significant 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 when dealing with longer-standing as well as new economic challenges.
China has the second largest economy in the world with a nominal GDP of USD 12.0trn in 2017 and a macroeconomic track record that has seen the transformation of its economy since market-oriented reforms began in 1978. China’s ratings are also underpinned by the economy’s tested resilience in the face of various financial crises. Important supervisory and regulatory actions have been taken to contain material financial sector risks. The government’s commitment and ability to reform represent a significant credit strength, in Scope’s view.
The first driver of Scope’s decision to assign a Negative Outlook is China’s outsized budget deficit despite recent consolidation initiatives, and its growing public-sector debt stock. Excluding certain transfers to the general budget from a budget stabilisation fund, China’s general government deficit was relatively unchanged at 3.8% of GDP in 2017, the same level as in 2016, but significantly up on 1.8% of GDP as of 2014. While there is evidence of some redressal of the deficit in 2018 data year-to-date, compared with 2017 figures, Scope expects the general government deficit in 2018 to nonetheless again exceed 3% of GDP (before stabilisation fund transfers). The ongoing slowdown in the economy could moreover trigger selective easing, stressing the deficit.
In addition, 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 10.8% of GDP in 2017, an increase on an augmented deficit of 10.4% of GDP in 2016 and 7.2% of GDP as of 2014. The Chinese 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 the augmented measure in its rating assessment due to the lack of clarity on the extent to which liabilities may migrate to the general government balance sheet in a stressed scenario.
Under a narrower definition, China’s general government debt totalled 36.9% of GDP in 2017. Given continued primary deficits over the medium term, offset partly by a highly favourable growth-interest rate differential, China’s debt ratio under the general government definition is projected to rise only gradually to 43.2% of GDP by 2023. However, including the debt of LGFVs and other off-budget entities, the IMF’s estimate of the government’s ‘augmented debt’ stood at 67.5% of GDP in 2017 (of which central government debt accounted for only 16.6% of GDP, however). Augmented debt is projected to rise more significantly to 91.6% of GDP by 2023, according to the IMF. In view of rising debt ratios even under conditions of a global economic expansion, Scope notes more significant risks to the debt trajectory in the event of a future global economic downturn.
Risks stemming from high economy-wide debt are the second driver of the Negative Outlook. Non-financial sector debt has plateaued at about the 256% of GDP level as of Q4 2017 since the end of 2016, according to data from the Bank for International Settlements, but not before the sharp increase from 141% of GDP as of Q4 2008. Significant supervisory and regulatory actions are being taken to address economy-wide debt risks. Corporate debt dipped to 160% of GDP in Q4 2017, from 167% of GDP at a Q2 2016 peak (with much of this tied to the state-owned enterprise sector). The tightening in financial conditions has sharply cut intra-financial sector credit to -6.0% YoY in August, from over 70% YoY in early 2016, including by virtue of supervisory actions against shadow banks and asset management vehicles. However, deleveraging in some sectors has been offset by rising debt in others – notably in the general government sector and the household sector, the latter having seen debt ratios increase rapidly to 48% of GDP in 2017, from a low base of 18% of GDP as of 2008. In Scope’s view, rising leverage risks are closely related to high, unsustainable economic growth objectives. Continued actions to counteract leverage risks and further steps away from ‘hard’ growth targets could, for instance, contribute to a stabilisation of the rating outlook.
Risks to China’s policy setting have also increased owing to the escalation of trade conflicts with the United States, begun by the US administration on the grounds of China’s surplus with the US. 25% tariffs on USD 50bn of one another’s goods have been followed with the US administration’s announcement of further 10% tariffs on an additional USD 200bn of China’s goods (which are seen being stepped up to 25% starting on 1 January 2019), alongside the threat of tariffs on all remaining Chinese goods exports. China has announced additional tariffs of up to 10% on another USD 60bn of US exports in retaliation. Escalating tariffs and investment restrictions could disrupt supply chains and represent a risk, especially if accompanied by continued market stresses. Moreover, Scope notes its concern that a more significant economic slowdown expedited by trade conflicts could lead to policy easing by China – potentially exacerbating existing macroeconomic imbalances.
Scope is mindful of China’s current account dynamics and weakened level of international reserves. China’s current account has declined in line with the rebalancing of the economy and edged into a deficit of 0.3% of GDP seasonally-adjusted in the first two quarters of 2018 – after a peak surplus of 9.9% of GDP in 2007. While reductions in China’s current account support global rebalancing and reduce global risks, they nonetheless represent a risk to China’s external strengths. However, recent improvements in net foreign direct investment flows offset this to an extent – the current account balance plus net foreign direct investment stood at 1.5% of GDP in the rolling four quarters to Q2 2018, roughly unchanged compared to the four quarters to Q2 2017. Despite disputes with the United States, Scope notes that China has championed greater trade openness and multilateralism, including the continued lowering of tariffs on consumer goods and autos and increasing of imports.
China’s foreign-exchange reserves stood at a total of USD 3.11trn in August, modestly down on a January 2018 peak. China’s reserve stock, however, while still accounting for 27% of all global forex reserves, remains materially lower compared to a peak of USD 4trn in June 2014. While China’s still-sizeable arsenal of reserves remains a significant credit strength, the lower outstanding level, alongside possible further drops in the future should capital outflow pressures return, weakens resilience.
China’s ratings benefit from the increased use of the renminbi in global markets, enhancing external resilience. The internationalisation of the renminbi has seen its inclusion in the IMF’s Special Drawing Rights basket of currencies since October 2016 and the establishment of a new renminbi-denominated Shanghai oil futures market in March 2018, challenging the post-war order. The share of yuan claims in total global forex reserves stood at 1.4% in Q1 2018, up modestly 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, as also evidenced by low external debt of 14% of GDP.
Real growth increased to 6.9% in 2017, up from 6.7% in 2016 (but below a peak of 10.6% in 2010). Scope expects the economy to slow in 2018 but nonetheless meet the government’s 2018 growth target of around 6.5%. Looking ahead, growth will remain robust, although Scope expects the growth rate to fall gradually. Given the use of stimulus in recent years to meet economic targets, the chance remains that the government will maintain adequate macroeconomic accommodation in the face of slowdown pressures in order to ensure that economic growth objectives are met, even as China prudently shifts priorities towards the quality rather than quantity of growth. Scope views elevated, above-potential economic growth necessitating credit and investment as credit negative, as the agency estimates that China’s potential growth is easing lower towards 5% over the medium term.
In March 2018, the reform to repeal the constitutional term limit on the President (a barrier set in place by China’s 1982 Constitution) will technically allow President Xi Jinping to remain in office for the foreseeable future (beyond 2023). Power consolidation could allow a unified leadership to push ahead with critical reforms which have been resisted by vested interests, including measures to expand productivity-enhancing transformations, a move away from ‘hard’ GDP growth targets, and measures to boost deleveraging and crack down on China’s financial sector. Indeed, such reforms are critical to economic stability, constituting an important credit-positive element affecting the near- to medium-term outlook in those areas in which they have been accelerated. However, Scope’s view is that significant power consolidation, even if it bolsters reforms in the near term, has credit-negative implications over the long run, 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.
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 ‘BBB’ (‘bbb’) 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) economic policy framework; iii) market access and funding sources; iv) external debt sustainability; v) vulnerability to short-term external shocks; vi) recent events and policy decisions; and vii) banking sector oversight and governance. Relative credit weaknesses are signalled for: i) debt sustainability; and ii) financial imbalances and financial fragility.
The combined relative credit strengths and weaknesses generate a three-notch adjustment and signal a sovereign rating of A for China. The lead analyst has recommended an additional one-notch adjustment of the indicated rating to A+ in order to take into account the size and resilience of the Chinese economy, and the capacity to reform owing to the governance structure. A rating committee has discussed and confirmed these results.
For further details, please see Appendix II of the rating report.
Factoring of Environment, Social and Governance (ESG)
Scope considers environmental, social and governance issues during the rating process as reflected in its sovereign methodology. China’s performance on ESG parameters has improved. Governance-related factors are explicitly captured in Scope’s assessment of ‘Institutional and Political Risk’ in its methodology, in which China has routinely scored weakly in terms of the World Bank’s Worldwide Governance Indicators. However, China’s scores on several indicators have improved – including on the Rule of Law, Government Effectiveness and the Control of Corruption. Qualitative governance-related assessments reflect Scope’s QS evaluation of ‘recent events and policy decisions’ as ‘good’ and ‘geo-political risk’ as ‘neutral’ compared with China’s sovereign peers. Scope notes that while the significant consolidation of power may bolster reforms in the near term, it has credit-negative implications over the long run.
Socially-related factors are captured in Scope’s CVS via China’s middle-income economy (GDP per capita of USD 8,643 as of 2017). 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 increasing. Significant social progress has been achieved, including the lifting of over 800 million citizens out of absolute poverty and improvements in education and health. In addition, there have been positive policy shifts towards a greater focus on the quality of economic growth and citizens’ lives, including priorities on boosting social safety nets and reducing income inequality. These social considerations are considered favourably in Scope’s QS evaluation 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 CO2, however meaningful progress is also being made in cutting the carbon intensity of the economy. 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.
Outlook and rating-change drivers
The Negative Outlook represents Scope’s concern over debt risks and macro-economic imbalances. Scope awaits greater clarity on the direction and extent of further reforms given challenges, while acknowledging the continued capacity and willingness of the Chinese authorities to enact significant reforms.
The ratings/outlooks could be downgraded if, individually or collectively: i) fiscal deficits remain large and public-sector debt ratios continue to increase, raising economic risks; ii) non-financial sector debt ratios resume a rising path, threatening financial stability; and/or iii) renewed capital outflows take hold, and/or China’s current account weakens more than anticipated, cutting China’s reserves and external resilience.
Conversely, the outlooks could be stabilised if: i) economic and financial reforms accelerate significantly, including continued 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 global reserve currency.
The main points discussed by the rating committee were: i) China’s capacity to reform; ii) rating level vs current CVS score on China; iii) non-financial debt dynamics; iv) general government debt dynamics; v) trade conflicts with the United States and implications for the economy; vi) China’s areas of economic strength and resilience; vii) QS adjustments and analyst adjustment; viii) peers considerations.
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.
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Rating prepared by Dennis Shen, Associate Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director, Public Finance
The ratings/outlook were first assigned by Scope as a subscription rating in January 2003. The ratings/outlooks were last updated on 29.09.2017.
The senior unsecured debt ratings as well as the short-term issuer ratings were last updated by Scope on 29.09.2017.
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 the issuance of the rating, 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.
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.
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