Rating action

Scope Ratings GmbH (Scope) has today affirmed the People’s Republic of China’s A+ long-term issuer and senior unsecured local- and foreign-currency ratings along with the short-term issuer ratings at S-1+ in both local and foreign currency. All Outlooks are revised to Negative from Stable.

Summary and Outlook

The revision of the Outlook to Negative on the People’s Republic of China’s A+ sovereign credit ratings reflects i) the significant structural public sector deficits and the steepening of the medium term debt trajectory, and ii) China’s challenge, and associated risks, of achieving sustainable economic growth without exacerbating its large financial imbalances, including high levels of non-financial sector debt. Authorities have introduced appropriate policies to begin to address financial imbalances and reduce leverage across crucial economic sectors of the economy, including the real estate sector. As expected, such structural reforms are contributing to an economic slowdown and a correction in the housing market. However, the recently worsening economic outlook puts increasing pressure on China’s public finances, while risking to slow reform momentum. In its efforts to engineer a ‘soft landing’, the government faces a difficult balancing act of deleveraging the economy, while maintaining politically acceptable levels of economic growth, without a rapid deterioration in public finances.

Despite these rising challenges, China retains considerable credit strengths including its i) large and diversified economy and high growth potential compared with similarly rated peer countries; ii) strong external resilience underpinned by high foreign exchange reserves and low external debt; and iii) the central government’s unique scope to facilitate effective reforms and influence economic and financial stability.

The Negative Outlook reflects Scope’s view that risks to the ratings over the next 12 to 18 months are tilted to the downside. The ratings/Outlooks could be downgraded if, individually or collectively: i) a financial or economic shock materialised, impairing economic growth over the medium term; ii) a protracted fiscal deterioration and/or crystallisation of contingent liabilities resulted in a weakened fiscal outlook and continued rise in the debt trajectory beyond Scope’s baseline; and/or iii) China’s external resilience weakened materially.

Conversely, the rating/Outlook could be upgraded, or the Outlook revised to Stable if, individually or collectively: i) China’s public finances strengthened, resulting in an improvement of the public debt trajectory; ii) economic and financial reforms strengthened financial stability and/or the sustainability of the economic growth outlook; and/or iii) the renminbi made substantive gains as a reserve currency.

Rating rationale

The first driver underpinning Scope’s decision to revise the Outlook to Negative on the People’s Republic of China’s A+ ratings is the country’s large public sector deficits and rising public debt. Debt levels were on a rising trajectory already in the decade before the pandemic. Under a narrow definition, China’s general government debt increased from 34% of GDP in 2010 to 57% in 2019. The fiscal stimulus in response to the pandemic raised debt levels to 73% of GDP in 2021 and Scope expects debt to reach around 93% of GDP by 2026, reflecting a steepening debt trajectory. Under the IMF’s¹ broader definition, which includes local government financing vehicles (LGFVs) and other off-balance-sheet entities, debt levels and the expected debt trajectory have also been significantly revised up in recent months. The government’s ‘augmented debt’ stood at 95.7% of GDP in 2020 and is now expected to reach 129% by 2026, significantly above sovereign peers with similar wealth levels.

Measures to support the economy at the onset of the pandemic resulted in a large increase in budget deficits, reaching 10.7% of GDP in 2020. Fiscal policy became more contractionary in early 2021 as policymakers shifted focus towards deleveraging. While some targeted fiscal support remained, including for small firms, the deficit decreased to 6% in 2021 driven by lower levels of public investment. In light of a slowing economy, Scope expects fiscal policy to be more expansionary this year as nationwide tax and fee cuts raise the deficit to 7.7%. The IMF’s augmented net lending/borrowing metric for China aims to account for infrastructure spending, financed through off-balance-sheet LGFVs, special construction funds and government guided debt issuance. According to this measure, China’s fiscal deficit stood at 16.5% of GDP in 2021, down from 19.9% in 2020. The augmented deficit is only gradually expected to fall towards 13% of GDP by 2026.

In addition, Scope also expects significant central government transfers to local governments over the coming years, further impacting the fiscal outlook. Specifically, as the authorities have implemented new restrictions on off-balance sheet financing channels to reduce the high levels of leverage taken on by LGFVs, the recent real estate market downturn places local governments in greater financial difficulty due to the expected drop in land sale revenue. To soften the impact, the central government plans to make large transfers to local governments, estimated at RMB 9.8tn for 2022 or about 8.5% of GDP (up 18% from 2021). Moreover, repayment pressures for LGFVs are likely to increase as a significant part of their debt (around RMB 15tn) will mature over the next three years. Scope expects local and regional governments to continue supporting most LGFVs, although official support may be increasingly selective. Overall, the high and rising fiscal deficits and debt levels, particularly under a wider definition which includes the local and regional government finances, are likely to deteriorate further over the medium-term, underpinning Scope’s decision to revise the Outlook to Negative.

The second driver underpinning Scope’s decision to revise the Outlook to Negative reflects China’s challenge, and associated risks, of achieving sustainable economic growth without exacerbating its large financial imbalances, including high levels of non-financial sector debt. After a strong rebound following the initial phase of the Covid-19 pandemic, the economy lost some momentum in the second half of 2021, mostly on the back of declining real estate investments given the introduction of policy measures aimed at deleveraging the real estate sector. Several outbreaks of the Omicron Covid-19 variant in early 2022 and the continued implementation of the zero-Covid policy led to a further slowdown. Consumption weakened as reflected by an 11% drop in retail sales in April compared with the previous year and industrial production decreased by 2.9%. While this is likely to be short-lived, Scope sees significant challenges in reaching this year’s 5.5% growth rate target set by authorities and expects slower growth of around 4.2% in 2022, slightly below the medium-term growth potential of around 5%.

Still, the challenges of achieving these growth targets and simultaneously deleveraging the economy, and the real estate sector in particular, are significant. At the end of 2021, debt levels of households and non-financial corporations stood at 221%, which remains far higher than in the United States (68%), the euro area (112%) and in other advanced economies (142%). After continued increases in private debt since the 2008 financial crisis, debt levels began to stabilise in mid-2020 at around 62% of GDP for households and 160% for non-financial corporates.

In this context, credit developments in the real estate sector led the authorities to enhance financial sector discipline, transparency and market-based price dynamics in their pursuit of a soft landing for China’s large-scale debt accrual since the global financial crisis. At the same time, authorities also aim to reign in local government spending through the use of off-balance-sheet financing. The three red lines policy was introduced in 2020 in order to restrict real estate developers’ access to credit based on their liabilities, debt levels and cash holdings. In addition, property lending concentration rules for banks and local-level initiatives to restrict new mortgage approvals were introduced. The broad regulatory campaign triggered financial stress in several property developers, among which the most prominent property developers Evergrande Group and Sunac, which faced severe liquidity stress and ultimately defaulted.

Amid sharply falling real estate prices in early 2022, the authorities will need to carefully balance risks to avoid a more severe and continuous spillover of risks across the large and interconnected real estate sector. Aggregate social financing, a broad measure of credit and liquidity in the economy, rose by 8.8% YoY in April 2022 – reduced from August 2020 highs of 12.6%, reflecting efforts from authorities to reduce credit growth. Now, given the economic slowdown caused by Covid-19 restrictions, the central bank has slowed the reform momentum and called for increased credit lending, particularly to support small businesses, green projects, technology innovation, energy supply and infrastructure. It also called for the stable growth of property loans to help cushion the slump in real estate markets. Credit growth is thus likely to increase again over H2 2022, and while this is likely to support the slowing economy, it could also adversely impact the banking sector over the medium-term. The banking sector maintained stable Tier 1 capital levels around 12% throughout the pandemic and reported non-performing loans have also remained low at less than 2%, consistently staying below the peer group average.

Finally, the transition towards a more sustainable growth path remains a crucial policy objective and poses a major challenge for authorities as there remains significant risk of policy mistakes. Even if the power consolidation achieved by President Xi Jinping should bolster reform momentum in the near term, it has credit-negative implications in the longer run. Scope believes it may undermine the delicate collective leadership structure underpinning China’s decade-long economic miracle and also reduce the quality of governance and policymaking in the long term.

Despite these challenges, the People’s Republic of China retains considerable credit strengths.

First, China’s A+ ratings are supported by its large and diversified economy and a strong growth potential when compared with peers. It has the second highest nominal GDP in the world following several decades of continuous economic growth. The pandemic resulted in a significant slowdown, although China’s economy was among the very few worldwide to still grow in 2020, expanding by 2.2%. Growth rebounded by 8.1% in 2021, driven by increased exports and investments, and easily exceeded the above 6% growth target set by the authorities. After slightly slower economic growth in 2022, Scope expects output to expand near its potential at 5.1% next year. This assumes that appropriate reforms to the zero-Covid policy approach can be implemented to avoid large-scale lockdowns.

Monetary policy has been effective at maintaining inflation rates below 3% over the past years. Despite the escalation of the Russia-Ukraine war, inflationary pressures have remained subdued in recent months compared with peers. CPI inflation reached 2.1% in April 2022, up from 1.5% in March, mostly due to rising food prices and supply bottlenecks amid Covid-19 restrictions. Some monetary policy easing measures have been taken to support the slowing recovery². These include a reduction of banks’ reserve requirements by 25bp and a reduction of the five-year lending rate from 4.6% to 4.45% in May. The reduction of the five-year lending rate should result in lower costs for mortgage borrowers, thereby supporting the slowing real estate market.

The official survey-based urban unemployment rate averaged 5.1% in 2021 and has been increasing in 2022 amid the zero-Covid policy restrictions, reaching 6.1% in April. Supporting the weakening labour market has become an important policy focus and all government departments and regions have been instructed to prioritise measures to help businesses retain jobs³. Scope expects the unemployment rate to average 5.7% this year and fall to 5.6% in 2023.

Second, the A+ ratings are also supported by China’s high external resilience. Resilience to short-term shocks is bolstered by the country’s sizeable foreign exchange reserves, which amounted to USD 3.2trn in March 2022, and its low external debt of USD 2.7trn (16.2% of GDP) as of Q4 2021. Russian sanctions over the Ukraine invasion and hikes in US interest rates have fuelled discussions on a faster reduction of China’s reliance on the US dollar. Anticipated long-run gains by the renminbi as a global reserve currency are expected to increase the government’s capacity to manage higher debt stocks. It would also enhance the currency’s resilience and China’s external-sector stability, such as reducing vulnerabilities to periods of capital outflows.

China’s current account balance improved at the onset of the pandemic, rising from 0.7% in 2019 to 1.7% in 2020 and remaining stable at 1.8% in 2021. This was driven by the increase in trade-in-goods surplus at 3.2% of GDP in 2021, and the declining trade deficit for services that stood at 0.6%. This largely reflects the strong rebound in global trade since the second half of 2020, combined with the sudden collapse in outbound travel spending. Strong overseas demand continued to support exports, which slowed down in early 2022 due to Covid-19 lockdowns, but are still up by 20.7% in the 12 months to April compared with the previous year. Scope expects continued modest current account surpluses of close to 1% in 2022 and 2023, followed by a gradual decline as the effects of the drop in outbound travel and the surge in exports wane, with the economy rebalancing towards consumption-driven growth.

China’s net international investment position has gradually fallen over the past 10 years from 24.5% of GDP in 2010 to 11.4% of GDP in 2021. The decline reflects higher inward direct investment and securities investment received amid relatively robust GDP growth. The net international investment position is expected to remain positive, although declining, over the medium term and above the peer group average. FDI inflows reached an all-time high of USD 334bn (1.8% of GDP) in 2021 as the impact of Covid-19 on GDP growth started to fade and the authorities continued with initiatives to liberalise the economy for foreign firms. However, capital outflows intensified during the first half of 2022 amid renewed Covid-19 restrictions and rising interest rates in other major economies.

Finally, China’s A+ ratings are supported by the country’s tight government control in some sectors, which can facilitate effective structural reform in the near term. This includes significant control over the banking sector and the ability to implement policies to achieve a soft landing by encouraging gradual deleveraging in the private sector. The ability to implement extensive macroprudential policy tools, such as the three red lines policy to moderate lending to real estate firms, reflects the authorities’ extensive powers to steer the economy. The government will continue to face a difficult balancing act of deleveraging the economy without causing a significant weakening in growth prospects or a rapid deterioration in public finances.

Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative rating of ‘a-’ for the People’s Republic of China, after including adjustment for reserve currency under Scope’s methodology. As such, under Scope’s methodology, an ‘a-’ indicative rating can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses against a peer group of countries.

For the People’s Republic of China, the following relative credit strengths via the QS have been identified: i) growth potential of the economy; ii) monetary policy framework; iii) macro-economic stability and sustainability; iv) debt profile and market access; v) current account resilience; vi) external debt structure; vii) resilience to short-term shocks; and viii) banking sector oversight. Conversely, the following relative credit weaknesses have been identified: i) fiscal policy framework; ii) financial imbalances; and iii) environmental risks.

Combined relative credit strengths and weaknesses identified in the QS result in a two-notch positive adjustment and indicate a sovereign credit rating of A+ for the People’s Republic of China.

A rating committee has discussed and confirmed these results.

Factoring of environment, social and governance (ESG)

Scope explicitly factors in ESG sustainability issues during its rating process via the sovereign methodology’s standalone ESG sovereign risk pillar, with a 20% weighting under the quantitative model (CVS) as well as in the methodology’s qualitative overlay (QS).

With respect to environmental risks, the People’s Republic of China receives a low CVS score when compared with peers. While it has slightly more positive scores for natural disaster risks and the ecological footprint of consumption compared with available biocapacity, it receives a particularly low ranking for having high carbon emissions per GDP. China is the world’s largest emitter of carbon dioxide, accounting for around 28% of global CO2 emissions. However, meaningful progress is being made in cutting the carbon intensity of the economy, with China striving to stop the growth in emissions by 2030⁴. The 14th five-year plan set specific targets regarding the energy system and green development, which are broadly in line with China’s current climate commitments to carbon neutrality by 2060. However, previous commitments to increase the share of non-fossil energy in primary energy consumption are no longer binding. The focus is now on capping carbon intensity per unit of GDP rather than capping the overall level of emissions.

Regarding social risks, the People’s Republic of China scores higher than its peers in the CVS for having a relatively high labour force participation and low old-age dependency ratio. It has the second lowest score among peers due to its high level of income inequality. However, significant social progress has been achieved in recent years, including improvements in poverty, education, and health. Moreover, the five-year plan has shifted towards a greater focus on the quality and efficiency of economic growth and citizens’ lives (including concentrating on GDP per capita), with priorities such as boosting social safety nets, reducing urban-rural inequality and property rights reform. Social safety nets remain inadequate as less than half of urban employees are covered by unemployment insurance, with much lower rates for rural households. According to the World Bank, China’s health expenditures at about 5.3% of GDP remains below other upper middle income countries (5.9%) although the gap has narrowed in recent years. Even though China’s old age dependency ratio is currently healthier than those of advanced economies, the rapidly ageing population will pose challenges for the social security system. The US and other Western nations have repeatedly accused China of human rights violations.

The People’s Republic of China has traditionally scored low on the World Bank’s Worldwide Governance Indicators⁵. The country ranks particularly poorly on the voice and accountability ranking. Scores on other categories such as political stability, regulatory quality, rule of law and control of corruption have improved in recent years. China achieves its highest ranking in the category of government effectiveness given its effective one-party political system. However, while the power consolidation achieved by President Xi Jinping strengthens reform momentum in the near term, Scope believes it may reduce the quality of governance and policymaking in the long term.

For the updated rating report, click here.

Rating Committee
The main points discussed by the rating committee were: i) domestic economic risk, including growth potential and resilience; ii) public finance risks, including debt dynamics; iii) external risks; iv) financial stability risks, including housing market and private sector debt; v) ESG considerations; and vi) peer developments.

Rating driver references
1. IMF, People’s Republic of China: 2021 Article IV Consultation, January 2022
2. People’s Bank of China, Open Market Operations
3. China State Department, Conference on Employment Stabilisation, 7 May 2022
4. National Development and Reform Commission, Action plan for carbon dioxide peaking before 2030, October 2021
5. World Bank, Worldwide Governance Indicators

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings’, 8 October 2021), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party Participation NO
With Access to Internal Documents                              NO
With Access to Management                                        NO
The following substantially material sources of information were used to prepare the Credit Ratings: public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks is/are UK-endorsed.
Lead analyst: Eiko Sievert, Director
Person responsible for approval of the Credit Ratings: Alvise Lennkh, Executive Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 29 September 2017. The Credit Ratings/Outlooks were last updated on 10 December 2021.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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