20/3/2018/Fitch Ratings
Fitch Ratings has affirmed China’s Long-Term Foreign-Currency Issuer Default Rating (IDR) at ‘A+’ with a Stable Outlook.
A full list of rating actions is at the end of this rating action commentary.
KEY RATING DRIVERS
The affirmation of the ratings and Outlook reflects the following key rating drivers:
China’s ratings are supported by the strength of its external finances and track record of delivering stable growth and low inflation. Improved growth momentum over the past year has enabled the authorities to address financial risks through tighter regulations and slower credit growth. These policies have helped to temper further increases in financial imbalances without jeopardising near-term growth objectives. It remains to be seen, however, whether there has been an enduring shift in policy settings in favour of stabilising debt levels over using credit-driven stimulus to meet growth targets. The true test for policy, and the direction of the sovereign rating, will hinge on whether the current bias towards tighter financial regulation endures what Fitch anticipates will be a sequential slowdown in the growth outlook over 2018-2019.
Economic growth in 2017 accelerated for the first time in nearly a decade to 6.9%, from 6.7% a year prior. Consumption trends remained strong, but the key driver was an upturn in external demand. Net exports contributed 0.6pp to overall growth in 2017, compared with negative contributions throughout 2015-16. This permitted the authorities to comfortably meet their annual growth target of “around 6.5%” despite a slowdown in investment spending, whose contribution to overall growth fell to 2.2pp, the lowest level since 2000.
The imposition of tighter financial regulations since early 2017 has prompted a notable deceleration in credit growth. Official measures of aggregate financing growth slowed to 11.2% yoy in February 2018 from 12.8% a year prior, while Fitch’s adjusted measure shows an even sharper deceleration – albeit from a higher base. At the same time, capacity cuts tied to the authorities’ supply-side reforms prompted a sharp rise in producer prices, lifting nominal GDP growth by roughly 3pp last year. As a result, while macro leverage ratios continue to rise on Fitch’s measure, they are doing so more slowly than at any time since 2009.
Fitch forecasts real GDP growth will slow to 6.5% in 2018 and 6.1% in 2019, due to a tighter credit environment, a cooling property sector, and under the assumption that the authorities refrain from additional policy stimulus. Our growth outlook for 2018 is consistent with the target of “around 6.5%” announced at the National People’s Congress (NPC) in March 2018, but our expectation of a sequential deceleration through the end of this decade points to an average growth rate slightly below the targets tied to the authorities’ long-term goal of doubling 2010 GDP and achieving a “moderately prosperous society” by 2021. In addition, trade tensions with the US have clearly risen, posing a downside risk to our baseline outlook. Either of these scenarios could tempt the authorities to fall back on the old growth engines of credit-fuelled investment and policy stimulus, and postpone commitments to stabilise leverage ratios.
External finances remain robust in absolute terms and relative to peers, and are expected to remain so over our rating horizon. The overall balance of payments recorded a surplus in 2017, following two years of deficits, which resulted in foreign reserves stabilising to around USD3.1 trillion as of end-February 2018. This outcome was achieved in large part through the imposition of capital account management measures to contain outflows. At the same time, capital inflows have also rebounded due to a stabilisation in currency expectations and policies aimed at attracting greater foreign participation in China’s domestic capital markets.
Fitch believes a modest resurgence in capital outflows remains a distinct possibility over the coming year, given our view on the pace of US monetary policy tightening, and the potential for a stronger US dollar to put pressure on the Chinese yuan. However, even under this scenario, we expect China’s external finances to remain a salient credit strength vis-a-vis other ‘A’ rated sovereigns due to its large external creditor position on both a sovereign and economy-wide basis, which we estimate at 27.5% of GDP and 25.5% of GDP, respectively.
Public finances remain a neutral rating factor in China’s sovereign rating profile. Fitch estimates gross general government debt (GGGD) was 47.5% of GDP at end-2017, in line with the ‘A’ category median. The agency’s GGGD figures include an additional 11% of GDP in contingent liabilities identified in a 2014 government audit. The authorities have sought to ring fence the direct obligations of the general government through regulatory actions targeting local government financing vehicles, but implicit guarantees remain ubiquitous and expose the sovereign balance sheet to potential shocks. This underscores the formidable challenge the central authorities face in trying to inject harder budget constraints into quasi-fiscal entities without triggering material disruptions to funding markets.
The implication for economic policy from President Xi Jinping’s consolidation of power – which has culminated in the removal of the presidential two-term limit at this year’s NPC – remains uncertain. In the short run, more centralised decision making could speed up difficult supply-side and service-sector reforms. However, faster and more centralised decision making also raises the risk of policy mistakes as China’s economy grows in size and complexity.
China’s levels of income and development remain low compared with peers, even after 40 years of rapid growth since market-oriented reforms began in 1978. Average income is around USD8,518 at market rates, or USD15,500 at purchasing-power parity, well below the ‘A’ medians of USD20,377 and USD32,360, respectively. Standards of governance also lag ‘A’ category peers based on standard international surveys including the World Bank’s Governance Indicators. These fundamental credit weaknesses weigh on the ratings.
SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)
Fitch’s proprietary SRM assigns China a score equivalent to a rating of ‘A+’ on the Long-Term Foreign-Currency (LT FC) IDR scale.
Fitch’s sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:
– External Finances: +1 notch, to reflect strengths in China’s external finances not captured in the SRM, such as its net external creditor status and the size of its foreign reserve holdings.
– Structural Features: -1 notch, to reflect weaknesses in the banking sector for which the average Viability Rating is two categories below the sovereign rating, posing a contingent liability risk for the sovereign balance sheet.
Fitch’s SRM is the agency’s proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch’s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
RATING SENSITIVITIES
The main factors that could lead to negative rating action, individually or collectively, are:
– Policy settings that would result in a further build-up of the economy’s imbalances and vulnerabilities.
– An adverse macroeconomic or financial shock that weakens medium-term growth prospects or negatively affects public finances.
– Sustained capital outflows sufficient to erode China’s external balance sheet strengths, or undermine financial stability.
The main factors that could lead to positive action, individually or collectively, are:
– Greater confidence that the debt problem in the broader economy can be resolved without a material negative impact to growth or financial stability.
– Widespread adoption of the Chinese yuan as a reserve currency.
KEY ASSUMPTIONS
– The ratings assume the continuation of a broadly open global trade and financial order.
– Fitch assumes China’s basic social and political stability is broadly maintained and that regional geopolitical risks do not escalate sharply.
The full list of rating actions is as follows:
Long-Term Foreign-Currency IDR affirmed at ‘A+’; Outlook Stable
Long-Term Local-Currency IDR affirmed at ‘A+’; Outlook Stable
Short-Term Foreign-Currency IDR affirmed at ‘F1+’
Short-Term Local-Currency IDR affirmed at ‘F1+’
Country Ceiling affirmed at ‘A+’
Issue ratings on long-term senior unsecured foreign-currency bonds affirmed at ‘A+’
Issue ratings on long-term senior unsecured local-currency bonds affirmed at ‘A+’
Issue ratings on short-term senior unsecured local-currency bonds affirmed at ‘F1+’