People’s Republic Of China Ratings Lowered To ‘A+/A-1’; Outlook Stable
- China’s prolonged period of strong credit growth has increased its economic and financial risks.
- We are therefore lowering our sovereign credit ratings on China to ‘A+/A-1’ from ‘AA-/A-1+’.
- The stable outlook reflects our view that China will maintain its robust economic performance and improved fiscal performance in the next three to four years.
On Sept. 21, 2017, S&P Global Ratings lowered the long-term sovereign credit ratings on China to ‘A+’ from ‘AA-‘ and the short-term rating to ‘A-1’ from ‘A-1+’. The outlook on the long-term rating is stable. We have also revised our transfer and convertibility risk assessment on China to ‘A+’ from ‘AA-‘.
The downgrade reflects our assessment that a prolonged period of strong credit growth has increased China’s economic and financial risks. Since 2009, claims by depository institutions on the resident nongovernment sector have increased rapidly. The increases have often been above the rate of income growth. Although this credit growth had contributed to strong real GDP growth and higher asset prices, we believe it has also diminished financial stability to some extent.
The recent intensification of government efforts to rein in corporate leverage could stabilize the trend of financial risk in the medium term. However, we foresee that credit growth in the next two to three years will remain at levels that will increase financial risks gradually.
The stable outlook reflects our view that China will maintain robust economic performance over the next three to four years. We expect per capita real GDP growth to stay above 4% annually, even as public investment growth slows further. We also expect the stricter implementation of restrictions on subnational government off-budget borrowing to lead to a declining trend in the fiscal deficits, as measured by changes in general government debt in terms of GDP.
We may raise our ratings on China if credit growth slows significantly and is sustained well below the current rates while maintaining real GDP growth at healthy levels. In this scenario, we believe risks to financial stability and medium-term growth prospects will lessen to lift sovereign credit support.
A downgrade could ensue if we see a higher likelihood that China will ease its efforts to stem growing financial risk and allow credit growth to accelerate to support economic growth. We expect such a trend to weaken the Chinese economy’s resilience to shocks, limit the government’s policy options, and increase the likelihood of a sharper decline in the trend growth rate.
The ratings on China reflect our view of the government’s reform agenda, growth prospects, and strong external metrics. On the other hand, we weigh hese strengths against certain credit factors that are weaker than what is typical for similarly rated peers. For example, China has lower average income, less transparency, and a more restricted flow of information.
Institutional and economic profile: Reforms to budgetary framework and financial sector in progress
- China’s policymaking has helped it to maintain consistently strong economic performances since the late 1970s.
- We project China’s per capita GDP to rise to above US$10,000 by 2019, from a projected US$8,300 for 2017.
The Chinese government is taking steps to bolster its economic and fiscal resilience. We view the government’s anti-corruption campaign as a significant move to improve governance at state agencies, local governments, and state-owned enterprises (SOEs). Over time, this could translate into greater confidence in the rule of law, improvements in the private-sector business environment, more efficient resource allocation, and a stronger social contract.
The government continues to make significant reforms to its budgetary framework and the financial sector. These changes could yield long-term benefits for China’s economic development. The government also appears to be signaling that it will allow SOEs with lesser policy importance to exit the market either through merger, closure, or default in order to allocate resources more efficiently. More recently, it has also indicated financial stability as a top policy priority and is acting to rein in growth of public sector borrowing. However, we believe some local government financing vehicles, despite their diminishing importance, continue to fund public investment with borrowings that could require government resources to repay in the future.
China’s policymaking has helped it to maintain consistently strong economic performances since the late 1970s. However, coordination issues between the line ministries and the State Council sometimes lead to unpredictable and abrupt policy implementation. The authorities also have yet to develop an effective communication channel with the market to convey policy intent, heightening financial volatility at times. Moreover, China does not benefit from the checks and balances usually coming from the free flow of information. These characteristics can lead to the misallocation of resources and foster discontent over time.
We expect China’s economic growth to remain strong at close to 5.8% or more annually through at least 2020, corresponding to per capita real GDP growth of above 5.4% each year. We also expect credit growth in China to outpace that of nominal GDP over much of this period.
We project China’s per capita GDP to rise to above US$10,000 by 2019, from a projected US$8,300 for 2017, given our assumptions about growth and the continued strength of the renminbi’s real effective exchange rate. Over the next three years, we expect final consumption’s contribution to economic growth to increase. However, we believe the gross domestic investment rate is likely to remain above 40% of GDP.
Flexibility and performance profile: External profile remains key strength
- We expect financial assets held by the public and financial sectors to exceed total external debt by more than 90% of current account receipts (CAR) at the end of 2017. At the same time, we estimate China’s total external assets will exceed its external liabilities by 65% of its CAR.
- In 2017-2020, we project the increase in general government debt in each of these years at 2.8%-4.9% of GDP. We project net general government debt will fall toward 46% of GDP in the period to 2020 and interest cost to government revenue will remain below 5% throughout the forecast horizon.
- We believe China’s monetary policy is largely credible and effective. We believe the liberalization of deposit rates at banks in recent years is an important reform that could further improve monetary transmission in China.
China’s external profile remains a key credit strength despite the recent decline of its foreign exchange reserves. We partly attribute the fall in reserves in 2016 to increased expectations of renminbi depreciation. Consequently, some private sector firms reduced or hedged their dollar debt and exporters kept a greater share of their proceeds in foreign exchange. We also attribute the accommodation of SOE and private-sector demand for foreign exchange as a willingness of officials to diversify China’s external assets away from holdings of U.S. government debt to other investments of the financial and private sectors.
China remains a large external creditor. We expect financial assets held by the public and financial sectors to exceed total external debt by more than 90% of current account receipts (CAR) at the end of 2017. At the same time, we estimate that China’s total external assets will exceed its external liabilities by 65% of its CAR. China’s external liquidity position is equally robust. We expect the country to sustain its current account surplus at more than 2% of GDP in 2017-2020. We project annual gross external financing needs in 2017-2020 to total less than 60% of CAR plus usable reserves.
The increasing global use of the renminbi (RMB) also bolsters China’s external financial resilience. According to the Bank for International Settlements’ (BIS) « Triennial Central Bank Survey, » published 2016, the renminbi was traded in 4% of foreign exchange transactions globally. We therefore assess the RMB as an actively traded currency. Demand for renminbi-denominated assets from both official and private-sector creditors could rise with the inclusion of the renminbi in the IMF’s Special Drawing Rights basket of currencies.
We expect the share of renminbi-denominated official reserves to rise over time. If the renminbi achieves reserve currency status (which we define as more than 3% of aggregated allocated international foreign exchange reserves), it could strengthen external and monetary support for the sovereign ratings. Although the People’s Bank of China (the central bank) does not operate a fully floating foreign exchange regime, it has allowed greater flexibility in the nominal exchange rate over the past decade. Based on estimates from the BIS, the real effective exchange rate has appreciated by close to 10% since the end of 2011. Any future weakness of the renminbi needs to be analyzed in this light.
China is gradually implementing an ambitious fiscal reform to improve fiscal transparency, budgetary planning and execution, and subnational debt management. These reforms could help the government to manage slower growth of fiscal revenue and lower its reliance on revenue from land sales.
In 2017-2020, we expect the Chinese government to keep the reported general government deficit close to, or below, 2.5% of GDP. However, off-balance-sheet borrowing could continue for the next two to three years. This reflects both the financing needs of public works started before 2015 as well as some new projects that the central government is willing to authorize to support growth. Consequently, we project the increase in general government debt in each of these years at 2.8%-4.9% of GDP.
We now include the entire sum of nearly RMB25 trillion (US$3.9 trillion, or approximately 36% of 2015 GDP) of government-related debt from local government financing vehicles in general government debt. We have also included the debts of China Railway Corp. in general government debt. The company was previously the Ministry of Rail but was incorporated as a special industrial enterprise. Bonds issued by the company are held on China banks’ books at a lower capital charge compared with other corporate debt.
We offset these debts to compute net general government debt with fiscal deposits held by the government, net assets of the China Investment Corp. and net assets of the National Council of Social Security Funds. Using this method, we project net general government debt will fall toward 46% of GDP in the period to 2020 and interest cost to government revenue will remain below 5% throughout the forecast horizon. These forecasts in turn follow from our assumptions regarding real growth and ample domestic liquidity keeping financing cost low for the government.
Although the fiscalization of the local government financing vehicles and China Rail Corp. has raised our figure for general government debt, it has simultaneously decreased our estimates for contingent liabilities to the government from this sector. Entities with weak financial metrics owe much of the financing vehicle loans that are being redeemed through government bond issuance. By putting these loans on the government’s balance sheet, the government has significantly reduced the banks’ credit risks, in our view.
We believe China’s monetary policy is largely credible and effective, as demonstrated by its track record of low inflation and its pursuit of financial sector reform. Consumer price index inflation is likely to remain below 3% annually over 2017-2020. Although the central government–through the State Council–has the final say in setting interest rates, we find that the central bank has significant operational independence, especially regarding open-market operations. These operations affect the economy through a largely responsive interbank market and a sizable and fast-expanding domestic bond market. The liberalization of deposit rates at banks in recent years is an important reform that could further improve monetary transmission in China.