Fitch Affirms China at ‘A+’; Outlook Stable

KEY RATING DRIVERS

Strong Externals, High Leverage: China’s ratings are supported by the country’s robust external finances, a track record of resilient macroeconomic performance, and size as the world’s second-largest economy. The ratings are constrained by fiscal and macro-financial stability risks associated with China’s highly indebted non-government sector, and per capita income and governance scores that fall below those of ‘A’ rated peers.

Omicron Outbreak Hits Growth: Covid-19 control measures adopted to curb an outbreak of the Omicron variant have led to widespread mobility disruptions since mid-March, including an extended lockdown of the commercial hub of Shanghai. The outbreak now appears largely contained, but monthly activity indicators have fallen to their lowest readings since early 2020 and trends in the property sector remain weak. Fitch sees increasing downside risks to its forecast for China’s economy to grow by 4.3% this year, from 8.1% in 2021, given the cautious pace at which restrictions have been eased.

No Imminent Pandemic Policy Changes: Future outbreaks of Covid-19 are likely to be contained more swiftly, in our view, given the ongoing adoption of precautionary mass testing. We therefore forecast activity to recover from 2H22 and for China’s economy to grow by 5.2% in 2023. There is considerable uncertainty over when the authorities may choose to pivot away from their current “dynamic zero Covid” policy strategy. In the absence of official guidance, Fitch assumes this process will not begin until at least 2023, and proceed at a tentative pace.

Fiscal Support Advances: We expect fiscal policy to loosen considerably this year. On a Fitch-consolidated basis, which includes infrastructure spending and other official budgetary activity outside of the headline budget, we forecast the deficit will widen to 7% of GDP in 2022, up from 4.5% in 2021. The government has publicised 33 measures to support the economy, including 2.2% of GDP in tax cuts and rebates, and will also advance the issuance of municipal bonds for infrastructure development. As growth recovers, we forecast the consolidated budget deficit will narrow to 5% in 2023.

Government Debt to Rise Modestly: We forecast general government debt will rise to about 59% of GDP this year, a level broadly in line with the current median for ‘A’ rated sovereigns. Counter-cyclical fiscal easing during the pandemic has led to a roughly 11pp rise in the government debt ratio since end-2019, though this is comparable to trends seen across Fitch’s global sovereign portfolio and ‘A’ peers.

Contingent Liabilities: Fitch views fiscal risks as higher than what is reflected in headline public-debt metrics, given market perceptions that government-related entities carry implicit state support. Non-financial corporate liabilities were 159% of GDP at end-1Q22, of which two-thirds correspond to state-owned enterprises, based on estimates from the National Institution for Finance & Development. In the event of a major shock, we believe the authorities will assume some fiscal responsibility for entities with weak standalone credit profiles and quasi-fiscal functions to ensure economic and social stability.

Credit Growth to Accelerate: Pandemic control measures appear to have disrupted credit intermediation, with Fitch-adjusted credit growth slowing to 10% yoy in April from 10.5% in March. With policymakers vowing to stabilise near-term economic momentum, we expect credit growth to accelerate over the coming months. This will lead to a double-digit rise in China’s economy-wide leverage ratio this year, after it fell modestly to about 264% of GDP in 2021.

Medium-Term Leverage Trends are Key: We expect the leverage ratio to stabilise again in 2023, given officials’ continued guidance that the rate of economic growth, money supply and credit growth should remain in balance over the medium-term. In particular, failure to stabilise corporate-sector leverage would exacerbate contingent liability risks for the sovereign, in our view.

External Resilience: China’s pivotal role in global manufacturing and merchandise trade has been an important source of economic growth and stability, both prior to and during the pandemic, as reflected in the country’s market share gains in world exports since 2019. Foreign demand for manufactured goods has softened this year as consumers pivot towards services, but we forecast China’s current account surplus to remain sizeable at 1.4% of GDP, double its 2019 level. Sovereign net foreign assets are also above that of ‘A’ peers, at roughly 17% of GDP, despite their continued structural moderation.

Currency Weakens: The Chinese yuan has depreciated against the US dollar and the authorities’ currency basket index since early April, following more than a year of sustained strength. Fitch views these trends as largely influenced by the US dollar’s trade-weighted appreciation and market concerns over China’s growth slowdown. Meanwhile, the agency expects only a small 15bp cut to the official policy rate, given the global backdrop of monetary policy tightening, and the Chinese authorities’ apparent caution that rising interest-rate differentials could precipitate capital-outflow pressures.

Continued Geopolitical Tensions: Relations with a growing number of Western democracies remain fraught over issues such as commercial practices, strategic alliances, human rights and national security, in Fitch’s view. Meanwhile, a sharp divergence in pandemic control methods relative to the rest of the world has disrupted supply chains and the operations of foreign multinational firms with a presence in China, prompting personnel departures and investment delays.

Thus far, the impact of these developments on China’s economy has been limited, given the size of its domestic market and stickiness of global supply chains. If left unchecked, however, the steady accretion of geopolitical rifts heightens the risk of global shocks and could hinder China’s long-term growth potential, should its economy become less globally integrated in the process.

ESG – Governance: China has an ESG Relevance Score (RS) of ‘5’ and 5[+]’ respectively for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. China has a medium WBGI ranking at the 45th percentile, reflecting a track record of peaceful political transitions, limited participation in the political process, relatively high institutional capacity, uneven application of the rule of law, and elevated levels of corruption.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to negative rating action/downgrade:

– Structural Features: A continued rise in macro-financial risks, for example through failure to maintain credit growth at a level close to nominal GDP growth over the next few years.

– Public Finances: A sharp upward trend in government debt/GDP or a crystallisation of contingent liabilities that leads to a significant rise in government debt relative to ‘A’ peers.

– External Finances: Sustained capital outflows sufficient to erode China’s external balance-sheet strengths relative to ‘A’ peers, which would cause the removal of the +1 Qualitative Overlay (QO) notch on External Finances.
Factors that could, individually or collectively, lead to positive rating action/upgrade:

– Structural Features: A material reduction in macro-financial risks and associated contingent liabilities facing the sovereign, for example, by maintaining credit growth below nominal GDP growth over a multi-year period, which would cause the removal of the -1 QO notch on Structural Features.

– External Finances: Widespread adoption of the Chinese yuan as a reserve currency, as reflected in a substantial increase in the share of yuan-denominated claims in the IMF’s currency composition of official foreign exchange reserves (COFER) database.

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 SRM data and output, as follows:

– Structural Features: -1 notch, to reflect high debt levels outside of the explicit general government sector and large and opaque financial system, which carries potential risks to macro-financial stability and of contingent liabilities migrating to the sovereign balance sheet.

– Macro: We have removed the temporary +1 notch introduced in July 2020 to offset the deterioration of the GDP volatility variable in the SRM driven by the impact of the coronavirus shock, which would have otherwise added excess volatility to the rating.

– External Finances: +1 notch, to reflect strengths in China’s external finances not fully captured in the SRM, such as its net external creditor status, the size of its foreign reserve holdings, and pivotal role in global merchandise trade and manufacturing.

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.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG CONSIDERATIONS

China has an ESG Relevance Score of ‘5’ for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch’s SRM and are therefore highly relevant to the rating and a key rating driver with a high weight. As China has a percentile rank below 50 for the respective Governance Indicator, this has a negative impact on the credit profile.

China has an ESG Relevance Score of ‘5[+]’ for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in Fitch’s SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight. As China has a percentile rank above 50 for the respective Governance Indicators, this has a positive impact on the credit profile.

China has an ESG Relevance Score of ‘4’ for Human Rights and Political Freedoms as the Voice and Accountability pillar of the World Bank Governance Indicators is relevant to the rating and a rating driver. As China has a percentile rank below 50 for the respective Governance Indicator, this has a negative impact on the credit profile.

China has an ESG Relevance Score of ‘4[+]’ for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for China, as for all sovereigns. As China has track record of 20+ years without a restructuring of public debt and captured in our SRM variable, this has a positive impact on the credit profile.
Source: Fitch Ratings