Fitch Affirms China at ‘A+’; Outlook Stable
Fitch Ratings has affirmed China’s Long-Term Foreign-Currency Issuer Default Rating (IDR) at ‘A+’ with a Stable Outlook.
KEY RATING DRIVERS
China’s ratings are supported by the country’s robust external finances, a record of strong and resilient macro 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 ‘A’ peers.
The Chinese economy has entered a mature stage in its pandemic recovery, following the country’s early success in virus containment. Real GDP surged by 18.3% yoy in 1Q21 (0.6% qoq seasonally adjusted), from 6.5% yoy in 4Q20, in part due to the base effect from last year’s shutdown. Activity indicators have been mixed since then, but broadly point to somewhat slower domestic demand, counterbalanced by still-strong export growth and manufacturing production amid the global economic rebound. Fitch forecasts GDP growth of 8.4% in 2021 (2020: 2.3%) and 5.5% in 2022, which will continue to position China among the world’s top performing economies.
China’s “zero-tolerance” policy towards domestic coronavirus infections has kept cases exceptionally low since mid-2020, and recent outbreaks have been contained swiftly through localised lockdowns and mass testing. This approach suggests further isolated lockdowns are likely, in Fitch’s view, and that China’s borders could remain closed to ordinary business and leisure travel for some time, perhaps until mid-2022. We nevertheless expect the growth impact to be limited because of China’s large domestic market and continued success in curbing outbreaks without generating significant economic disruptions. More than 40% of the population has been inoculated with domestically produced vaccines (with 1.17 billion doses administered thus far), though it seems unlikely this will have near-term implications for the reopening of borders, given the advent of “variants of concern” worldwide.
Fiscal policy remains supportive. The government underscored at the annual session of the National People’s Congress in March that it would adopt a cautious approach in withdrawing fiscal stimulus to ensure the economy’s sustained recovery from the coronavirus shock. The official budget deficit target was reduced to 3.2% of GDP in 2021, from “above 3.6%” in 2020. On a Fitch-consolidated basis, which includes infrastructure spending and other official budgetary activity that fall outside of the headline target, we forecast the fiscal deficit will moderate to 7.4% this year, from 8.9% in 2020. This is well above China’s pre-pandemic levels, but broadly in line with the cautious pace of fiscal consolidation Fitch expects globally this year.
We estimate China’s general government debt-to-GDP ratio will rise to about 55% this year, up by less than 2pp over 2020 despite the elevated deficit, given our expectation of a rebound in GDP growth. At this level, explicit government debt in China will remain below the current ‘A’ median, having risen by a comparatively modest 8pp throughout the course of the pandemic.
Official budgetary outturns and headline public debt metrics understate the degree of underlying fiscal risks because of large quasi-fiscal activities, in Fitch’s view. The National Institution for Finance and Development estimates non-financial corporate liabilities at 161.4% of GDP as of end-1Q21, of which about two-thirds corresponds to SOEs. Market participants continue to assume high levels of implicit support for government-related entities, including those with weak stand-alone credit profiles, as reflected in bond spreads for local government financing vehicles. Numerous policies have been enacted to curb these perceptions, but in the event of a major credit event, Fitch believes the authorities’ efforts to prioritise macro-financial stability would result in the crystallisation of some quasi-fiscal liabilities onto China’s sovereign balance sheet.
Monetary policy support is receding, even in the absence of official policy rate adjustments. Fitch-adjusted credit growth slowed to 10.2% yoy in May, below nominal GDP growth, and down 3pp since late-2020. This implies the economy-wide leverage ratio will nudge down this year, after rising sharply to about 270% of GDP in 2020. The authorities have signalled a desire to reprioritise pre-pandemic financial de-risking measures, but with credit sensitive areas of the economy decelerating, it remains to be seen whether tighter policy settings will endure. Fitch views the recent spike in producer prices as transitory, and does not expect it will have material implications for headline consumer price inflation nor for the monetary policy outlook.
External finances are a key rating strength. China is a large net external creditor on a sovereign and economy-wide basis at a Fitch forecasted 17.4% and 20.4% of GDP, respectively, at end-2021. Export performance has been exceptional throughout the pandemic, while international travel restrictions have led to a sharp decline in services imports. As a result, the current account surplus surged to 1.8% of GDP in 2020, more than double its 2019 level, and Fitch expects a further rise to 2.0% this year. These trends, alongside an acceleration in foreign portfolio inflows, have contributed to the Chinese yuan’s appreciation against the US dollar over the past year, and a modest rise in official foreign-exchange reserves to USD3.4 trillion by end-May 2021.
Geopolitical tensions between China and a number of major economies, including the US, have persisted over issues such as human rights, national security and strategic competition. Partly as a result, the Chinese authorities have put greater emphasis on their “dual circulation” policy, which seeks to enhance the country’s reliance on domestic demand and innovation as a driver of growth. Thus far, heightened tensions have not had a material impact on the extensiveness of global business interests operating in China nor its vast global supply-chain linkages. If these factors change over time, the potential impact on the sovereign rating will ultimately depend on the authorities’ chosen policy response, and whether it can partly offset the resulting negative pressures to medium-term growth without eroding China’s credit fundamentals.
The level of interconnectedness and contagion risks within the financial system has moderated since 2017, contributing to Fitch’s recent upward revision of banks’ operating environment score to ‘bbb-‘/positive from ‘bb+’/stable. There is still potential for reported bank disclosures to understate the extent of asset quality risks, due to forbearance and off-balance sheet or non-loan exposures. However, we believe these risks have subsided in recent years with the acceleration in recognition and resolution of problems loans, particularly for large state banks.
China’s level of income and development remains low compared with rating peers. Per capita income of USD12,000, which we project for this year, is about half the ‘A’ peer median of USD25,379. Governance standards also lag ‘A’ peers based on World Bank Governance Indicators.
ESG – Governance: China has an ESG Relevance Score (RS) of ‘5’ for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. These scores reflect the high weight that the World Bank Governance Indicators have in our proprietary Sovereign Rating Model. China has a medium World Bank Governance Indicator ranking at the 41st percentile, reflecting a record of political stability, weak rights for participation in the political process, moderate institutional capacity, uneven application of the rule of law and a moderate level of corruption.
FACTORS THAT COULD, INDIVIDUALLY OR COLLECTIVELY, LEAD TO NEGATIVE RATING ACTION/DOWNGRADE:
- Structural features: A further rise in macro-financial risks, for example through failure to maintain credit growth close to or below nominal GDP growth over the next few years.
- Public finances: A sustained upward trend in government debt/GDP, or a crystallisation of contingent liabilities that leads to a sharp rise in government debt relative to ‘A’ peers.
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: Evidence of widespread adoption of the Chinese yuan as a global 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/or contingent liabilities migrating to the sovereign balance sheet.
- 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 and the size of its foreign reserve holdings.
- Macro: +1 notch, to offset the deterioration of the GDP volatility variable in the SRM driven by the impact of the coronavirus shock, which we believe will be temporary, and would otherwise add excess volatility to the rating.
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.
The global economy performs broadly in line with Fitch’s latest Global Economic Outlook, published on 15 June 2021 and available at www.fitchratings.com/site/re/10166250.
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.
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, which include Government Effectiveness, 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.
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of ‘3’. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or to the way in which they are being managed by the entity.
Source: Fitch Ratings