Fitch Upgrades Taiwan, China to ‘AA’; Outlook Stable

Fitch Ratings has upgraded Taiwan, China’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘AA’ from ‘AA-‘. The Outlook is Stable.

A full list of rating actions is at the end of this rating action commentary.

KEY RATING DRIVERS

The upgrade of Taiwan’s IDRs reflects the economy’s outperformance versus peers through the Covid-19 pandemic, a further strengthening of the external sector, and continued fiscal prudence.

Fitch forecasts Taiwan’s economy will expand by 6.0% in 2021 (‘AA’ median: 4.6%), following its growth outperformance of 3.1% last year (‘AA’ median: -6.1%). Growth momentum is underpinned by robust export performance and Taiwan’s relative success in containing Covid-19 without causing major disruptions to manufacturing operations, including a recent outbreak. However, Taiwan has lagged developed economies in the pace of its vaccination rollout. About 45% of the population had received at least one dose of a Covid-19 vaccine as of 8 September 2021, but only about 4% have been fully vaccinated due to supply constraints.

Merchandise exports increased by 30.9% yoy during the first eight months of 2021 in US dollar terms, picking up from 4.9% yoy in 2020. We expect demand for Taiwanese electronics and other information and communications equipment to remain strong through 2022, boosted by global semiconductor supply shortages. We therefore project Taiwan’s economy to grow by 3.3% in 2022, before moderating to 2.6% in 2023.

Major semiconductor and high-tech manufacturers have unveiled multi-year capacity expansion plans in response to digital transformation initiatives that have accelerated across the globe since the onset of the pandemic. Such firms believe the transformation will lead to structurally higher demand for 5G-related hardware and high-performance computing equipment. We expect strong investment in high-tech manufacturing alongside capacity expansions, the continued reshoring of Taiwanese manufacturing, and policy efforts to facilitate industrial upgrading and enhance supply-chain resilience with key trading partners, will strengthen Taiwan’s medium-term growth potential.

The rating upgrade also reflects Fitch’s assessment that Taiwan’s external finances, which were already among the strongest across Fitch-rated sovereigns prior to the pandemic, have strengthened further relative to ‘AA’ rated category peers. We forecast the current account surplus will widen to 14.8% of GDP in 2021 (‘AA’ median: 1.8%) from 14.2% in 2020, driven by strong merchandise exports and a collapse in outbound tourism. We expect Taiwan to maintain its large net external creditor position at about 200% of GDP in 2021 (‘AA’ median: -0.9%). Foreign-exchange reserves will cover 17.5 months of current external payments in our 2021 baseline projections, well in excess of the ‘AA’ median of 3.8 months.

Taiwan has a record of prudent fiscal management. In addition, the economy’s resilience during the pandemic has enabled the authorities to be modest in their use of fiscal stimulus, underscored by a general government deficit of just 1% in 2020 (‘AA’ median: 6.2%). The Legislative Yuan approved an increase (equivalent to about 2% of projected 2021 GDP) of the Covid-related special budget cap to further support individuals and businesses. Fitch projects the general government deficit will rise to 2.2% of GDP in 2021, still below the projected ‘AA’ median of 5.3%. Our forecast is narrower than the government’s baseline of 3.1%, as we expect stronger revenue growth relative to previous budget assumptions. We expect the deficit to narrow to 0.7% in 2022 on continued revenue growth and a gradual unwinding of pandemic-related spending.

We forecast gross general government debt will edge down to 35.8% of GDP by end-2021 based on Fitch’s definition, below the current ‘AA’ median of 43.6%. Our baseline projections suggest public debt will remain on a slightly downward path over the medium term, although this is sensitive to assumptions regarding the growth outlook and primary balance. We believe Taiwan’s Public Debt Act, which has imposed a debt ceiling of 50% of GDP since its inception in 1996, remains an effective medium-term fiscal policy anchor.

Taiwan’s competitive business environment and high governance standards also support the rating. These strengths are balanced by per capita income that is projected to remain low relative to the ‘AA’ category median, complex relations with mainland China that raise the potential for economic and political shocks, structural challenges from an ageing population, and vulnerability to abrupt shifts in global trade policy that could affect the technology sector.

Cross-strait tensions are a key credit weakness, and are accompanied by risks we believe will persist. Thus far, tensions have had only a limited impact on cross-strait economic ties. Economic sanctions have been narrowly targeted, in part due to close and mutually beneficial investment and trade ties, but broader or more punitive forms of economic coercion cannot be ruled out. There is a risk that US-China geopolitical frictions may further exacerbate already-strained cross-strait relations, though the pivotal role that Taiwan’s high-tech manufacturing supply chain plays across the economies of both China and the USA may partially offset this risk, in our view.

The central bank has maintained its benchmark policy rates at a historical low of 1.125% since its last cut in March 2020. The monetary authorities extended an SME lending facility through end-2021 and doubled the cap on Covid-19 relief loans to support small private businesses struggling amid the pandemic. Fitch forecasts headline inflation to average 1.7% in 2021, before moderating to 1.2% in 2022. We anticipate the central bank will keep its policy rates on hold through end-2022.

Fitch has a stable sector outlook on the Taiwanese banking sector, which reflects reduced risk to the operating environment. We expect the impact of the Covid-19 outbreak on banks’ asset quality and profitability to be mitigated by the strong growth outlook and macroprudential measures aimed at curbing property speculation. Taiwan’s banking system remains a potential contingent liability risk, in our view, in light of its considerable size (sector assets represented 285% of GDP at end-2020), the significant role of state ownership (state-owned and state-controlled banks accounted for about half of system assets at end-1Q21), and the fragmentation and thin margins of domestic banks.

ESG – Governance: Taiwan 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. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Taiwan has a high WBGI ranking at the 83rd percentile, reflecting its long track record of stable and peaceful political transitions, well-established rights for participation in the political process, strong institutional capacity, effective rule of law and a low level of corruption.

RATING SENSITIVITIES

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

– Structural Features: Deterioration in cross-strait relations sufficient to undermine Taiwan’s economic or political stability.

– Public Finances: An adverse macroeconomic or financial shock that weakens medium-term growth prospects and negatively affects public-debt dynamics.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

– Structural Features: A sustainable resolution of cross-strait tensions that significantly reduces the possibility of economic and political shocks.

SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)

Fitch’s proprietary SRM assigns Taiwan a score equivalent to a rating of ‘AA+’ 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 complex and tense relations with mainland China that raise the potential for economic and political shocks.

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.

KEY ASSUMPTIONS

The global economy performs broadly in line with Fitch’s Global Economic Outlook published in June 2021, available at www.fitchratings.com/site/re/10166250.

No significant escalation in geopolitical and cross-strait tensions that would otherwise threaten Taiwan’s political and economic stability, and undermine its economic prospects.

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

Taiwan 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 Taiwan has a percentile rank above 50 for the respective Governance Indicator, this has a positive impact on the credit profile.

Taiwan has an ESG Relevance Score of ‘5[+]’ for Rule of Law, Institutional and 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 Taiwan has a percentile rank above 50 for the respective Governance Indicators, this has a positive impact on the credit profile.

Taiwan 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 Taiwan has a percentile rank above 50 for the respective Governance Indicator, this has a positive impact on the credit profile.

Taiwan 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 Taiwan, as for all sovereigns. As Taiwan has track record of more than 20 years without a restructuring of public debt and this is captured in our SRM variable, this has a positive impact on the credit profile.

Taiwan has an ESG Relevance Score of ‘4’ for International Relations and Trade, as complex relations with mainland China that raise the potential for political and economic shocks are relevant to the rating and a rating driver. This has a negative impact on the credit profile.

Except for the matters discussed above, the highest level of ESG credit relevance, if present, 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. For more information on Fitch’s ESG Relevance Scores, visit www.fitchratings.com/esg.

ARTICIPATION STATUS

The rated entity (and/or its agents) or, in the case of structured finance, one or more of the transaction parties participated in the rating process except that the following issuer(s), if any, did not participate in the rating process, or provide additional information, beyond the issuer’s available public disclosure.
Source: Fitch Ratings