DBRS Morningstar Downgrades China to “A”, Trend Changed to Stable

DBRS, Inc. (DBRS Morningstar) downgraded the People’s Republic of China’s (China) Long-Term Foreign and Local Currency – Issuer Ratings to “A” from A (high). At the same time, DBRS Morningstar downgraded China’s Short-Term Foreign and Local Currency – Issuer Ratings to R-1 (low) from R-1 (middle). The trends on all ratings have been changed from Negative to Stable.

KEY CREDIT RATING CONSIDERATIONS
The downgrade to the ratings reflects DBRS Morningstar’s assessment of fiscal deterioration and structural growth challenges facing the economy. DBRS Morningstar’s expects the weakness in the property sector, the challenges of China’s ageing demographics, and heightened U.S.-China tensions will translate into lower economic growth over the medium term. These factors have structural implications for the country’s economic prospects, weighing on government finances. The ratings are also hindered by opaque public finances at the local level, high debt levels across sectors, and growing governance concerns. Including the recent stimulus, while the general government’s deficit is estimated at 3.8% of GDP in 2023, the IMF’s augmented deficit which includes off-budget items financed by local government financing vehicles (LGFV’s) and various special funds is significantly higher at 16.7% of GDP. China’s overall debt levels have risen with the BIS estimates of China’s combined gross debt (general government, households, and corporates) rising from 140% of GDP in 2006 to 306.5% of GDP in Q1 2023. The IMF projects China’s debt-to-GDP ratio to trend higher through its forecast horizon due to headwinds to the economy. This rating action reflects the deterioration in the ‘Economic Structure’, ‘Fiscal Management and Policy’, and ‘Debt and Liquidity’ building blocks.

That said, DBRS Morningstar considers that China’s economic and policy buffers remain sufficient to limit the risk of an abrupt near-term adjustment. China’s A ratings reflects its large and diversified economy, strong external balance sheet, moderate public debt, comparatively low inflation rate, and high domestic savings. China is the world’s top merchandise trader, and is the second largest economy with GDP at USD 17.9 trillion accounting for roughly one-fifth of global growth. Decades of rapid income growth have created one of the largest consumer markets in the world. China’s external position is another core credit strength. Its current account surplus reflects a positive trade balance and high domestic savings (46% of GDP). China is a net creditor, holding USD 3.2 trillion of reserves that more than cover its external debt obligations.

CREDIT RATING DRIVERS
DBRS Morningstar could upgrade the credit ratings if China (1) markedly reduces its domestic imbalances, through deleveraging and increasing domestic consumption; and (2) significantly reduces the overall level of deficits while improving the transparency of local government finances.

Alternately, credit ratings could be downgraded due to one or a combination of the following factors: (1) a deeper and sustained deterioration in economic performance; (2) a lack of progress on reducing fiscal imbalances and financial risk exposure among corporate and local government sectors; or (3) increased evidence of a material deterioration in institutional quality and policy management.

CREDIT RATING RATIONALE

Structural and Cyclical Factors Continue to Take A Toll on China’s Growth Engines

Following the post-pandemic rebound in growth to 8.1% in 2021, China’s GDP growth slowed to 3.0% in 2022 missing its official growth target of 5.5% by a considerable margin. The economy was expected to recover strongly in 2023 after the government lifted lockdown measures, but growth has been disappointing with sub-par trends in retail sales and investment. Policy measures to reduce speculative property development have resulted in prolonged housing market weakness that has been weighing on industrial production and fixed asset investment. Further, China’s external demand continues to face headwinds as the pace of rate hikes in advanced economies has reduced export growth. In the latest World Economic Outlook, the IMF estimates that the Chinese economy will grow at 5.0% in 2023. The IMF also expects growth to moderate in the medium term, averaging 3.8% through its forecast horizon (2024-2028).

In addition to the cyclical factors, developments over the last few years are impacting China’s structural growth drivers. First, growth in China remains accompanied by a sustained increase in debt and growing income inequalities. China’s combined gross debt (general government, households, and corporates) has more than doubled from 140% of GDP in Q1 2006 to 306.5% of GDP in Q1 2023. Policymakers have been attempting to shift China’s growth model from an over-reliance of debt-fueled investment (including housing) towards consumption and services. There has been some progress in reversing the trend but progress is slow. Private consumption is low at 37% of GDP and China still has the highest investment to GDP ratio (43% of GDP) among large economies.

Second, China’s ageing population is likely to shrink its productive capacity. With a population of 1.4 billion, China is the second most populous country in the world. However, thanks to its one-child policy that was in place from 1979 to 2015, China's working-age population is expected to decline by 22% from 2022 to 2050. Consequently, labor's negative contribution will persistently weigh on China's potential growth. Further, the UN expects China’s old age dependency ratio to rise from 19% currently to 50% by 2050. This will require higher government spending on social services, which could have a significant impact on public finances.

Third, the shift in the U.S.-China relationship since 2017 has increasingly added to China's domestic challenges of debt and demographics. While tariffs imposed by the previous U.S. administration on Chinese exports and sanctions on Chinese tech companies remain in place, the Biden administration has further tightened restrictions on Chinese purchases of American technology. The latest round of export controls by the U.S. limits not just exports of semi-conductor chips but also semi-conductor manufacturing and design software. Furthermore, the controls are not limited to U.S. companies; they also apply to foreign companies that create products that incorporate American technology. The intensification of U.S. restrictions on advanced technology industries are likely to impact productivity. In addition, rising geopolitical tensions, have resulted in multinational companies revisiting their China strategy, with a greater emphasis on supply chain resiliency rather than efficiency, resulting in another headwind to Chinese growth.

Despite these challenges, China is the second largest economy with GDP at USD 17.9 trillion, is the world’s largest merchandise trader, and contributes one-third of global growth. Decades of income growth have created one of the largest consumer markets in the world. Furthermore, China has near-term policy buffers to manage an abrupt adjustment and cushion itself from shocks. These buffers include its moderate public debt, high domestic savings, low inflation, and high foreign exchange reserves. China’s relatively strong growth prospects and balance of risks contribute to a positive adjustment in the ‘Economic Structure and Performance’ building block.

China’s Overall Fiscal Situation Deteriorates Further With Debt Touching New Highs

China’s fiscal framework is characterized by strong central government finances, but weak local government finances. Local governments face structural revenue shortfalls relative to their spending needs; they account for half of general government revenues, but make up over 75% of general government expenditure. Budget transparency at the local government level remains limited. Prior to 2015, as local governments were banned from borrowing, higher local government expenditure was financed via local government financing vehicles (LGFVs) and proceeds from land sales. China’s ongoing fiscal reforms have enabled local governments to issue debt subject to a cap and brought on-budget a large amount of off-balance sheet activity. However, continued higher expenditure at the local government level and lower land sales have resulted in local governments using new sources of funding such as special funds and public private partnerships to fund growth.

Consequently, as compared to the general government deficit which has averaged of 3.1% since 2018-2023, the IMF’s broader measure of the fiscal deficit (the augmented deficit, which includes off-budget items financed by LGFVs, special construction funds, and government-guided funds) is much higher. This measure currently stands at 16.8% in 2022, compared to a pre-pandemic average of 12.2% of GDP during 2018-2019. Ongoing expenditures and lower growth are likely to result in the augmented deficit averaging 15% through the IMF’s forecast horizon of 2027. Given the implicit state support for these new sources of local government funding, China’s fiscal and debt metrics are weaker than the headline figures. Risks associated with these quasi-fiscal activities contribute to a negative adjustment to the building block assessment for ‘Fiscal Management and Policy’.

Since the pandemic and the downturn in the property market, China has seen a steady rise in public debt and an increase in contingent liabilities. The official definition for general government debt (which includes explicit local government debt) is 51.0% of GDP in 2022, which has risen from a pre-pandemic level of 38.1% in 2019. The IMF under its definition of ‘augmented debt’ (which includes explicit and implicit off-budget liabilities to LGFVs) estimates debt at 110.0% of GDP in 2022 as compared to a pre-pandemic level of 86% in 2019. This augmented ratio likely overstates public debt, as some of the LGFV borrowing is on a commercial basis and not all guarantees wind up on the public balance sheet. Higher deficits and lower nominal GDP growth are likely to result in China’s debt-to-GDP ratio trending higher at 69% of GDP under the official government definition and at 167% of GDP in 2031 as per the IMF estimates for augmented debt. Given the interlinkages between the state and quasi-government institutions, the government could also be compelled to support SOEs and other private companies for financial stability reasons.

That said, China has fiscal space as indicated by its high domestic savings, low borrowing costs, and substantial liquid assets, including foreign reserve assets held by the government, and government deposits with the central bank. Moreover, as debt is largely domestic, overall general government debt servicing is manageable even as baseline projections for debt show a considerable increase over the forecast period.

Property Sector Woes Continue to Unravel Raising Macro and Financial Stability Risks in China

China’s property sector woes have worsened since the correction began in 2021 and the sector remains one of the key sources of downward pressure on the economy. The correction is both cyclical, due to regulatory tightening measures announced in August 2020, and structural, reflecting changes in demand. As a result, several large developers defaulted on their bond payments. The downturn is a major drag on the economy as China's property sector has been a key engine of growth for two decades, contributing to nearly 15% of GDP and 25% of total fixed investment. The slowdown also has implications for public finances as land sales to property developers account for nearly 25% of local government tax revenues. As the sector begins to downsize, it could take a toll on employment and consumption given that housing accounts for 70% of Chinese household assets.

While banks’ direct exposure to the property sector appears manageable, the high-indebtedness of property developers suggests that the spillovers could go beyond the banking sector, affecting households, upstream and downstream industries, and non-bank funding channels. The real estate sector currently accounts for 30% of bank loans. With nearly 75% of the banking sector exposure to the property sector via mortgages, macroprudential guidelines including loan-to-value ratio requirements, have so far contributed to low delinquency rates. But given the interlinkages of the property sector in the economy, while official estimates of non-performing loans and special-mention loans are low at 5.5% of GDP, private sector estimates are significantly higher. This coupled with liability side issues reflected in increasing recourse to non-deposit liabilities results in DBRS Morningstar applying a negative qualitative factor in the ‘Monetary Policy and Financial Stability’ building block. DBRS Morningstar continues to monitor potential capital outflows and property sector developments.

The government is taking several measures to address the property downturn. These include initiatives to help complete abandoned projects as well as building low cost public housing. In addition to lowering down payment requirements and relaxing home purchase restrictions, authorities have also been taking several measures to stabilize housing prices with price caps on new home sales keeping new home prices lower than secondary market prices. In addition, with inflation remaining subdued at near zero levels since April 2023, China has lowered its 1-year loan prime rate from 3.70% in July 2022 to 3.45% currently and its 5 year loan prime rate from 4.45% to 4.2% in the same period. Moreover, China has many buffers such as low external funding needs, adequate capitalization (CAR at 14.2%; Tier 1 capital ratio at 11.6%), high reserve requirements, high domestic savings, and a large sovereign wealth fund, all of which lend assurance to the government’s capacity to support the financial system.

U.S.-China Relationship Remains Fraught; But China’s External Balance Sheet Is Strong

The shift in the U.S.-China relationship since 2017 adds to China's existing challenges. Tariffs imposed by the previous U.S. administration on over USD 350 billion in Chinese exports and sanctions on Chinese tech companies remain in place, with the Biden administration continuing to progressively tighten restrictions on Chinese purchases of U.S. technology. The relationship continues to experience added strains on advanced economy concerns over the centralization of power within China and perceived repression of dissidents and minority populations, and Chinese concerns over foreign intervention into Taiwan and other domestic affairs. DBRS Morningstar maintains its view that this evolving relationship between the largest economies in the world remains important to the overall global outlook and may have implications far beyond their own borders.

Nonetheless, despite the growing challenges, China’s external balance sheet is strong, and its external rebalancing has been substantial. The current account surplus narrowed from an average of 5.2% between 2001 and 2010 to stand at 2.2% in 2022. The overall decline has been driven by a lower goods balance and widening services balance as China’s growth model transitions from exports to consumption. China’s relatively strong external balance sheet is reflected in high foreign exchange reserves (USD 3.3 trillion, or 13% of GDP) and low external debt (16% of GDP). China remains a net lender to the rest of the world with a net asset position of 14.1% of GDP. Although China’s capital account is dominated by FDI, authorities have been taking various measures towards its calibrated opening by allowing both inflows and outflows of portfolio investments, permitting two-way flows via the Shanghai and Shenzhen Stock Connect Schemes, the Bond Connect, and approving the inclusion of Chinese companies in global indices. China’s onshore bond market is now estimated at USD 14 trillion, overtaking Japan to become the second largest after the United States.

Increasing Role of the State Runs the Risks of Policy Errors

China has a centralized political and economic structure where decisions are made and executed via a network of Chinese Communist Party (CCP) authorities. Reforms made over the last few years include increasing fiscal accountability and the passage of the budget law, liberalizing interest rates, opening of capital markets, and instituting regulatory measures to address domestic leverage. The general pragmatism of China’s economic policymaking have led to a positive qualitative adjustment in the ‘Political Environment’ building block.

However, a growing concern is the role of the state in both the economy and society, which has increased over the last several years. The anti-corruption campaign initiated after Xi Jinping took over in 2012 may have addressed genuine corruption issues, but it may also have cemented the President’s authority and limited competing voices. Further, the removal of the two-term limit for the State President in the 19th Party Congress in 2017 and the appointment of Xi as party general secretary in the 20th Party Congress in 2022 for an unprecedented third five-year term has further cemented Xi Jinping’s leadership role. Moreover, the seven-member Politburo Standing Committee is now dominated by President Xi’s allies. Recent regulation of industries in the education, fintech and gaming space demonstrate an increased level of government intervention. While the concentration of power at the top of the political structure makes it easier for the CCP to carry out reforms, insufficient checks and balances could heighten the risk of policy errors and test the dynamics of China’s single party system. Extensive restrictions on the media and academia and issues on human rights are another concern. These challenges are reflected in China’s low ranking in Worldwide Governance Indicators, particularly ‘Voice and Accountability.’

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

ESG Considerations had a significant effect on the credit analysis.

Environmental (E) Factors
There were no Environmental factors that had a relevant or significant effect on the credit analysis.

Social (S) Factors
The following Social factors had a significant effect on the credit analysis: The Human Capital and Human Rights factor significantly affects the credit ratings assigned to China. China’s per capita GDP is low at USD 12,669, reflecting relatively low levels of productivity. Concerns over individual and human rights are a source of tension with some domestic populations and international peers. China’s hukou system (a household registry that ties health, education, housing and other government services to the parents’ status, whether urban or rural) limits economic mobility and human capital accumulation for migrant workers from rural areas. Recent hukou reforms have eased the barriers to converting a rural hukou to an urban one, but urban registrations remain low relative to urban-rural migrants. These factors have been taken into account in the ‘Economic Structure and Performance’ and in the ‘Political Environment’ building blocks.

Governance (G) Factors
The following Governance factors had a significant effect on the credit analysis: The Institutional Strength, Governance and Transparency factor affects the credit ratings assigned to China. In addition, Bribery, Corruption, and Political Risks and Peace and Security are relevant considerations. China ranks in the 4th percentile in the Worldwide Governance Indicators on Voice and Accountability. All political institutions are dominated by the Chinese Communist Party, which limits press freedoms and other independent voices. The government has conducted regular anti-corruption campaigns since President Xi Jinping took office to root out corruption and graft in the military, in the central and local governments, and in state-owned enterprises, though investigations are opaque and due process appears to be disregarded. Additionally, ongoing tensions on the India-China border, in the South China Sea, and around the Taiwan Straits occasionally flare up. These factors have been taken into consideration in the ‘Fiscal Management and Policy’ and ‘Political Environment’ building blocks.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (04 July 2023) https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/423115.

Notes:
All figures are in US Dollars unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments (06 October 2023) https://www.dbrsmorningstar.com/research/421590/global-methodology-for-rating-sovereign-governments . In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (04 July 2023) https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and credit ratings are monitored.

The primary sources of information used for these credit ratings include Chinese Ministry of Finance, China National Bureau of Statistics, People's Bank of China, State Administration of Foreign Exchange, China Index Academy, Bank for International Settlements, IMF World Economic Outlook, Haver Analytics, World Bank, UNDP and DBRS Morningstar. DBRS Morningstar considers the information available to it for the purposes of providing these credit ratings was of satisfactory quality.

The credit rating was not initiated at the request of the rated entity.

The rated entity or its related entities did not participate in the credit rating process for this credit rating action.

DBRS Morningstar did not have access to the accounts, management and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is an unsolicited credit rating.

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