Scope downgrades the People's Republic of China's credit ratings to A; Outlook revised to Stable
Scope Ratings GmbH (Scope) has today downgraded the People’s Republic of China’s long-term issuer rating and senior unsecured local- and foreign-currency ratings to A from A+ and revised the Outlooks to Stable from Negative. China’s short-term issuer ratings have been downgraded to S-1 from S-1+ in both local and foreign currency, with Outlooks revised to Stable from Negative.
For the updated report accompanying this review, click here.
Summary and Outlook
The downgrade of China’s credit ratings to A from A+ reflects:
The high structural public sector deficits and the further steepening of the medium-term public sector debt trajectory; and
- A decline in medium-term growth expectations and China’s challenge, and associated risks, of achieving sustainable economic growth over the medium term in light of the ongoing crisis in the real estate sector without further exacerbating its large financial imbalances, including high levels of non-financial sector debt.
Authorities previously introduced appropriate policies to begin to address financial imbalances and reduce leverage across crucial economic sectors of the economy, including the real estate sector. As expected, such structural reforms are contributing to an economic slowdown and a correction in the housing market. The worsening medium-term economic outlook puts increasing pressure on China’s public finances, while reform momentum has slowed. In its efforts to engineer a ‘soft landing’, the government faces a difficult balancing act of deleveraging the economy, while maintaining politically acceptable levels of economic growth, without a rapid deterioration in public finances.
The downgrade reflects changes in Scope’s assessments in the ‘domestic economic risk’, ‘public finance risk’ and ‘ESG risk’ categories of its sovereign methodology.
The Stable Outlook reflects Scope’s view that risks to the ratings are balanced over the next 12 to 18 months.
The ratings/Outlook could be upgraded if, individually or collectively: i) China’s public finances strengthened, resulting in an improvement in the public debt trajectory; ii) economic and financial reforms strengthened financial stability and/or the sustainability of the economic growth outlook; and/or iii) the renminbi made substantive gains as a reserve currency.
Conversely, the rating/Outlook could be downgraded if, individually or collectively: i) a financial or economic shock materialised, impairing economic growth over the medium term; ii) a protracted fiscal deterioration and/or crystallisation of contingent liabilities resulted in a weaker fiscal outlook and a continued rise in the debt trajectory beyond Scope’s baseline; and/or iii) China’s external resilience weakened materially.
The first driver underpinning Scope’s decision to downgrade the People’s Republic of China’s ratings from A+ to A is the country’s large public sector deficits and rising public debt.
Debt levels were on a rising trajectory already in the decade before the pandemic. Under a narrow definition, China’s general government debt increased from 34% of GDP in 2010 to 60% in 2019. The fiscal stimulus in response to the pandemic raised debt to 77% of GDP in 2022 and Scope expects debt to exceed 100% of GDP by 2027, reflecting a further steepening debt trajectory since Scope assigned a negative Outlook on China’s ratings in June 2022. Under the IMF’s broader definition1, which includes local government financing vehicles (LGFVs) and other off-balance-sheet entities, debt levels are substantially higher while the debt trajectory is steeper. The government’s ‘augmented debt’ stood at 99% of GDP in 2020 and is now expected to reach 149% by 2027, up around 15 pp from estimates last year, and significantly above sovereign peers with similar wealth levels.
Measures to support the economy at the onset of the pandemic resulted in a large increase in budget deficits, reaching 9.7% of GDP in 2020. In an attempt to decrease public and private sector leverage, the government tightened policy to restrict access to credit in early 2021. While some targeted fiscal support remained, including for small firms, the deficit decreased to 6.0% of GDP driven by lower levels of public investment. To offset slowing economic growth in 2022, the government again loosened fiscal policy as nationwide tax and fee cuts raised the deficit to 7.5% of GDP. Scope expects fiscal support to continue in 2023, resulting in a similar deficit of 7.4% of GDP, remaining at around 7% over the next five years. The IMF’s augmented net lending/borrowing metric for China aims to account for infrastructure spending, financed through off-balance-sheet LGFVs, special construction funds and government guided debt issuance. According to this measure, China’s fiscal deficit stood at 16.8% of GDP in 2022, up from 13.8% in 2021. The augmented deficit is only expected to fall gradually towards 14% of GDP by 2027.
The real estate market downturn is placing local governments in greater financial difficulty due to falling land sale revenues. At the same time, reliance on LGFVs is high as they have significantly increased land purchases in 2022, buying more than half of residential land sold during the year. Debt held within LGFVs continued to increase and is estimated to reach RMB 66trn in 2023 (53% of GDP), rising to 66% of GDP by 2027 and up from 40% before the Covid-19 pandemic. Authorities have implemented restrictions on off-balance sheet financing channels to reduce the elevated leverage levels taken on by LGFVs. Despite these restrictions, there is an increasing likelihood of debt restructurings to tackle the rising danger of LGFV defaults in some of the most vulnerable provinces and to prevent systemic risk from materialising.
Similar deleveraging efforts have been undertaken in the private sector where China’s ‘three red lines’ policy aimed to enhance financial discipline in the real estate sector. The pace of restructuring real estate developers has been slow, partially to avoid very large losses from materialising for pre-sale homebuyers. A 16-point plan was announced in November 2022 in an attempt to soften the correction in the real estate market. This includes measures by the central and local governments to support homebuyer demand by introducing mortgage repayment moratoria, protecting homebuyer’s credit scores, introducing a central government-funded mechanism to finance the completion of unfinished housing projects and allowing borrowers to renegotiate repayment schedules. In addition, developers and construction firms have been able to extend their loans and restrictions on bank lending to developers have been eased. While the policies are helping to cushion the immediate impact on the real estate market, they also raise already high levels of leverage while the need to restructure developers remains and some highly indebted regions face large stocks of unfinished housing projects.
As a result, the central government is making large transfers to support local governments. Transfers increased by around 17% in 2022 and are expected to rise further by 3.6% in 2023, reaching just over RMB 10trn (8.2% of GDP). Scope expects local and regional governments to continue supporting most LGFVs, although official support may be increasingly selective. Overall, the high fiscal deficits and rising debt levels, particularly under a wider definition which includes the local and regional government finances, are likely to deteriorate further over the medium-term, underpinning Scope’s decision to downgrade China’s rating.
The second driver underpinning Scope’s decision to downgrade China’s ratings from A+ to A is the weaker medium-term economic growth outlook. The ongoing shock from the real estate sector weighs on the government’s efforts to achieve sustainable economic growth in the medium term without further exacerbating its large financial imbalances, including high levels of non-financial sector debt.
After a strong rebound in 2021 following the initial phase of the Covid-19 pandemic, GDP growth slowed more than expected to 3.0% in 2022. In addition to China’s zero-Covid policy which led to large-scale lockdowns, previous policies introduced to reduce borrowing by highly indebted property developers resulted in a correction in real estate prices. Prices for existing house sales fell sharply throughout 2022 and have only started to stabilise in March 2023 due to significant intervention by authorities. The latest support measures and the end of Covid-19 lockdowns should support GDP growth of around 5.5% in 2023. This is largely driven by the services sector as retail sales and spending on services rebound after prolonged lockdowns, while growth in the manufacturing sector weakened at the start of the year with the PMI index falling to 49.2 in April 2023, indicating a slight contraction.
In March 2021, the National People’s Congress endorsed the 14th five-year plan covering the years 2021 to 2025. For the first time this did not include an explicit growth target. However, China’s 2035 Vision outlines a longer-term development goal of becoming a ’moderately developed country’ by 2035, targeting a doubling in size of China’s economy by then2. This implies an average annual growth rate of around 4.7% over 15 years.
The challenges of achieving these growth targets and simultaneously deleveraging the economy, in particular the real estate sector, are significant. As of Q3 2022, total credit to private non-financial sectors stood at 220% of GDP, well above the average level in emerging economies (149%) and advanced economies (157%). Without significant structural reforms, China’s longer-term growth objectives will be difficult to achieve. Estimates by Peschel and Liu (2022) suggest a significant drop in sustainable potential growth after 2025, falling to 3.5% per annum, as the property downturn and lower overall investment continues to weigh on the outlook3. Without successful reforms, China’s growth potential could fall below 3% from 2030 onwards. Structural reforms that could lift the country’s growth potential include ensuring neutral competition between large state-owned enterprises and privately-owned enterprises; education reforms such as narrowing the urban-rural gap in years of schooling; reducing local protectionism and administrative borders between prefectures; and labour market reforms such as raising the retirement age and increasing female workforce participation amid rising demographic challenges. In 2022, China’s population fell by around 850,000 according to National Bureau of Statistics estimates, the first decrease since 1961, and the UN expects the population to shrink by 113m (down 8%) by 2050.
Scope expects the real estate sector to contribute significantly less to economic growth going forward as the government aims to contain financial imbalances. Rogoff and Yan (2022) estimate that the direct value added of the real estate sector amounted to 11.4% of GDP in 2021, rising to 25.4% of GDP when connections to other sectors are included4. There will need to be a continued focus on enhancing financial sector discipline, transparency and market-based price dynamics in authorities’ pursuit of a soft landing for China’s large-scale debt accrual since the global financial crisis. This will require a balance of policy tightening to contain rising financial imbalances, against policy loosening to avoid a more severe and continuous spillover of risks across the large and interconnected real estate sector. Efforts to reduce credit growth are reflected in the growth rate of aggregate social financing, a broad measure of credit and liquidity in the economy, which slowed to 8.8% by end-2022 (down from around 12% at end-2020), but has started to accelerate this year, reaching 9.6% in March 2023 in light of the recent policy loosening.
Finally, the transition towards a more sustainable growth path remains a crucial policy objective and poses a major challenge for authorities as there remains significant risk of policy mistakes. Even if the power consolidation achieved by President Xi Jinping in October 2022 should bolster reform momentum in the near term, it can have credit-negative implications in the longer run. Scope believes it may undermine the delicate collective leadership structure underpinning China’s decade-long economic miracle and also reduce the quality of governance and policymaking in the long term.
Despite these challenges, the People’s Republic of China retains considerable credit strengths.
First, China has a large and diversified economy and still the strongest growth potential when compared with peers. It has the second highest nominal GDP in the world following several decades of continuous economic growth. The pandemic resulted in a significant slowdown, although China’s economy was among the very few worldwide to still grow in 2020, expanding by 2.2%. While there are clear medium-term structural challenges, the economy is rebounding strongly in 2023 following the end of Covid-19 related lockdowns. To date, authorities have been able to contain systemic risks from crystallising and the real estate market is showing some signs of stabilising.
Monetary policy has been effective at maintaining inflation rates below the 3% target over the past years. Despite the escalation of the Russia-Ukraine war, inflationary pressures have remained subdued compared with peer countries. CPI inflation averaged 1.9% in 2022 and fell to 0.8% in March 2023, partially due to slowing food price inflation and declining producer prices as a result of weak demand and a slow recovery in real estate investment. As labour markets start to tighten again, inflation is likely to increase slightly over the coming months but stay below target. To support lending, the central bank lowered the reserve requirement for financial institutions by 0.25 pp in March5 and there could be room for policymakers to take further steps to support the uneven economic recovery. However, Scope expects only targeted support measures as authorities remain concerned about rising financial imbalances.
The official survey-based urban unemployment rate averaged 5.6% in 2022 and has started to fall in early 2023 reaching 5.3% in March as zero-Covid policy restrictions have been lifted. The decrease was driven by a decline in the unemployment rate of the population aged 25-59 from 4.8% in February to 4.3% in March, while those aged 16-24 saw an increase to near record highs at 19.6%. Scope expects the unemployment rate to average 5.4% in 2023 and remain stable in 2024.
Second, China benefits from high external resilience. Resilience to short-term shocks is bolstered by the country’s sizeable foreign exchange reserves, which amounted to USD 3.2trn in March 2023, and its low external debt of USD 2.5trn (13.6% of GDP) as of Q4 2022. Western sanctions on Russia over the Ukraine invasion and hikes in US interest rates have fuelled discussions about a faster reduction of China’s reliance on the US dollar. Anticipated long-run gains by the renminbi as a global reserve currency are expected to increase the government’s capacity to manage higher debt stocks. It would also enhance the currency’s resilience and China’s external-sector stability, such as reducing vulnerabilities to periods of capital outflows. In March 2023, the renminbi became the most widely used currency for cross-border transactions in China, reaching 48.4% of transactions compared with 46.7% of USD-denominated transactions. However, wider global adoption will be gradual as the currency still accounts for just 4.5% of global currency transactions compared with 83.7% for USD transactions according to SWIFT6.
China’s current account surplus increased significantly at the onset of the pandemic, rising from 0.7% in 2019 to 2.3% in 2022. Pandemic-related factors contributed to the higher surpluses and included increased medical exports, subdued outbound tourism and a rapid shift in consumption patterns towards goods rather than services among households abroad. Annual export growth has slowed since mid-2022 as a result of weaker global demand, although the trade surplus was supported by weaker imports driven by the domestic economic slowdown with the real estate crisis reducing commodity imports. We expect the current account surplus to narrow over the coming years as higher commodity and energy prices raise import costs and China’s economy continues to rebalance towards more consumption-driven growth.
The country’s net international investment position (NIIP) has gradually fallen over the past 10 years from 24.5% of GDP in 2010 to 14.0% of GDP in 2022. The decline reflects higher inward direct investment and securities investment received amid robust GDP growth. The NIIP is expected to remain positive but decline over the medium term, although it is still expected to be above the peer group average. FDI inflows reached an all-time high of USD 334bn in 2021 (1.8% of GDP) as the impact of Covid-19 on GDP growth faded and the authorities implemented initiatives to liberalise the economy for foreign firms. However, inflows slowed during 2022, reflecting the impact of continued Covid lockdowns, slowing economic growth and a weaker renminbi due to monetary policy divergence.
Finally, China also benefits from the country’s tight government control in some sectors, which can facilitate effective structural reform in the near term and can provide stability when implementing long-term structural changes. This includes significant control over the banking sector and the ability to implement policies to achieve a soft landing by encouraging gradual deleveraging in the private sector. The ability to implement extensive macroprudential policy tools, such as the three red lines policy to moderate lending to real estate firms and the subsequent 16-point plan to ease restrictions, reflects the authorities’ extensive powers to steer the economy. The government will continue to face a difficult balancing act of deleveraging the economy without causing a significant weakening in growth prospects or a rapid deterioration in public finances.
Core variable scorecard (CVS) and qualitative scorecard (QS)
Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative rating of ‘bbb+’ for the People’s Republic of China after including an adjustment for reserve currency under Scope’s methodology. Hence, under Scope’s methodology, a ‘bbb+’ indicative rating can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses versus a peer group of countries.
For the People’s Republic of China, the following relative credit strengths via the QS have been identified: i) growth potential of the economy; ii) monetary policy framework; iii) macroeconomic stability and sustainability; iv) debt profile and market access; v) current account resilience; vi) external debt structure; vii) resilience to short-term shocks; and viii) banking sector oversight. Conversely, the following relative credit weaknesses have been identified: i) fiscal policy framework; ii) financial imbalances; and iii) environmental factors.
Combined relative credit strengths and weaknesses identified in the QS result in a two-notch positive adjustment and indicate a sovereign credit rating of ‘A’ for the People’s Republic of China.
A rating committee has discussed and confirmed these results.
Factoring of environment, social and governance (ESG)
Scope explicitly factors in ESG sustainability issues during its rating process via the sovereign methodology’s standalone ESG sovereign risk pillar, with a 25% weighting under the quantitative model (CVS) and a 20% weighting in the qualitative overlay (QS).
With respect to environmental risks, the People’s Republic of China receives a low CVS score when compared with peers. While it has a slightly more positive score for the ecological footprint of consumption compared with available biocapacity, it receives a particularly low ranking for having high carbon emissions per GDP, high greenhouse gas emissions per capita and high natural disaster risks. China is the world’s largest emitter of carbon dioxide, accounting for around 27% of global CO2 emissions. While meaningful progress is being made in cutting the carbon intensity of the economy, the World Bank notes that significant policy and regulatory reform will be needed for China to meet its target of stopping the growth in emissions by 20307. The 14th five-year plan set specific targets regarding the energy system and green development, which are broadly in line with China’s current climate commitments to carbon neutrality by 2060.
Regarding social risks, the People’s Republic of China scores higher than its peers in the CVS for having relatively high labour force participation and a low old-age dependency ratio. However, it has the lowest score among peers for its high level of income inequality. Significant social progress has been achieved in recent years, including improvements in poverty, education and health. Moreover, the five-year plan has shifted towards a greater focus on the quality and efficiency of economic growth and citizens’ lives (including concentrating on GDP per capita), with priorities such as boosting social safety nets, reducing urban-rural inequality and on property rights reform. However, social safety nets remain inadequate as less than half of urban employees are ordinarily covered by unemployment insurance, with much lower rates for rural households. According to the World Bank, China’s health expenditures at about 5.3% of GDP remain below other upper middle income countries (5.8%) although the gap has narrowed in recent years. Even though China’s old age dependency ratio is currently healthier than those of advanced economies, the rapidly ageing population will pose challenges for the social security system. The US and other Western nations have repeatedly accused China of human rights violations, which China has disputed.
The People’s Republic of China has traditionally scored low on the World Bank’s Worldwide Governance Indicators8. The country ranks particularly poorly on the voice and accountability ranking. Scores on other categories such as political stability, rule of law and control of corruption have improved in recent years. China achieves its highest ranking in the category of government effectiveness given its effective one-party political system. However, while the power consolidation achieved by President Xi Jinping strengthens reform momentum in the near term, Scope believes it may reduce the quality of governance and policymaking in the long term.
The main points discussed by the rating committee were: i) domestic economic risk, including growth potential and resilience; ii) public finance risks, including fiscal framework and debt dynamics; iii) external risks; iv) financial stability risks, including housing market and household debt; v) ESG considerations; and vi) peer developments.
Rating driver references
1. IMF, People’s Republic of China: 2022 Article IV Consultation, February 2023
2. Asian Development Bank: The 14th Five-Year Plan of the People’s Republic of China
3. Peschel and Liu, Asian Development Bank Working Paper, The Long-Term Growth Prospects of the People’s Republic of China, December 2022
4. Rogoff and Yan, IMF Working Paper, A Tale of Tier 3 Cities, September 2022
5. People’s Bank of China, Required Reserves, March 2023
6. SWIFT, RMB Tracker monthly report, April 2023
7. World Bank, China’s Transition to a Low-Carbon Economy and Climate Resilience Needs Shifts in Resources and Technologies, October 2022
8. World Bank, Worldwide Governance Indicators
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 27 September 2022), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The model used for this Credit Rating and Outlook is the Core Variable Scorecard (version 2.1), available in Scope Ratings’ list of models, published under https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. Also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.
Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party participation NO
With access to internal documents NO
With access to management NO
The following substantially material sources of information were used to prepare the Credit Ratings: public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Eiko Sievert, Director
Person responsible for approval of the Credit Ratings: Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 29 September 2017. The Credit Ratings/Outlooks were last updated on 3 June 2022.
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