MESOPOTAMIA NEWS FITCH RATINGS : RED CHINA IN BEST SHAPE FOR GLOBAL TRADE  / EUROPE NOT !

Rating Action Commentary – Fitch Affirms China at ‘A+’; Outlook Stable

Mon 27 Jul, 2020 – 23:18 ET – Fitch Ratings – Hong Kong – 27 Jul 2020: 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 track record of strong macroeconomic performance, and size as the world’s second-largest economy. The ratings are primarily constrained by large structural vulnerabilities in the financial sector, relatively low per capita income, and weaker governance metrics than those of ‘A’ peers.

After a severe blow to economic activity during the first quarter of this year from the imposition of stringent social distancing measures to contain the spread of the coronavirus, China’s economy is now staging a remarkable recovery. Real GDP rose by 3.2% yoy during 2Q20, above Fitch’s prior expectations, and up from a 6.8% contraction in 1Q20. While the economic recovery remains uneven, with consumer-driven activity lagging the industrial sector, monthly data outturns continue to gain pace amid low domestic infection rates.

Fitch forecasts real GDP growth of 2.7% in 2020 (previously 1.2%), among the highest across Fitch-rated sovereigns this year, though well below China’s five-year historical trend of 6.7%. The risk of further coronavirus outbreaks cannot be ruled out, but the authorities’ recent success in rapidly containing a spike in infections in Beijing points to a growing capacity to manage outbreaks locally, without resorting to the kind of large-scale lockdown that would be highly damaging to economic activity. Fitch’s baseline assumes growth will temporarily accelerate to 7.5% in 2021, before returning to our estimated trend rate of 5.5% in 2022.

Fiscal policy has become highly expansionary to support the economy through the pandemic. The official budget deficit target was raised to 3.6% of GDP at this year’s National People’s Congress, up from 2.8% in 2019. In addition, significant fiscal resources are being mobilised through the issuance of special purpose bonds to fund infrastructure investment and public health initiatives. These expenditures are recognised by the authorities as official budgetary activities, but largely fall outside of the headline deficit. On a Fitch consolidated basis, the agency estimates the general government deficit will rise to 11.1% of GDP this year, up significantly from 4.9% in 2019, though not dissimilar to the scale of fiscal deteriorations globally this year.

Fitch estimates general government debt will rise to 56% of GDP by end-2020 due to the wider deficit, up by 9pp since end-2019, though still in line with the current median of ‘A’ rated peers. Our baseline assumes fiscal support will be scaled back at a sufficient pace to stabilise government debt at about 58% of GDP by 2022, a view premised on our understanding that sizeable revenue and expenditure components of the pandemic response are non-recurring.

The authorities’ fiscal response has thus far not been accompanied by a large rise in off-budget quasi-fiscal spending, perhaps because official financing channels are more plentiful. Fitch estimates the stock of onshore bonds issued by local government financing vehicles rose to 10% of GDP as of mid-July 2020, from 9.3% at end-2019. Quasi-fiscal entities also rely on less transparent financing channels, but data limitations complicate high-frequency surveillance.

The monetary policy response has been relatively restrained, and has included 150bp in cuts to banks’ required reserve ratios, a 30bp reduction in the de facto policy rate, and administrative adjustments to reduce financing costs for borrowers. As a result, credit growth has accelerated, with Fitch’s aggregate financing measure rising by 12.8% at end-June 2020, up from 11.5% a year prior. With nominal GDP growth at a multi-year low, this will lead to a sharp rise in economy-wide leverage this year, to an estimated 274% of GDP by end-2020 from 253% at end-2019, based on official data.
Nevertheless, Fitch expects this trend to be short-lived and for leverage ratios to stabilise in 2021, due to stronger projected economic growth and the continued prominence financial de-risking policies are given in major policy forums.

External finances are robust relative to ‘A’ peers. China is a net external creditor on both a sovereign and economy-wide basis at a forecast 21.9% and 22.5% of GDP, respectively, at end-2020. Foreign reserves have remained stable at about USD3.1 trillion throughout the pandemic, equivalent to 15x current-external payments, and well above that of ‘A’ rated peers. Exports have suffered amid the sharp retrenchment in global activity, which if sustained, could prolong China’s economic recovery, though the impact on its external accounts has been blunted by strong import compression. Fitch forecasts a modest rise in the current account surplus to 1.2% of GDP this year, largely due to a sharp decline in outbound tourism flows.

Geopolitical tensions between China and a number of major economies, including the US, have escalated sharply across a spectrum of issues, including the pandemic, policies towards Hong Kong, territorial claims and a protracted trade dispute. Fitch believes these tensions will persist, even while China’s vast global supply-chain linkages and the extensiveness of global business interests operating in the country will impose a moderating force on them. In the short term, heightened tensions have not had an impact on China’s credit fundamentals, and the degree to which they translate into policies that are supportive, neutral, or detrimental to the sovereign rating will only become evident over time.

The level of interconnectedness and contagion risks within China’s financial system has moderated since 2017, but the size of the potential credit overhang remains large. Near-term profitability and asset-quality pressures from the pandemic are high, as banks are expected to reduce lending rates to support the economy. At the same time, Fitch believes the need to preserve capital buffers will continue to limit banks’ ability to expand excessively.

China’s level of income and development remains low compared with that of peers, even after more than 40 years of rapid growth since market-oriented reforms began in 1978. Per capita income of about USD10,246 is well below the ‘A’ peers’ median of USD19,041. Governance standards also lag those of ‘A’ peers based on surveys such as the World Bank’s 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. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) has in our proprietary Sovereign Rating Model. China has a low WBGI ranking at the 43rd percentile, reflecting relatively weak rights for participation in the political process, uneven application of the rule of law, and elevated levels of corruption.

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 rated peers, as follows:

– Structural: -1 notch, to reflect vulnerabilities in the financial sector, which pose a contingent liability risk for the sovereign balance sheet, given the sector’s large size as a share of GDP.

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

– Macro: +1 notch, we have introduced a new positive notch to offset the deterioration of the GDP volatility and GDP growth variables in SRM driven by the impact of the coronavirus, which we believe will be temporary, and would otherwise add excess volatility to the rating.

RATING SENSITIVITIES

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

– Structural: A material reduction in financial sector risks, for example, through credit growth decelerating to levels 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.

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

– Structural: A sharp rise in financial vulnerabilities, for example through failure to taper credit growth to a level close to nominal GDP growth over the next few years.

– Public finances: Failure to reduce the budget deficit after the initial shock from the pandemic that leads to a sustained upward trend in government debt/GDP, or evidence of a substantial rise in contingent liabilities associated with off-budget quasi-fiscal spending.

– External finances: Sustained capital outflows sufficient to erode China’s external balance-sheet strengths relative to ‘A’ category peers, which would cause the removal of the +1 QO notch on External Finances.

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 latest Global Economic Outlook.

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 highly relevant to the rating and a key rating driver with a high weight.

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.

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.

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.

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.