Ripley’s believe it or not world continues. Earlier today, Hong Kong’s Hang Seng market entered a bull market, rising 20% from its February lows, just as Hong Kong retail sales plunged 20.6%, the bigest drop since 1999…
… and then moments ago, in a move that pushed the Chinese Yuan stronger at least initially, S&P revised its Chinese outlook to negative, saying the economic rebalancing is likely to proceed more slowly than had expected over next 5 years and warning about China’s debt load.
Among the report highlights:
- The economic and financial risks to the Chinese govt’s creditworthiness are gradually increasing and could lead to a downgrade this year or next
- Forecasts China’s economic growth over next 3 years will remain at or above 6% annually, but government and corporate leverage ratios are likely to deteriorate, and the investment rate could be well above what S&P calculates to be sustainable levels of 30%-35% of GDP
- These trends could weaken the Chinese economy’s resilience to shocks, limit the govt’s policy options, and increase the likelihood of a sharper decline in trend growth rate
- May downgrade if China looks to be increasing credit at a significantly faster rate than the nominal GDP growth in a bid to stabilize growth at or above 6.5%, such that the investment ratio is above 40%
- The negative outlook also partly reflects S&P’s opinion that the pace and depth of State Owned Enterprise reform may be insufficient to attenuate the risks of credit-fueled growth
- China’s monetary policy is largely credible and effective, as demonstrated by its track record of low inflation and its pursuit of financial sector reform
- The nation’s credit rating is AA- with a negative outlook, S&P said in a statement
Full note:
S&P Revises China Outlook To Negative; Afrms ‘AA-/A-1+’ Rtgs
OVERVIEW
- Following China’s legislative meetings in March 2016, we believe the country’s reform agenda is on track.
- However, we are revising the rating outlook on China to negative from stable because economic rebalancing is likely to proceed more slowly than we had expected.
- We are also affirming our ‘AA-/A-1+’ sovereign credit ratings and ‘cnAAA/cnA-1+’ Greater China regional scale ratings on China.
RATING ACTION
On March 31, 2016, Standard & Poor’s Ratings Services revised the outlook on the People’s Republic of China to negative from stable. At the same time, we affirmed our ‘AA-‘ long-term and ‘A-1+’ short-term sovereign credit ratings on China. We also affirmed the ‘cnAAA’ long-term and ‘cnA-1+’ short-term Greater China regional scale ratings on China. Our transfer and convertibility risk assessment on China is ‘AA-‘.
RATIONALE
We revised the outlook to reflect our expectation that the economic and financial risks to the Chinese government’s creditworthiness are gradually increasing. This follows from our belief that, over the next five years, China will show modest progress in economic rebalancing and credit growth deceleration.
We project that China’s economic growth over the next three years will remain at or above 6% annually. However, government and corporate leverage ratios are likely to deteriorate, in our view, and the investment rate could be well above what we believe to be sustainable levels of 30%-35% of GDP and among the highest ratios of rated sovereigns. In our opinion, these expected trends could weaken the Chinese economy’s resilience to shocks, limit the government’s policy options, and increase the likelihood of a sharper decline in trend growth rate.
The ratings on China reflect our view of the government’s reform agenda as reaffirmed by the recently concluded National People’s Congress as well as the country’s growth prospects and strong external metrics. We weigh these strengths against certain credit factors that are weaker than what is typical for similarly rated peers. For example, China has lower average income, less transparency, and a more restricted flow of information.
The Chinese government is taking steps to bolster its economic and fiscal resilience. Most importantly, we view the government’s anti-corruption campaign as a significant move to improve governance at state agencies and state-owned enterprises (SOEs). Over time, this could translate into greater confidence in the rule of law, improvements in the private-sector business environment, more efficient resource allocation, and a stronger social contract.
The government continues to make significant reforms to its budgetary framework and to the financial sector. These changes could yield long-term benefits for China’s economic development. The government also appears to be signaling that it will allow SOEs with lesser policy importance to exit the market either through merger, closure, or default in order to allocate resources more efficiently. However, our negative outlook is partly motivated by our opinion that the pace and depth of SOE reform may be insufficient to attenuate the risks of credit-fueled growth.
China’s policymaking has helped it maintain consistently strong economic performances since the late 1970s. However, coordination issues between the line ministries and the State Council sometimes lead to unpredictable and abrupt policy implementation. The authorities also have yet to develop an effective communication channel with the market to convey policy intent, heightening financial volatility. Moreover, China does not benefit from the checks and balances usually coming from the free flow of information. These characteristics can lead to the misallocation of resources and foster discontent over time.
We expect China’s economic growth to remain strong at 6% or more annually through at least 2019, corresponding to per capita real GDP growth of above 5.5% each year. By 2019, we project per capita GDP to rise to more than US$10,000 from a projected US$8,200 for 2016, given our assumptions about growth and the relative strength of the renminbi versus the dollar. Over the next three years, we expect final consumption’s contribution to economic growth to increase. However, we believe the gross domestic investment rate is likely to remain above 40% of GDP. We also expect credit in China to outpace nominal GDP over this period. Thus we expect domestic credit to rise from below 165% of GDP in 2016 to close to 180% by 2019.
These projections reflect our view that the Chinese government will seek to boost public investment that are financed by strong credit growth to support the economy. Although some officials have voiced concerns over rising leverage in China, the latest Chinese five-year plan calls for average growth of about 6.5% annually in the 2016-2020 period. We believe that achieving this rate of growth will require credit growth to outpace nominal GDP growth in the period.
China’s external profile remains a key credit strength despite the decline of China’s foreign exchange reserves. We partly attribute the fall of reserves to increased expectations of renminbi depreciation. This reflected the uncertainties following a change in the authorities’ management of the currency introduced last year. As a consequence, some private sector firms reduced or hedged their dollar debt and exporters kept a greater share of their proceeds in foreign exchange. This source of financial account outflows should dissipate as expectations adjust with clearer policy signals regarding the exchange rate policy.
China remains a large external creditor. We expect financial assets held by the public and financial sectors to exceed total external debt by a little more than 100% of current account receipts (CAR) at the end of 2016. At the same time, we estimate that the country’s total external assets exceeded its external liabilities by approximately 65% of its CAR. China’s external liquidity position is equally robust. We expect its current account surplus to be sustained at more than 2.5% of GDP in 2016-2019. We project annual gross external financing needs in 2016-2018 to total less than 60% of CAR plus usable reserves.
The increasing global use of the renminbi also bolsters China’s external financial resilience, in our view. According to the Bank for International Settlement’s (BIS’) “Triennial Central Bank Survey,” published September 2013, the Chinese currency is one leg of 1.7% of global spot foreign exchange transactions. Demand for renminbi-denominated assets from both official and private-sector creditors could rise with the inclusion of the renminbi in the IMF’s Special Drawing Rights basket of currencies.
Over time, we expect the share of renminbi-denominated official reserves to rise to its share of foreign exchange transactions. Although the People’s Bank of China (the central bank) does not operate a fully floating foreign exchange regime, over the past decade it has allowed greater flexibility in the nominal exchange rate. Based on estimates from the BIS, we compute that the real effective exchange rate has also appreciated by close to 21% since 2011.
China is implementing its most ambitious fiscal reforms since 1994 to improve fiscal transparency, budgetary planning and execution, and subnational debt management. The speed of implementation is relatively gradual, owing to the weak economic environment. Nevertheless, as these reforms are pushed ahead, they could help the government to manage slower growth of fiscal revenue and lower its reliance on revenues related to land sales that will accompany slower economic growth.
In 2016-2019, we expect the government to keep the reported general government deficit to within 3% of GDP. However, off-balance-sheet borrowing could continue for the next two to three years. This reflects both the financing needs of projects started before 2015 as well as some new projects that the central government is willing to authorize to support growth. Consequently, we project the increase in general government debt in each of these years to be 3%-4% of GDP.
Due to these projected increases over the next few years, the government’s debt as a share of GDP could rise moderately. We have already included the entire sum of RMB16 trillion (US$2.5 trillion, 23.6% of 2015 GDP) of direct debt owed by local governments in general government debt from 2015. This step-rise in debt followed the finance minister’s announcement that the provincial-level governments will issue bonds to redeem debts largely owed by local government financing vehicles to banks over the next three years. Given our assumptions regarding growth and the moderate financing costs (less than 5% of revenues) arising from sizable domestic liquidity, we project that net general government debt will plateau at 43% of GDP through the forecast horizon.
Although the fiscalization of the local government financing vehicles has raised our figure for government debt, it has simultaneously decreased our estimates for contingent liabilities to the government from this sector. The financing vehicle loans that are being redeemed through government bonds issuances are largely owed by companies with weak financial metrics. By putting these loans on its balance sheet, we believe that the government has significantly reduced the banks’ credit risks.
We believe that China’s monetary policy is largely credible and effective, as demonstrated by its track record of low inflation and its pursuit of financial sector reform. Consumer price index (CPI) inflation is likely to remain at 1%-3% annually over 2016-2019. Although the central government–through the
State Council–has the final say in setting rates, the central bank has significant operational independence, in our view, especially regarding open-market operations. These operations affect the economy through a largely responsive interbank market and a sizable and fast-expanding domestic bond market. Last year’s liberalization of deposit rates at banks is an important reform that could further improve monetary transmission in China, in our view.
OUTLOOK
The negative outlook reflects our view of gradually increasing economic and financial risks to the government’s creditworthiness, which could result in a downgrade this year or next.
A downgrade could ensue if we see a higher likelihood that China will seek to stabilize growth at or above 6.5% by increasing credit at a significantly faster rate than the nominal GDP growth, such that the investment ratio is above 40%. Such trends could weaken the Chinese economy’s resilience to shocks, limit the government’s policy options, and increase the likelihood of a sharper decline in the trend growth rate.
The ratings could stabilize at this level if the central government adopts policies to moderate credit growth at levels more in line with nominal GDP growth, accompanied by signs that rebalancing will progress more quickly than we currently expect. This could allow the investment ratio to come down to levels that we believe to be more sustainable.
We would also see a higher likelihood that credit metrics will stabilize at the current rating level if the government continues to implement reforms that lead to much greater reliance on market-based macroeconomic management tools. Better transparency, improved information availability, deeper liberalization of the financial market, and greater official use of renminbi for reserve management would support such reforms.
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