Fitch Ratings - Hong Kong - 09 Apr 2024: Fitch Ratings has revised the Outlook on China's Long-Term Foreign-Currency Issuer Default Rating (IDR) to Negative from Stable, and affirmed the IDR at 'A+'.

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

KEY RATING DRIVERS

Negative Outlook: The Outlook revision reflects increasing risks to China's public finance outlook as the country contends with more uncertain economic prospects amid a transition away from property-reliant growth to what the government views as a more sustainable growth model. Wide fiscal deficits and rising government debt in recent years have eroded fiscal buffers from a ratings perspective. Fitch believes that fiscal policy is increasingly likely to play an important role in supporting growth in the coming years which could keep debt on a steady upward trend. Contingent liability risks may also be rising, as lower nominal growth exacerbates challenges to managing high economy-wide leverage.

Ratings Affirmed: China's 'A+' rating is supported by its large and diversified economy, still solid GDP growth prospects relative to peers, integral role in global goods trade, robust external finances, and reserve currency status of the yuan. These strengths are balanced against high economy-wide leverage, rising fiscal challenges and per capita income and governance scores below those of 'A' category peers.

Wider Fiscal Deficit: Fiscal stimulus is being stepped up, as the government seeks to offset economic headwinds. We forecast the general government deficit to rise to 7.1% of GDP in 2024 ('A' median 3.0%) from 5.8% in 2023, on a Fitch-consolidated basis, which includes infrastructure and other official fiscal activity outside the headline budget. The 2024 deficit will be the highest since the 8.6% of GDP deficit in 2020. Deficits have been high since 2020, running roughly twice the 3.1% of GDP 2015-2019 average.

Central Government Plays Larger Role: The central government (CG) will shoulder a greater share of the fiscal burden in 2024, as local and regional government (LRG) finances remain constrained from declines in land-related revenue and high debt burdens. In 2024, the CG plans a CNY1 trillion (0.8% of GDP) ultra-long bond issuance, on top of a bond issuance of the same size in 2023.

Uncertain Consolidation Path: We expect deficit reduction to be gradual as it will likely be balanced against economic growth objectives. There is little clarity on reform measures to support medium-term fiscal consolidation. The revenue base has also eroded, as a result of tax relief measures since 2018 and a weaker outlook for property-related revenue (20%-30% of total LRG revenue). The CG will likely continue taking on a larger fiscal role to support investment priorities, amid renewed efforts to curtail off-budget spending, particularly if there is an absence of reforms to enhance LRG revenue.

Government Debt Rising Steadily: We forecast general government debt (explicit local and central government debt) to rise to 61.3% of GDP in 2024 (54.0% 'A' median) from 56.1% in 2023. This is a clear deterioration from 38.5% in 2019, when debt was well below the peer median, due primarily to sustained fiscal support to counter economic pressures. Debt as a share of revenue is forecast to be 234% in 2024, well above the 145% 'A' median. We forecast the debt ratio to rise to 64.2% in 2025 and nearly 70% by 2028, higher than our forecast of just under 60% in our previous review.

The degree to which fiscal support reignites underlying GDP growth is a key uncertainty for our debt path. Risks from higher government debt are mitigated by a high domestic savings rate, which supports debt affordability and financing flexibility.

Contingent Liabilities: We view fiscal risks as higher than suggested by official government debt metrics, given perceptions that certain government-related entities carry implicit government support. Non-financial corporate liabilities stood at 167% of GDP at end-3Q23. Our baseline does not envision the government engaging in large-scale balance sheet support, but rather incremental support, including through the policy institutions and state banks, so as to respond to potential financial stability risks to preserve economic and social stability.

Fiscal Risks from LGFVs: LRGs have been affected by the property slowdown and some Local Government Financing Vehicles (LGFVs) are facing refinancing pressures. In 2023, some highly indebted regions were permitted to issue about CNY1.4 trillion in refinancing bonds to bring LGFV debt directly onto their balance sheets; we expect such issuance to continue in 2024. Banks have been requested to support LGFV debt structures through restructurings, while local asset management companies have also stepped in with support.

The incremental approach to managing LRG debt challenges from LGFVs means that risks of contingent liability crystallisation are likely to remain for some time, potentially creating a gradual, but persistent, drain on fiscal resources. Large state banks are well positioned to manage a gradual pace of restructurings in the near term, whereas local and regional banks face greater difficulties.

Near-Term Growth Headwinds: Fitch forecasts GDP growth to moderate to 4.5% in 2024, from 5.2% in 2023, due to persistent property sector weakness and subdued household consumption, resulting from negative wealth effects from the property correction and somewhat sluggish income growth. These headwinds are partly offset by fiscal stimulus, with external demand turning mildly supportive.

Deflation Remains a Concern: Deflationary risks have emerged over the past year, amid weak domestic demand dynamics and temporary factors. We do not forecast a prolonged period of deflation, with inflation of 0.7% by end-2024 and 1.3% by end-2025. Even so, risks are tilted to the downside and inflation could remain lower than we forecast, further weighing on the nominal GDP growth outlook.

Medium-term Growth Prospects: Fitch forecasts growth to remain around 4.5% through 2028 - higher than rating peers - supported by large manufacturing and tech sectors, high investment and urbanisation. Sustained investments in technologically advanced industries, in line with government objectives, could boost productivity and enhance growth prospects. Notable downside risks include uncertainties around the economic transition, demographics, declining productivity, abrupt regulatory policy shifts and geopolitical risks, especially related to trade and investment flows.

Central Role in Global Supply Chains: China's pivotal role in global trade and manufacturing has provided the economy and external finances a degree of strength and resilience that is uncommon among Fitch-rated sovereigns. This role has been sustained, despite years of rising trade tensions with the US. Supply chain diversification is gathering pace, but we believe this process will be gradual given China's advanced manufacturing ecosystem, high quality infrastructure and shift into higher value-added industries.

ESG - Governance: China has an ESG Relevance Score (RS) of '5' for Political Stability and Rights and '5[+]' for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption. These scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. China has a medium WBGI ranking at the 41st percentile, reflecting a record of peaceful political transitions, limited participation in the political process, relatively high institutional capacity, uneven application of the rule of law, and a moderate level of corruption.

RATING SENSITIVITIES

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade

- Public Finances: A continued upward trajectory in general government debt/GDP from persistently high fiscal deficits or a rise in the probability of the materialisation of contingent liabilities, for instance from LGFVs or the financial sector, such that government debt levels compare less favourably with rated peers.

- Macro: Reduced confidence in medium-term growth prospects.

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade

- Public Finances: Faster deficit reduction consistent with a stabilisation of the general government debt ratio in the medium term, for instance through a stronger and sustained recovery in underlying growth or fiscal reforms which structurally improve local government finances.

- Macro: Stronger medium-term growth prospects, which bring per capita GDP more closely in line with rating peers and increases China's weight in the global economy.

- Structural Features: A material reduction in macro-financial risks and associated contingent liabilities facing the sovereign, for example, by maintaining credit growth below nominal GDP growth over a multi-year period, which would cause the removal of the -1 QO notch on structural features.

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 SRM data and output, as follows:

- Structural: -1 notch, to reflect high debt levels outside of the explicit general government sector and large and opaque financial system, which carries potential risks to macro-financial stability and of contingent liabilities migrating to the sovereign balance sheet.

- Macro: Fitch has introduced a +1 notch to reflect lingering negative effects on structural and macroeconomic indicators, including per capita income, China's share in global GDP, and GDP volatility, on the SRM score from the prolonged Covid-19 pandemic-related disruptions in China and weaker yuan against the US dollar. We believe these negative effects could be temporary in nature and may be adding additional volatility to the SRM score.

- External Finances: +1 notch, to reflect strengths in China's external finances not fully captured in the SRM, such as its net external creditor status, the size of its foreign reserve holdings, and pivotal role in global merchandise trade and manufacturing.

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.

COUNTRY CEILING

The Country Ceiling for China is 'A+', in line with the LT FC IDR. This reflects no material constraints and incentives, relative to the IDR, against capital or exchange controls being imposed that would prevent or significantly impede the private sector from converting local currency into foreign currency and transferring the proceeds to non-resident creditors to service debt payments.

Fitch's Country Ceiling Model produced a starting point uplift of 0 notches above the IDR. Fitch's rating committee did not apply a qualitative adjustment to the model result.

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 WBGIs 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 China has a percentile rank below 50 for the respective governance indicator, this has a negative impact on the credit profile.

China has an ESG Relevance Score of '5[+]' for Rule of Law, Institutional & Regulatory Quality and Control of Corruption, as WBGIs 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 China has a percentile rank above 50 for the respective governance indicators, this has a positive impact on the credit profile.

China has an ESG Relevance Score of '4' for Human Rights and Political Freedoms, as the Voice and Accountability pillar of the WBGIs is relevant to the rating and a rating driver. As China has a percentile rank below 50 for the respective governance indicator, this has a negative impact on the credit profile.

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. As China has record of 20+ years without a restructuring of public debt and captured in our SRM variable, this has a positive impact on the credit profile.

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/topics/esg/products#esg-relevance-scores.