S&P Affirms Ratings on China; Sees Increased Resiliency on New Reforms (FXI)

OVERVIEW

• We believe government policies will make China's economy more resilient.
• We are affirming our 'AA-' long-term and 'A-1+' short-term sovereign credit rating on China.
• We are also affirming our 'cnAAA/cnA-1+' Greater China regional scale ratings.
• The stable outlook reflects our expectation that reform towards a more market-driven economy and enhanced governance could help China sustain robust GDP growth while curbing credit growth over the next two to three years.

RATING ACTION

On Feb. 26, 2015, Standard & Poor's Ratings Services affirmed the 'AA-' long-term and 'A-1+' short-term sovereign credit ratings on the People's Republic of China. The outlook on the long-term rating is stable. In line with this, we are also affirming our 'cnAAA/cnA-1+' Greater China regional scale ratings. Our transfer and convertibility (T&C) assessment is 'AA-'.

RATIONALE

The ratings on China reflect our view of the government's reform agenda, the country's growth prospects, and its strong external metrics. We weigh these strengths against credit factors that are weaker than typically seen in similarly rated peers. These include China's lower average income, lesser transparency, and more restricted information flows.

We believe the government is taking a number of steps to make its economy and public finances more resilient. Initiatives include determined efforts to reduce graft, measures to enhance the business environment for private companies, and directives to delineate more clearly the fiscal responsibilities of different levels of the public sector. Reforms to liberalize the financial sector include allowing greater flexibility in the exchange rate regime.

The design and implementation of the government's measures support our view that policymaking has generally been effective since China embarked on reforms in the late 1970s. We acknowledge that the central government has delivered strong economic growth and sustainable public finances. However, limited information flow could lead to the misallocation of resources and create discontent over time.

Implementing the central government's reforms may help to lower China's growth rate over the next few years. But we believe the reforms will also reduce the chances of abrupt changes in GDP from one year to the next.

We also expect sluggish demand for China's exports, a soft property market, and slowing credit growth to weigh on the economy in the next year. We estimate that annual growth in real GDP will average roughly 6% over the next decade from 10% in the previous decade. Such growth is still faster than that of countries with similar income levels. GDP per capita would likely reach US$8,100 in 2015 from US$7,500 in 2014.

China's strong external profile remains a key credit strength. We expect China to post a current account surplus of close to 2% of GDP over the next three years--partly as more Chinese exporters move up in the value chain and as improved transportation links better connect inland provinces to foreign markets. China is a large external creditor. By the broadest measure, we estimate the country's external assets exceeded its external liabilities by 73% of its current account receipts (CAR) at end-2014. China's external liquidity position is equally robust: We project its gross external financing needs in 2015 will be only 52% of CAR plus usable reserves.

We project the reserves will rise moderately over the next three years from about US$4 trillion in 2014. These reserves are a major part of China's non-equity external assets. We estimate the reserves represent a third of global currency reserves as of the third quarter of 2014, based on the IMF's "Currency Composition of Official Foreign Exchange Reserves."

The increasingly global use of China's currency is also bolstering its external financial resilience, in our view. According to the Bank for International Settlement's "Triennial Central Bank Survey," published September 2013, the renminbi is one leg of 1.7% of global spot foreign exchange transactions. Although the People's Bank of China (the central bank) does not operate a fully floating foreign exchange regime, it has allowed much greater flexibility in the exchange rate. This in turn has provided a useful buffer to external shocks, a boost to domestic consumption, and a palliative to protectionist sentiment from China's major trading partners.

We expect China to maintain a largely healthy fiscal profile over next two to three years. The country's most ambitious fiscal reforms since 1994 include much greater fiscal transparency, better budgetary planning and execution, and risk-based subnational debt management. Speedy implementation of these reforms could help China manage slower growth of fiscal revenue during the next two to three years. We therefore project reported general government debt will increase by an average of 2.6% of GDP each year over 2015-2017. Our forecast factors in the prospective issuance of provincial governments bonds to refinance some of the debts of government-related entities (GREs).

The government's debt position remains a credit strength for the sovereign rating. We believe that China's net general government debt should rise modestly to only 19% of GDP in 2017 from 16% in 2015, and interest expenses will likely remain below 2.5% of general government revenue. China's net general government debt should be notably lower than 60% of GDP, even if we factored in some of the debt (mostly bank loans) incurred by GREs that rely in substance on fiscal funds for repayment. Excluding such GRE debt, we do not believe contingent fiscal liabilities from the financial or other sectors pose material risks to public finances.

We believe that China's monetary policy is largely credible and effective, as highlighted by low inflation. China's consumer price index (CPI) has risen on average 3% over 2008-2014. The CPI inflation is likely to remain at 1%-2% annually over 2015-2017. Although the central government has the final say in setting rates, the central bank has significant operational independence, in our view, especially regarding open-market operations. The impact of these operations on the economy transmits through a largely responsive interbank market and a sizable and expanding domestic bond market.

OUTLOOK

The stable outlook is based on our assessment that the central government's policy agenda will make China's economy more resilient to shocks, meaning less-extreme changes in GDP. This assessment includes our assumption that China should be able to curb credit growth and gradually shift its growth model away from investment towards private consumption.

We may raise the ratings if the central government's announced reforms lead to much greater reliance on market-based macroeconomic management tools. Support would likely come from better transparency, improved information availability, and deeper liberalization of the financial market.

Conversely, we may lower the ratings if material contingent fiscal risks crystalize, perhaps due to a hard landing of the economy. Such a scenario is contrary to our current expectation, however. We could also lower the ratings if policymakers resort to fast credit expansion to cushion economic shocks prior to having materially better governance to prevent ineffective investments. Such a scenario would increase the risks to stability in the financial sector and may trigger a sharp correction of the economy.

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