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A Boost for Beijing

The Chinese government's aggressive restructuring of its financial sector, combined with improved profitability of government-controlled businesses -- state-owned enterprises -- prompted Standard & Poor's Ratings Services to upgrade its long- and short-term sovereign credit rating on the People's Republic to A- from BBB+ on July 20. The ratings outlook remains positive.

Beijing's efforts to strengthen the country's financial system appear to be bearing fruit. Standard & Poor's has lowered its projection of nonperforming loans (NPLs) in the financial system to 25%-28% of total loans by end of 2005.

Standard & Poor's expects this ratio to decline further, citing additional disposals of distressed loans to state-owned entities known as asset-recovery vehicles and the better quality of recent lending.

ENHANCED CREDIT STRENGTHS. Rising cash flow from operations at state-owned enterprises has improved the robustness of loan portfolios, as has better bank supervision -- with additional strengthening expected with higher foreign participation in the financial system.

The government's move to restructure its financial sector will lower contingent fiscal costs and improve the allocation of part of China's high savings rate (exceeding 50% of GDP) to more profitable investment.

These improvements to China's financial system enhance the government's credit strengths. China enjoys a strong external position, with net external assets projected to rise to 80% of current account receipts (CAR) at year-end 2005.

FOREIGN INFLOWS. The nation's substantial foreign exchange reserves, at more than US$700 billion, second only to Japan, are more than seven times the amount of its short-term debt and are expected to increase with continued current and capital account surpluses. China's competitive export sector and growing domestic market continue to benefit from high inflows of foreign direct investment.

The ratings are also supported by the government's commitment to economic reform and excellent economic prospects, with the growth trend exceeding 7% a year. Notwithstanding China's considerable economic and social challenges, policymakers have not wavered in executing reforms gradually, steadily, and predictably.

Standard & Poor's expects China's leadership to maintain a measured and incremental approach in dealing with the current debate over its exchange rate policy in order to preserve its export competitiveness without provoking retaliatory sanctions from major trading partners.

POTENTIAL BURDENS. Despite these strengths and improvements, high levels of government debt and remaining fiscal liabilities constrain the ratings. Direct debt and bank recapitalization costs are expected to increase general government debt to 44% of 2005 GDP, or 220% of government revenue.

This government debt will grow faster than future deficits suggest and could reach 80% of GDP, depending on the pace of transferring additional bad debts of the financial system onto the government balance sheet. Given the sheer size of China's financial system, with domestic credit at about 140% of 2005 GDP, and given bankers' still-developing credit skills, a sharp downturn in economic activity could create fresh burdens for the government.

Furthermore, China faces the challenge of building market and political institutions to govern an increasingly affluent and pluralistic market-oriented economy and society. Weak monetary flexibility is further complicated by the huge capital inflows.

Outlook: The positive outlook reflects Standard & Poor's expectation that China will continue to pursue economic reforms successfully and deliver rising prosperity to its population. Faster progress in further liberalizing the economy would lead to an upgrade.

Conversely, a slowdown of banking and reform of state-owned enterprises -- or policy mistakes that lead to marked decline in economic activity -- could keep the rating stabilized at the current level.

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