China, Hong Kong Climb the Ratings Ladder
Standard & Poor's Ratings Services raised its long-term sovereign credit rating on the People's Republic of China on July 27 to A from A-. The outlook is stable. At the same time, Standard & Poor's raised its long-term credit ratings on China Development Bank and Export-Import Bank of China to A from A-. The outlooks on the banks are stable. The ratings reflect their sovereign parent.
Also on July 27, Standard & Poor's Ratings Services raised the long-term credit rating on Hong Kong Special Administrative Region to AA from AA-. The outlook for the rating is stable.
What's behind the upgrades for China and Hong Kong? Here, S&P explains its rationale for each:
"The upgrade on the ratings on China reflects China's persistent efforts to strengthen the banking sector to reduce the future fiscal burden, as well as China's continuing economic liberalization and reform that will further entrench excellent growth prospects," says Standard & Poor's credit analyst Ping Chew. At the same time, notes Chew, improving fiscal flexibility, robust external liquidity, and strong government commitment shield the country from most shocks, and facilitate the process of gradual restructuring. This has also led to progressive improvements in credit fundamentals since 1999.
Significant progress has been made through the government's ongoing restructuring of the financial sector. Continuing regulatory and supervisory strengthening, the efforts to clean up past bad loans, and the better quality of loan books (which have benefited from strong corporate cash flows) have led Standard & Poor's to lower its estimation of existing nonperforming assets in the financial system to 21% to 25% of total loans by the end of 2005, which is expected to decline further.
Foreign participation in China's financial system will also help to spread best practices, which in turn will improve the performance of the banking sector's credit underwriting. While the above range of 21% to 25% is still among the highest compared to other banking systems, the contingent cost to the government is substantially lower, and allows better allocation of China's high savings rate (exceeding 50% of GDP) to more profitable investments.
China's high economic growth has engendered strong budgetary performances, with rising revenue, expected to reach 20% of 2006 GDP, and falling deficits, expected to be less than 1% of 2006 GDP. This strong budgetary performance allows the government to effectively deal with past excesses in the banking system and economy. China's foreign exchange reserve, already the largest in the world, will reach $1 trillion before year's end, and is expected to increase with continuing current and capital account surpluses.
"Nevertheless, these strengths are offset by the high level of government debt and high contingent liabilities, the inadequacy of market institutions, and limited monetary flexibility," cautioned Mr. Chew.
The current cycle, especially the rapid loan and investment growth in the first half of 2006, highlight how China's structural rigidities, including its exchange rate and use of investment as a key driver of growth, have constrained monetary policy. This is further complicated by huge capital inflows and liquidity overhang. The authorities have to apply administrative measures to limit credit growth, rather than let market forces operate through pricing, exchange rates, and interest rates.
Nonetheless, the authorities have reacted early in this cycle, tightening monetary policy and attempting to limit unproductive investments. China's central bank raised its reserve requirement in July for the second time in two months to 8.5%. While current measures are only the first steps, Standard & Poor's expects ongoing efforts to moderate growth to more sustainable levels. More lending-rate hikes and monetary tightening, including gradual appreciation of the yuan, are expected.
China's credit strengths are mitigated by high levels of government debt and contingent liabilities. Direct debt and bank recapitalization costs are expected to increase general government debt to 40% of GDP, which could reach 60%to 70% of GDP, depending on the pace at which existing bad debts of the financial system are transferred onto the government balance sheet. Furthermore, China faces the challenge of building market and political institutions to govern an increasingly affluent and pluralistic market-oriented economy and society. Income inequality is still an unresolved problem that could increase social pressures.
The stable outlook reflects the expectation that China will maintain macroeconomic stability while it continues with its economic restructuring. A slowdown of banking and state-owned enterprises reform, or policy mistakes that lead to a marked decline in economic activity, could result in a negative outlook. Any failure to manage the monetary environment presents the greatest risk to growth and banking system asset quality in the short term.
"The new rating mirrors the positive effect on Hong Kong arising from the improved credit fundamentals of the People's Republic of China, the ultimate sovereign," says Standard & Poor's credit analyst Kim Eng Tan. "The higher credit rating on China reduces the likelihood of potential negative developments in China spilling over to Hong Kong and adversely affecting its credit standing."
The fundamental supports for the ratings on Hong Kong, however, remain its economic strength, the government's large net creditor position, and a large net external creditor position. Recent improvements to Hong Kong's fiscal situation, particularly the discipline shown by the administration in controlling expenditure, have further reinforced this support.
Hong Kong's continuing reliance on cyclical and volatile sources of revenue—asset sales, land sales, and investment income—remains a key credit weakness. Broadening the tax base would reduce this revenue volatility. The government has begun the process of addressing this weakness by launching a public consultation on the possible introduction of a Goods and Services Tax.
As a special administrative region of China, the ultimate sovereign, the ratings on Hong Kong are constrained by those on China. Nevertheless, Hong Kong enjoys higher ratings than China because of the large degree of autonomy in domestic policy, international economic relations, and external affairs that is enshrined in the Basic Law. This shields Hong Kong from risks associated with weaker mainland institutions to a significant degree.
The stable outlook on Hong Kong reflects expectations of the government's ability to maintain its fiscal balance by continuing to exercise discipline in restraining expenditure growth. Further improvements in China's credit strength, coupled with the implementation of measures to increase the stability of public finance, would have a positive impact on the credit rating on Hong Kong.
Conversely, a renewed deterioration in the fiscal situation could weaken the credit rating on Hong Kong. This could arise in the event of a sustained economic slowdown due to the reliance of the government on highly volatile sources of revenue.