Fitch Downgrades China to Negative on Rising Public Finance Risks

The Fitch Ratings logo is seen at its offices at the Canary Wharf financial district in London, on March 3, 2016. Reinhard Krause/Reuters

Following Moody’s lowering of China’s credit rating outlook last December, ratings agency Fitch downgraded its China sovereign credit rating to Negative on Tuesday, citing risks to public finances as the economy shifts to new growth models.

Given China’s economic woes in the past two years, while analysts hardly found Fitch’s latest move surprising, the new cut in the ratings outlook, however, highlights increasing concern over debt sustainability.

“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,” Fitch said  in its ratings action commentary on Tuesday.

In recent years, widespread deficits and escalating government debt have diminished fiscal buffers from a ratings standpoint, the agency added. It also said that China’s fiscal policy is poised to assume a crucial role in bolstering growth in the foreseeable future, potentially perpetuating a steady increase in debt.

Besides, contingent liability that may or may not occur, including government guarantees or obligations related to state-owned enterprises risks, could be on the rise as lower growth exacerbates the challenges of managing high economy-wide debts.

“We view fiscal risks as higher than suggested by official government debt metrics, given perceptions that certain government-related entities carry implicit government support,” said Fitch.

The agency estimated that non-financial corporate liabilities were 167 percent of GDP at the end of the third quarter of 2023, and suggested gradual government support, including through policy institutions and state banks, to address financial stability issues and protect economic and social stability.

Other reasons contributing to the downgrade include risks arising from local government financing vehicles (LGFVs), a slowdown in growth, and a shift away from the former public financing strategy, which was primarily reliant on local governments highly dependent on land sales for their revenues.

Although these challenges have been extensively debated by experts, Fitch highlighted that the central government is expected to take on a higher degree of fiscal responsibility, raising its debt-to-GDP ratio, which has previously been relatively low.

In 2023, China’s debt-to-GDP ratio reached a new peak despite slower borrowing, signaling the economy’s faltering growth, according to a recent report by a state-backed think tank.

The macro-leverage ratio, indicating the total outstanding non-financial debt relative to nominal GDP, surged to 287.8 percent in 2023, marking a 13.5 percentage-point increase compared to the previous year, said a report by the National Institution for Finance and Development, reported Caixin Global.

A Fiscal Conundrum

Fitch’s downgrade underscores the challenging choices facing policymakers; “the dilemma between fiscal spending or consolidation,” wrote Lynn Song, chief economist, Greater China at ING, in his note on Wednesday (viewed by The Epoch Times).

According to him, while there’s a pressing need to bolster short-term economic growth, with fiscal support that may be crucial to avoid the “Japanization” trap—a cycle of weak confidence, declining asset values, and sluggish growth, which could temporarily inflate government debt levels.

On the other hand, prioritizing long-term fiscal consolidation remains crucial. Finding alternatives to land sales is essential in the medium term, yet conventional solutions like raising taxes are currently unpopular given the economic climate. However, the reliance on land sales for government financing must evolve as China’s economy undergoes transition.

Mr. Song adds that focusing on short-term stabilization might overshadow long-term consolidation efforts, potentially worsening the debt outlook initially. Failure to revive growth and confidence could weaken the GDP aspect of the debt equation, jeopardizing long-term debt sustainability.

“However, it is important that fiscal spending from this point onward is directed toward productive areas of growth for the future,” he wrote.

Growth Challenges

Fitch anticipates China’s general government deficit, covering infrastructure and other fiscal activities outside the headline budget, to increase to 7.1 percent of GDP in 2024 from 5.8 percent in 2023, marking the highest since 8.6 percent in 2020, attributed to strict COVID-19 measures.

Despite downgrading the outlook to negative from stable, implying a potential medium-term downgrade, the agency, however, affirmed China’s issuer default rating at ‘A+’, equivalent to Moody’s A1.

But Fitch projects China’s economic growth to decelerate to 4.5 percent in 2024 from 5.2 percent last year, while the International Monetary Fund forecasts a 4.6 percent growth rate for this year. These figures reinforce Beijing’s ambitious GDP growth target of around 5.0 percent for 2024.

China aims to reduce its budget deficit to 3 percent of economic output from a revised 3.8 percent last year. China also plans to issue 1 trillion yuan ($138.30 billion) in special ultra-long-term treasury bonds, not accounted for in the budget.

The special bond issuance quota for local governments is set at 3.9 trillion yuan, compared to 3.8 trillion yuan in 2023.

Fitch’s ratings decision, though, was met with a pushback by China’s finance ministry, which promised action to mitigate risks associated with local government debt.

“In the long run, maintaining a moderate deficit size and making good use of valuable debt funds is beneficial for expanding domestic demand, supporting economic growth, and ultimately maintaining good sovereign credit,” the ministry said in a statement, reported by Reuters.

But Fitch argues that the policymakers’ consolidation path is uncertain.

The agency felt there is little clarity about reforms to help medium-term budgetary consolidation. The revenue base has also shrunk as a result of tax cuts implemented since 2018 and a weaker outlook for property-related revenue.

The central government will most certainly continue to play a stronger fiscal role to support investment initiatives, despite intensified attempts to reduce off-budget expenditure, particularly in the absence of reforms, Fitch said.

In other words, China confronts a tougher scenario in its public finances due to the dual impact of slowing growth and increased debt.