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Standard & Poor’s Ratings Services has raised its long and short-term sovereign credit ratings on the People’s Republic of China to ‘A-/A-1’ from ‘BBB+/A-2’. The outlook is positive.

 

“The upgrade reflects the Chinese government’s aggressive restructuring of its financial sector combined with improved profitability of the state-owned enterprises (SOEs),” says Standard & Poor’s credit analyst Ping Chew.

 

China’s economic restructuring and macroeconomic stability has engendered a virtuous cycle. Given its considerable economic and social challenges, China’s policymakers have not wavered in executing reforms gradually, steadily, and predictably. This strengthens China’s exceptional growth prospects, and boosts the policymakers’ financial resources, including budgetary revenue and central bank’s assets.

 

The improved flexibility is thus allowing China to overcome one of its key challenges, ie, its weak banking system. Standard & Poor’s has lowered its projection of non-performing loans (NPLs) in the financial system to 25-28% of total loans by end of the year. Standard & Poor’s expects this ratio to decline further because of additional distressed loan disposals to state-owned asset recovery vehicles and because of the better quality of recent lending.

 

Rising cash flow from operations at the SOEs has improved the robustness of performing loans portfolios, as has better bank supervision, with additional strengthening expected with higher foreign participation in the system. The government actions 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 sovereign’s credit strengths. China enjoys excellent growth prospects and has a strong external position, with net external assets projected to rise to 80% of current account receipts (CAR) at year-end 2005.

     

    “Nevertheless, these strengths are offset by the high level of government debt and high contingent liabilities, the inadequacy of effective market institutions, and weak monetary flexibility,” cautions Chew.

     

    Direct government debt and bank recapitalization are expected to increase general government debt to 44% of 2005 GDP, or 220% of 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.

     

    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 liberalising the economy by more reflective interest rates, reducing price controls, and raising the productivity of its non-tradable sector would lead to an upgrade. Conversely, a slowdown of banking and SOE reform or policy mistakes that lead to marked decline in economic activity could have the ratings stabilise at the current level.

     

    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 to preserve its export competitiveness without provoking retaliatory sanctions from its major trading partners.