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Standard & Poor’s Ratings Services has raised both foreign currency ratings on the People’s Republic of China by one notch to ‘BBB+/A-2’. The outlook is positive. The upgrade reflects China’s more resilient economy after sustained structural reform, and the government’s broader revenue base, which relieves spending pressure and provides room for manoeuvre in pushing ahead with ongoing reform.

“Progress made in the past few years has made China’s economy more market-orientated and less reliant on government spending to maintain GDP growth,” says Ping Chew, director in Standard & Poor’s Sovereign and Public Finance Ratings Group. “Moreover,” he continues, “the state sector, although still inefficient, has boosted its profitability, spurred on by the booming domestic economy and high commodity prices.”

The government’s banking system reform programme – including the recent US$45bn capital injection into two state-owned commercial banks that enhanced their balance sheets – signified further effort to turn the banks into commercial entities.

The overall improvement in the economy, combined with tax reform and tighter administration, has boosted general government revenue to an estimated 19% of GDP in 2003, from 13% in 1998. “This revenue growth allows the government to pad the social safety net to cushion fallout from further SOE restructuring. It will also help to absorb bad debts from the banking system,” says Chew.

“The positive outlook reflects Standard & Poor’s expectation of acceleration in the pace of economic reform,” says Chew. A strengthening of market institutions will sustain growth and raise its potential, and continued reform of the state sector will moderate the contingent liabilities to the government. “Of particular importance is the establishment of a better financial system,” underlines Chew, “this will curb new nonperforming loans and allocate resources more efficiently.”

A stronger banking system will also improve monetary flexibility. Currently, policy tools to deal with rapid growth in credit and monetary aggregates are limited and blunt.

Underpinning China’s investment grade ratings is its strong external position, which is based on high reserve coverage, and the moderate and falling level of its debt and debt-servicing burden. Gross external debt is projected to dip to about 40% of current account receipts and total debt service (including short-term debt) to consume about 20% of current account receipts in 2004. China’s massive foreign exchange reserves cover short-term debt six times, and are expected to increase. Foreign direct investment also continues to flow in.

Despite facing considerable economic and social challenges, China’s policymakers have not wavered in executing reforms gradually and steadily, and their policies have been stable and predictable. This has provided the platform for excellent growth prospects. Moreover, falling trade barriers and more liberal rules for foreign investment in coming years should continue to boost external competitiveness. Real GDP growth is expected to be sustained above 7% per year.

Nevertheless, of concern to China’s creditworthiness is the high level of consolidated government debt and the burden of contingent liabilities to the government. If the government had to assume the stock of bad debts in the financial system and based on a modest nonperforming loan recovery value of 20%, the cost of recapitalising the financial system alone could raise general government debt from the official debt level of 38% of GDP to more than 100%.

The government also faces considerable challenges to build resilient and effective market institutions that are able to govern an increasingly affluent and pluralistic market-oriented economy. Sustainable growth depends on this ability, allowing China’s leadership to manage the strains of rapid economic modernization and social dislocation within an institutional structure that is lagging domestic economic trends.