Thomas Torgerson Authors

Ratings, Risks and Readjustments

November 10, 2023

Thomas Torgerson, Managing Director and Co-head of Sovereign Ratings at DBRS Morningstar, discusses China’s economic headwinds and the challenges they pose

After years of double-digit GDP growth, China’s economic development has begun to slow. While often this is seen as a bad thing, it is widely acknowledged that the country’s previous economic trajectory was unsustainable, and a correction was due. But understanding the implications of this change in growth is imperative to assessing the country’s future potential.

One way to form an assessment is through the use of sovereign credit ratings, which are a tool for investors looking for an independent view of a government’s capacity and willingness to pay its debts on time. Global markets are particularly responsive, over the short- and long-term, to an upgrade or downgrade in a country’s rating, meaning that the process for rating development needs to be as precise as possible.

DBRS Morningstar currently has an A-high rating for China, but with a negative trend, reflecting an expectation of weaker macroeconomic performance for the Chinese economy in the medium term. In this interview, Thomas Torgerson, Managing Director and Co-head of Sovereign Ratings at DBRS Morningstar, discusses the key elements that go into the development of sovereign ratings, the economic challenges facing China, and the possibilities for future growth.

Q. How are sovereign ratings calculated and how often do they change, particularly in relation to China?
A. Our sovereign rating methodology contains six building blocks, which assess all the key elements of sovereign creditworthiness. We look at fiscal management and policy and debt and liquidity, which together encompass public finances and the overall performance of a government. With regard to its finances, we also assess economic structure and performance, monetary policy and financial stability, and the balance of payments, all of which typically cover the macroeconomic fundamentals of a country and the performance of policymakers in fostering stable capital flows and predictable policies. And of course, the political environment relates to that as well, as does the strength of governing institutions, the overall political process, and the efficiency of policymaking.

China’s ratings have not changed significantly in recent years. We’ve had an A-high rating on China since 2014. What has changed and has been reflected recently in a negative trend on our rating, is China’s fiscal position in particular, which has deteriorated significantly over the course of the past seven or eight years, and remained weak during the COVID years. And in addition to that, we see weaker growth and some elevated financial stability risks from the property market. Those together have been reflected in the negative trend, but again, the rating itself has been quite stable for many years.

Q. To what extent do you see the Chinese policy process as being predictable?
A. Chinese policymakers are pretty transparent in laying out their objectives, and fairly pragmatic about adjusting those when conditions require. What I think is lacking, particularly in comparison to other countries that we rate, is the feedback mechanisms of local press and investors, who will often voice independent views of those policies, and at times point out risks and challenges ahead that policymakers often should respond to.

In the West, you have these mechanisms, but there is also a lot of “noise” to get through in order to get the useful information, and this is perhaps lessened in the Chinese environment. But there can also be value in this “noise” and the feedback mechanisms that it enables. What we worry about in the Chinese context, is that those feedback mechanisms will be muted, and therefore result in larger future changes if policymakers miss key changes or key trends that they otherwise would have caught.

Q. What have been the main reasons for China’s slowing economic growth in recent years and how does it impact the country’s ratings? To what extent do you expect this to change, both in the short- and long-term?
A. This is a complex topic, where there are positives and negatives to slowing growth. On the positive side, China has been on what was ultimately an unsustainable growth trajectory, achieving very high growth by importing expertise and technology which made it very productive, but that only gets you so far. China needs to generate that productivity growth domestically, and as it modernizes it is always going to slow, as we have seen in all the advanced economies—it’s much harder to achieve high productivity growth when you’re close to that production possibility frontier. So this, plus the demographic changes in the country, mean that China’s growth really should slow. And in many respects, I would be more worried if we saw extremely rapid growth continuing, because that would suggest rising leverage and rising investment into infrastructure, housing and commercial real estate beyond what the country can usefully deploy.

But slower growth has its challenges as well, particularly when it is caused by frequent short-term disruptions to economic activity, which we saw in the numerous COVID-related shutdowns. There is also a broad decline in the property markets, which poses financial stability risks. Whether those risks can be contained in the property development sector or if they will spread beyond that remains to be seen. So these are worries for us, and beyond that, the international environment has become increasingly tense regarding trading, with China’s trading partners less hospitable to Chinese export growth in the future. And that can compound domestic challenges, even for a large economy like China’s. So all of those headwinds are a concern. But of course, I’d be more concerned if growth were still 10% for the wrong reasons.

Q. China’s property market has experienced a number of difficulties in recent years. However, we have recently seen a return of lending availability for property firms, among other changes. To what degree do you think these rollbacks have a significance for the Chinese economy?
A. This is also difficult to say, because to some extent healthy corrections can be a positive. What we’re worried about is that some quarters are still fairly opaque and it’s hard to tell what’s really happening. We’re worried about the impact it will have on local government finances, especially because there are still strong incentives to foster more investment even when it’s not necessarily productivity-enhancing. And looking at growth-generating investment in China, it looks like that has deteriorated very significantly. So there is a need to redirect investment into areas that will foster more productivity growth, and we think that’s substantial. Above all, though, we are worried about the quality of investment, and whether it will help China return to a stable growth path, or whether we’ll continue to see very weak growth as a result.

Q. How does the structure of China’s economic system impact the country’s ratings?
A. This is a question we have been watching since the mid-2000s, and I’d point to one statistic in particular. China’s measure of gross debt to GDP was roughly 140% in 2007, by the second quarter of 2022 it was 295%. This has been shifting since the global financial crisis, and it is how China avoided a substantial slowdown within its economy. The shift was partly made possible by the structure of the system because it was able to continue to support economic growth through a period of very weak global growth. And China’s performance has been very important to the global economy over that period.

Our worry now is the leverage that created the buildup of debt, which is on par with many advanced economies, while China is not yet, in terms of just per capita GDP levels, a fully advanced economy. Meaning you have a still-emerging market, with very high levels of debt. If you combine that with the limited transparency within local government debt, the inter-linkages between government and quasi-government entities, which suggests there may be future government liabilities that are not fully represented in the debt levels, you can see there are fiscal implications for the future.

Q. How do you see the country’s growth engines shifting following China’s 20th Party Congress?
A. Centralized control has, in the past, been very effective in boosting investment and in ensuring that the state-owned enterprises, for example, remain key contributors to that growth story. But the way China is seeking to change the composition of growth requires a different approach, and centralized control is not going to be as effective in promoting that. But I think policymakers see that and they have been attempting to shift the growth model and investment towards consumption and services. There has been some progress, but when you look at private consumption relative to output, it’s still quite low at 38% of GDP. China has the highest investment-to-GDP ratio among large economies, but there is a weaker growth trend there and it again raises questions about quality of investment.

For China to be able to stimulate private consumption, what you ultimately need is households that are confident enough in the future, that they are willing to save less and spend more of their current income. That requires expanding social safety nets and doing things that enable people to have a level of comfort that their savings are adequate and will be adequate. And it’s difficult to achieve that at a time when property, which is one of the key household assets, has been declining in value. So that’s where I think the challenges lie for China. At the Party Congress they articulated some of the things that need to be done, but it is unclear whether they will be able to achieve that with all of the headwinds they face.

Q. How do you expect China’s economy to develop over the next five to 10 years? And how would you expect this to impact its sovereign ratings?
It’s clearly a slower growth story, which we expect to be mid-to-low single digits. Compared to the past, this alone will not have a negative impact on the rating, but that could change depending on the fiscal challenges that China faces and how the government reacts to that low-growth environment. It’s more challenging and costlier to reduce fiscal deficits when you have weak growth.

But I’m always hesitant to dismiss the potential of an economy that has seen tremendous change over my whole adult life, and I think the potential for furthering development is certainly still there. But again, the trend growth rate is going to gradually creep lower, and in the near term, there are still a number of challenges to be addressed before we would really see that being stable and solid growth in the 3-5% range, which I think China is certainly capable of.

There have been some real successes in China’s track record, particularly in its economic development over the past few decades. The worry we have going forward is whether that track record will continue, or whether there is a risk of bigger challenges emerging that will really change the growth trajectory.

Interview by Patrick Body

Thomas Torgerson is Managing Director and the Co-head of Sovereign Ratings at DBRS Morningstar. As one of two group co-heads, he is responsible for methodology development and manages the group’s data support team.

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