China’s newly installed fifth generation of leaders will face new challenges from a shifting economic growth model.
For the first time since China embarked on fundamental reforms to open its economy in the late 1970s, its leadership will face an era of single-digit growth, weak external demand, a maturing domestic economy and changing demographics. China faces six key credit challenges that will ultimately shape its (Aa3 positive) credit profile during the next decade.
Slowing growth, but no hard landing
During the next decade, we expect China’s growth, which has already fallen from double-digits, to converge toward, but remain above, trend growth for the world. For 2012, 7.5% GDP growth is likely with similar levels in 2013 and 2014. Slower growth this year, including 7.4% from the year previous in third-quarter 2012, has dampened central-government and local-government tax revenues, while bank asset quality has also.
The slowdown has also been generally credit negative for Chinese state-owned and private corporations, particularly those in cyclical industries with overcapacity, or those that are engaged in the production of low-margin products with a heavy reliance on exports. As a result, rating downgrades have outnumbered upgrades during the past two years, although the situation began stabilising this quarter (see Exhibit 1).
More constraint in policy options
The new leadership does not have the latitude that the previous leadership had as recently as four years ago to stimulate the economy if growth slows more than the government expects. Although China’s central- and local-government debt burdens remain relatively moderate, especially for a rapidly growing economy, the magnitude of the rapid expansion in local-government debt in 2009 and banking-system exposures precludes the country from adopting credit-fuelled stimulus to the same degree as it has previously.
Moreover, the authorities’ vigilance against the threat of price pressures re-emerging, along with the destabilising social pressures that accompany elevated prices for goods and inflation of asset prices, constrains policymakers’ ability to use expansionary fiscal and monetary policy to combat slowing growth (see Exhibit 2).
Rebalancing the economy
A rebalancing of the components of economic growth is essential and inevitable. This primarily means reducing the economy’s reliance on fixed-capital formation and exports to generate economic growth and employment. In searching for drivers of growth, the economy must secure the benefits of higher levels of private consumption, innovation and an expanded services sector. A more sustainable growth model would enhance economic resilience and support sovereign creditworthiness.
Unlike many other countries languishing in the post-financial crisis era, China has the luxury of pursuing necessary rebalancing without the drag on growth from fiscal consolidation and private-sector deleveraging underway in many advanced economies. Its central government fiscal deficit and debt levels compare favourably to the US, Japan and large European economies, providing ample capacity to facilitate this requisite rebalancing (see Exhibit 3).
Implementing additional market reforms and fostering competition
Without more market-based price signals driving the efficient allocation of capital and improving the competitive delivery of services, China’s growth rate will likely slow more rapidly. Accordingly, the economy is more likely to accelerate if China implements reforms in key areas such as market-based competition; regulation, including greater certainty and transparency on future regulations and regulatory decisions; and structural reform of some state-owned enterprises.
Financial-sector liberalisation and a further relaxation of capital-account restrictions
A new wave of reforms, especially in the financial system, is necessary if China is to sustain rapid and stable growth for the rest of this decade.
Further interest-rate liberalisation and continued development of the domestic bond market would promote a host of advantages, including the efficient pricing of capital, and reductions in financing costs for the most creditworthy local governments and corporations, compared with bank financing.
That said, this acceleration towards a fully liberalised environment is generally credit negative for Chinese banks. Competition would erode net interest margins, introduce market-driven volatility into a portion of bank funding structures and potentially push banks to increase lending to higher-risk borrowers or become involved in complex businesses to maintain margins and profitability. But the effect of liberalisation on overall profitability would be modest during the next 12 to 18 months and is consistent with the banks’ ratings and stable outlook. We expect liberalisation of interest rates to be gradual, and that the major banks will continue to command a degree of pricing power on loans.
Maintaining social stability and enhancing political accountability, while also providing a social safety net
China faces emerging demographic pressures as its workforce begins to fall in the latter part of this decade. This trend will not only negatively affect the fiscal sustainability of the country’s nascent development of a social safety net, but the lower number of workers will also translate into upward pressure on wages, thereby constraining competitiveness, restricting growth, and potentially generating imbalances as the savings rate declines. Meanwhile, unrest over wages and working conditions are immediate challenges for corporate profitability.
Speaking at the opening of the Communist Party Congress, outgoing President Hu Jintao committed to doubling 2010 GDP as well as urban and rural income per capita in real terms by 2020, equating to annual growth of around 7.2% during the next decade. However, compared with the previous administration, this figure provides less of a buffer above the minimum growth threshold that the authorities estimate China needs to ensure social stability.
A copy of the full report is available here (to registered users on Moodys.com).
Moody’s will host teleconferences on this topic on Tuesday, November 27 at 11am Hong Kong time for Asia-Pacific market participants, and on Tuesday November 27 at 9.30am New York time / 2.30pm London time for Americas and European market participants. To register for these teleconferences, go here for the Asia timed call and here for the US/EMEA timed call. These calls are open to all market participants.