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China Balances Policy Risk With A Need For Reform

This report does not constitute a rating action.

Economists are cutting their projections for China's growth this year. That's the good news. The lower GDP assumptions track government measures to rein in rampant credit expansion in some sectors, to create a slower, more stable form of growth. The bad news--from a market perspective--is that the recent burst of policymaking may be destabilizing. We see this, for example, in the likely default of heavily indebted China Evergrande Group, which has struggled with funding restrictions. S&P Global Ratings believes policy implementation risk is rising in China, with elevated investor uncertainty straining economic growth and rattling markets.

We believe Beijing's policy shifts will lead to more sustainable growth and improved sovereign credit metrics over a five to 10-year period. The key issue over the next year or two will be execution. Officials will need to tread a narrow path, ensuring that their ambitious policy-setting is not overly disruptive.

The Geopolitical Winds Are Shifting

China's measures are unfolding in a risky external environment. U.S.-China relations are chilly. The views of leaders in other advanced economies also seem to be turning more negative toward China. Chinese officials and media often describe this climate as "severe and complex".

This situation brings strains. Export growth could flag, foreign direct investment inflows could stagnate, and Chinese investments overseas may face even more regulatory and legal obstacles. Sanctions could suddenly shut Chinese businesses out of offshore markets and new restrictions may slow foreign purchases of Chinese stock and bonds. The U.S. has already blocked the access of several Chinese technology manufacturers--most notably, Huawei Technologies Co. Ltd.--to components made with American technology.

Chinese policymakers have become more focused on domestic risks as a result. Since mid-2020, China has intensified efforts to address pressures on the economy and social stability. Investors did not anticipate some of these measures. They created volatility and arrived even as the global pandemic raged, with economic prospects still uncertain.

The timing suggests the government views the steps as urgent and must be taken ahead of the important party congress next year. They reflect their concerns that domestic risks could worsen under persistent external pressures, in our view.

Battening down the financial hatches

Chart 1


Reducing financial risks is an important part of this effort. Years of rapid credit growth have weakened some of the foundations of financial stability in China. This erosion is associated with a few volatile episodes in Chinese markets in the past decade. Some policymakers worry that the continued spread of financial risks could derail economic development.

Moral hazard is a key problem. Many Chinese lenders have been willing to fund projects with low commercial value, on the view the government would support any investment that soured. Beijing has found it difficult to shift this expectation.

With their eye on financial stability, the Ministry of Finance and regulators have been applying piecemeal measures to slow credit growth. For example, they have restricted banks from lending to local government financing vehicles, and have also reduced the share of the payment for residential purchases that can be funded by borrowing.

In 2020, with COVID in full force, the government only allowed credit to expand modestly. They resisted the urge to accelerate the economy even when the health crisis shut supply lines and shuttered factories. This contrasted with the dramatic increase in bank lending during the global financial crisis (see chart 1).

After a pause in the first half of 2020, policy focus quickly returned to financial risk (see chart 2). Attention fell mainly on the usual suspects: financial institutions, state-owned enterprises (SOEs), and local governments.

Chart 2


Additionally, regulators also introduced strict financial restrictions on real estate developers. Despite their keen appetite for debt, the sector had escaped serious financial controls, until recently. This likely owed much to their contributions to economic growth and local government coffers.

This time round, however, their contributions do not appear to offer as much protection as before. In late 2020, the government introduced new controls on the amount of debt that real estate developers could take on. The latest rules, described as "three red lines", restrict developers' bank borrowings if they don't meet thresholds on three ratios: liabilities to assets, net debt to equity, and cash to short-term debt (see "China Property Watch: Issuers Go On A Debt Diet," published Nov. 12, 2020 on RatingsDirect).

This has put heavy pressure on highly leveraged property companies and contributed to high-profile bond defaults. The most recent example was seen in a missed payment of bond principal by the midsize Chinese developer Fantasia Holdings Group Co. Ltd. (see "Fantasia Holdings Downgraded To 'SD' On Missed Principal Payment," Oct. 5, 2021)

Several property firms are buckling under this pressure, not least one of the world's most indebted developers, Evergrande. We see a risk that a disorderly correction in the property market could cause sharp price declines, hitting the personal wealth of homeowners. Such an event could also contribute to large-scale losses by investors in wealth management products, and the contractors and service firms that support the developers (see "Evergrande Default Contagion Risk--Ripple Or Wave?" Sept. 20, 2021).

Reining in public enterprises: defaults, consolidation and more

China's deleveraging push also has implications for the country's huge SOEs. Many SOEs borrow heavily against their weak credit metrics, with government backing (see "SOE Stress Is A Double Bind For China's Local Governments," June 8, 2021).

Chinese SOEs are not going away despite the distortions and risks that they bring. The central government views the entities as tools to implement policy and political objectives. However, it is increasingly selective in giving financial support to these firms and is accelerating efforts to improve their efficiency.

The increasing number and prominence of SOE bond defaults speaks to this dynamic (see "China Bond Defaults 2021: More Tolerance For Bigger Hits," June 23, 2021). An SOE first defaulted on a domestic SOE bond in 2015. Authorities let the trend continue in 2020 during the depths of the pandemic. Indicative of the Beijing's newfound tolerance for such SOE failures, recent defaults involved companies deemed to be of strategic value to the government. This includes the technology conglomerate Tsinghua Unigroup Co. Ltd.

The defaults of recent years, especially since 2020, have led to greater credit differentiation among SOEs. With government support increasingly uncertain, investors now pay more attention to company-specific factors and are reflecting these views in how they price their bonds.

The tightening financial constraints are also pushing SOEs toward consolidation, which the central government encourages. Mergers among these entities reduce incentives for debt-financed investments and allow the firms to devote more resources to research and development. This consolidation trend accelerated in the past two years, involving companies in steel, coal, chemicals, electronic manufacturing, and other industries (see chart 3).

Enterprise consolidation is just a more visible thrust of the broader Chinese SOE reform effort. The government has also been implementing a strategic plan that aims to strengthen competitiveness, innovation, and risk management at SOEs in recent years. In addition to mergers, authorities have allowed many nonviable firms to fail, cut excess industrial capacity, and flattened SOE management structures. The government rolled out a three-year action plan to accelerate these changes through to 2023. Such was the urgency of this action it came at the height of the COVID outbreak in China.

Chart 3


Diffusing Social Angst

Investors are familiar with policies to tame financial and SOE risks by now. But China's recent big push to address social stability is new to them. Since late 2020, the government has restricted foreign listings by Chinese firms, fined the country's biggest internet companies for anticompetitive activities, called a stop to commercial tuition businesses, regulated overtime work, and limited internet gaming for the young. Some of these changes have raised questions about the continued viability of Chinese firms raising funds abroad through variable interest entities (see "China Internet: Navigating A New Regulatory Landscape," Aug. 2, 2021).

The policy shifts have weighed on the biggest private sector firms in the country, including internet giants Alibaba Group Holding Ltd., Tencent Holdings Ltd., and Didi Chuxing Technology Co. Among the notable actions, regulators blocked the listing of Alibaba affiliate Ant Group on the Shanghai and Hong Kong exchanges, what was to be biggest IPO in history at that point. Authorities have also fined Tencent, Alibaba, Meituan and Beijing Kuaishou Technology Co. Ltd. for various violations. Media sources reported that these four firms collectively shed more than US$1 trillion in equity value between February and August this year, shaking investors.

Chart 4



Some investors are asking if China's actions spell the beginning of a tougher era that is less friendly to private businesses. Chinese leaders recently reaffirmed their support for the private sector. We believe the negative effects of the recent policies on firms are a side effect--not a primary aim--of the measures.

The government's messaging suggests its actions are meant to head off social tensions. Chinese policymakers are concerned by several trends in recent years, in our view. These include increasing wealth disparity, reduced social mobility, regional and urban-rural divides, unaffordable home prices, and the dominance of a small number of companies in social media. The dynamics are a typical byproduct of rapid economic development.

Authorities in developed nations face similar challenges and are making similar policy shifts, as seen in antitrust complaints made against the likes of Facebook Inc., Apple Inc., Alphabet Inc., and Inc.

Economic growth in the next five to 10 years will likely be lower than what Chinese have grown used to. As income growth decelerates, dissatisfaction may set in among the people. They may believe that it has become harder to get ahead in life and that rising costs put a reasonably comfortable life beyond their reach. With external pressures increasing the risks of this slowdown, these forces may unleash social unrest like those seen elsewhere in the world. And the rapid rollout of these measures may reflect policymakers' assessment that these risks need to be addressed quickly, even at the cost of immediate financial volatility.

More stable and inclusive growth

China is also adapting its growth model to a more uncertain external environment. Since mid-2020, policymakers have talked up a new "dual circulation" economic strategy. This calls for promoting domestic consumption as the main driver of growth, while maintaining China's international economic openness. It is an implicit acknowledgement that Chinese consumer demand is underperforming.

The policies to bring about these conditions now seems likely to be grouped under the banner of achieving "common prosperity." The term comes from Mao Zedong and some see in it a more people-oriented, less business-oriented tack in official policy. We believe the government's intention is to grow China's middle class and to increase their purchasing power (see "Credit Conditions Asia-Pacific Q4 2021: COVID Besets, China Resets," Sept. 28, 2021).

The common-prosperity initiative is prompting tax changes. The government has recently raised the personal income tax thresholds and added new deductions. It aims to increase the share of government revenue coming from direct taxes in the next few years. Stricter tax enforcement focusing on high-income earners and businesses appears to be part of this effort. These changes are likely to be coupled with reductions in indirect taxes that will benefit lower income households more.

The effort to introduce a nationwide property tax also seems to have gained momentum. This not only potentially adds a new tax that falls more heavily on the wealthy, but also could temper increases in home prices. Together with a stronger supply of public housing, especially in key cities, the action may reduce upward pressure on home prices.

Officials also want to assist small private businesses. Apart from reducing their tax and regulatory burdens, the government has been pushing banks to lend more to smaller businesses. It has also cut red tape by reducing the number of approvals that businesses need to obtain from government agencies.

Good intentions, but…

If China achieves the stated objectives of recent policy initiatives, it will likely be credit positive for the nation and for enterprises. It could see the country transition to a more sustainable model of economic growth. While trend growth would be lower than in the past, it could come at lower risk to economic and social stability. Credit risks should improve over five to 10 years.

However, implementing all these changes successfully will require finesse. Tensions exist among the policies. Pushing companies to deleverage quickly may cause economic growth to decelerate sharply.

Regulating the internet companies strictly could dampen private sector investment, slowing employment growth. Raising efficiency at SOEs could squeeze out private sector competitors and shrink households' share of income.

Good coordination among China's policy agencies is essential. However, as in other large and complex governments, the competing priorities of different policy units and regions often prevent smooth coordination. And the number of major policies with far-reaching consequences that are being rolled out at the same time makes it a bigger challenge than usual.

China's policy steps can also be unpredictable, sometimes unsettling markets. Chinese official communication with the media has improved in recent years. However, there are still times when high-impact policy changes (like those recently implemented) come as a surprise to investors. Some investors may not understand the policy intentions behind changes well and may be uncertain about how far measures will be pushed. Such uncertainties had contributed to a few sharp fluctuations in Chinese financial markets.

Amid the fraught external environment and China's sweeping goals, there is a chance that things may not go as smoothly as they hope. We are mindful that Beijing's policy steps are ambitious--radical, even--and this makes a more negative scenario possible. Unforeseen contagion effects that severely dent investor confidence could hit the economy and strain the financial system. The key uncertainty is whether events will get away from the policy-setters--that they will not be able to control the many spill-over effects of their far-reaching measures.

All's well that ends well?

We believe that Chinese policymakers will navigate the complex policy environment without serious damage to China's credit standing, and this is reflected in our rating and outlook on the sovereign (A+/Stable/A-1). China has a good record on policy execution and has firm control of many of the levers of implementation, including the key financial institutions and SOEs. These attributes buffer the government's credit metrics against potential volatility.

In case financial disruptions increase, the government will likely be able to stabilize financial markets using liquidity injections and easier credit access, as it had done previously. It could also pause or reverse any policy steps causing difficulty. While leverage ratios would rebound in this scenario, authorities could regain control amid turbulence, with perhaps some of the reforms intact.

Editor: Jasper Moiseiwitsch

Digital Design: Evy Cheung

Related Research

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