Events in the past year have clouded China's growth prospects and hindered the government's efforts to reduce financial risks. External developments, in particular, have complicated the policy environment, even as the country enters a key phase in its deleveraging policy. Chief among these is the rapid deterioration in China-U.S. relations, highlighted by ongoing trade friction and disputes over technology transfers between the two largest economies in the world. Despite these external threats, S&P Global Ratings believes that the main risk to China's sovereign credit fundamentals would come from domestic factors.

In our view, a further weakening of the country's financial stability could be negative for the sovereign creditworthiness of China (A+/Stable/A-1). This could happen as a result of an excessive policy reaction to near-term growth pressures. While recent policy measures to stabilize growth do not appear to have materially worsened financial risks, the impetus on policymakers to pursue more aggressive actions could increase if labor market conditions worsen significantly or if investor confidence slips suddenly.

In comparison, persistent strains in China-U.S. relations are unlikely to seriously impair China's long-term economic potential--as long as structural reforms continue. And we hazard a guess that the U.S.-China "trade war" will begin to de-escalate at some point.

Trade Tensions Unlikely To Materially Damage China's Economic Potential

In the long run, the trade war can be seen more as an unhelpful distraction for Chinese policymakers than a major hurdle to economic development. For an economy the size of China's, domestic demand must be the main engine of economic growth if it is to maintain growth rates anywhere near current levels. Even today, China's share of exports is low compared with other rated sovereigns. And this share has been falling in recent years (see chart 1).

Chart 1

Restrictions on technological transfers and sales are also unlikely to seriously hurt China's long-term economic growth, even if they prove painful for some companies. Such curbs are likely to inflict significant economic damage only if they are accompanied by abrupt policy changes in major economies or unexpected major events that severely disrupt global supply chains. In the absence of these developments, we believe that China will continue to grow at a faster rate than most economies near its income level (see chart 2).

Chart 2

China's average annual per capita income of approximately US$10,000 is well below those in advanced economies. This implies that a large part of its economy performs some way behind the global efficiency frontier. The import of new technology is therefore likely to be less important than better and wider use of current technology to sustain strong growth. China's modern urban and high-speed rail networks is a case in point.

China will also continue to upgrade its technological know-how despite the U.S. restrictions. While the U.S. is an important source of innovation, it is not the monopoly of new inventions. Over time, many firms will also find ways to circumvent the restrictions to sell to the fast-growing Chinese market. China has also been growing its capacity for innovation through heavy investments over many years.

China To Remain The World's Foremost Manufacturing Nation

We also don't expect China's role as the world's leading manufacturing hub to diminish significantly in the near future. True, China-U.S. tensions have added another reason for foreign manufacturers to move their production out of China. Earlier on, rising costs and China's strained bilateral relations with Japan and Korea had also prompted manufacturers from these countries to consider relocation.

Still, many of the strengths that made China a compelling location for large-scale manufacturing remain intact despite recent events. The country's infrastructure continues to improve rapidly with heavy public investments. The Chinese market is also growing at a pace that few, if any, other big economies can match. At the same time, China's well-established supply chains and strong international connectivity make possible short turnaround times and precise inventory management for firms that depend on them to gain a competitive edge over rivals.

Furthermore, capacity constraints and already large trade surpluses with the U.S. limit the amount of new investments alternative locations can receive. Most viable alternative locations, such as Vietnam and Thailand, are significantly smaller than China. Infrastructure is often not as strong and improving at a slower speed. Moreover, because of their competitiveness in the export trade, these countries already have sizable current account surpluses with the U.S.--and expanding surpluses risk attracting the attention of U.S. policymakers (see chart 3).

Chart 3

Negative Economic Impact Comes At A Bad Time For China

Even if the long-term consequences of trade tensions are manageable for China, they still complicate policymaking and bring risks to sovereign credit metrics. The negative pressures on growth arising from slowing trade and weakened investor sentiment exacerbate the impact of China's deleveraging policy. At the same time, other major economies are beginning to see slower growth.

The government response to these pressures is likely the most important factor determining how China's credit fundamentals evolve in the next few years. Directly addressing trade tensions and cementing a quick trade agreement with the U.S. does not appear to be a top priority.

This lack of anxiety on the part of Chinese policymakers may reflect a number of considerations. One is that the most important economic damage has already been inflicted and is unlikely to be reversed. Whether or not a trade deal is signed, foreign manufacturers are likely to be cautious in investing in China for export production in the near future.

Chinese policymakers likely also assessed that damage from further U.S. tariff measures would be tolerable. A large portion of Chinese exports that have yet to attract additional tariffs are goods with high import content, including mobile phones and computer equipment. The actual value added in China is relatively small and reduced demand for these goods is unlikely to seriously affect Chinese economic performance.

The very public manner in which the U.S. administration states its demands also makes it difficult for the Chinese government to make concessions without incurring political costs. In a year that marks the centennial of the May Fourth Movement--protests sparked by the Allies' treatment of China after World War I--Chinese leaders have little room to make concessions that are seen as giving in to the U.S.

Stimulus Measures Have Not Worsened Financial Risks

Current measures to support growth focus on helping private-sector firms and encouraging infrastructure investment with government bond issuances. Taxes and social security contributions have been cut. At the same time, the government is taking various steps to help smaller firms get financing. The quotas for subnational government "special purpose" bonds have been raised significantly and their issuances have been brought forward. This program allows local governments to issue bonds to fund infrastructure, and is intended to replace off-balance-sheet debt raised through local government finance vehicles.

While these measures have weakened China's reported fiscal metrics, they have not materially worsened financial risks. Growth of the central bank's broad-based aggregate financing indicator has been kept at below 11% this year, despite strong double-digit expansion in the government special purpose bond component. Before 2018, this measure of financing growth had been at least 12%. In part, this slowdown reflects continued restraint on local government off-balance-sheet borrowing. In the first seven months of the year, infrastructure investment growth remained low at 3.8%; such spending had risen at double-digit rates until late 2018. Nevertheless, the government appears to have put the corporate deleveraging policy on hold, given the decline in credit growth that began last year has ceased.

So far the recent strains have not turned the government away from structural reforms. It could even be argued that tensions with the U.S. may have accelerated reform efforts. In the past year, curbs on foreign investors have been eased. The government also started addressing risks associated with weaker small and midsized banks; for example, with the regulatory takeover of commercial lender Baoshang Bank. The move to align bank lending rates more closely with market rates has also gained momentum with the introduction of the loan prime rate. And the State Council recently announced bolder reforms in the Shenzhen special economic zone.

Credit Weakening Measures Possible If Labor Market Or Investor Confidence Weakens Materially

Continued stability in the employment market and a lack of disorderly market disruptions have allowed for relatively restrained policy support. Despite weaker economic growth, total employment appears to have expanded in the past two years. Official reports showed that falling labor demand in the coastal regions were more than offset by increases in labor demand in the central and western regions (see chart 4). In fact, the aging population saw fewer workers seeking jobs compared with the number of job vacancies. This led to a further increase in the vacancy-to-job-seeker ratio in China's major cities (see chart 5), a trend that began in mid-2017.

Chart 4

Chart 5

Weakened investor confidence and policy-related market actions have not severely disrupted financial markets. Although the impact of Baoshang Bank's takeover continues to affect smaller banks' financing, financial conditions in the broader interbank market remain relatively stable. The abrupt depreciation of the Chinese renminbi to beyond 7.00 to the U.S. dollar--a level many financial market participants believed was a red line for the central bank--has also not created the kind of uncertainty associated with the depreciation in August 2015.

However, all that may change if the economy decelerates faster than expected and the weak external environment persists. It is possible that employment losses could mount or an unexpected development could shake the confidence of market participants. In either scenario, policymakers may perceive risks to social stability to be large enough to warrant a stronger and more immediate economic stimulus. If credit expansion rebounds sharply from levels seen recently, this could hurt long-term financial stability. In that scenario, downward pressure on the sovereign ratings could intensify.

Related Research

• China Credit Spotlight: The Staying Power Of A US$3 Trillion Local Government Problem, Aug. 22, 2019
• Asia-Pacific Sovereign Rating Trends Midyear 2019, July 26, 2019
• How Can China Cut Taxes And Maintain Low Budget Deficits?, March 12, 2019