It's a change of heart that some have waited for, but very few expected. China has decided to prioritize structural reforms above current economic growth. The change came with little warning. And various hypotheses have sought to explain it. Whatever the reason, S&P Global Ratings believes the immediate impact is to weaken business and consumer confidence, which in turn exacerbates the economic effect of anti-pandemic restrictions.

These developments could prolong the drag on China's economy, although that is not our base case. Even in more negative scenarios, we believe the government still holds powerful policy tools. Most importantly, China's large domestic saving pool would help to head off serious damage to credit support. It remains hard to tell how significant the longer-term credit benefits of these immediate sacrifices will be.

Slower Growth Elicits Restrained Policy Response

Most economic forecasters see 2022 as being a weak year for the Chinese economy. Following growth of 4.8% in the first quarter, activities decelerated sharply in the second quarter because of efforts to contain the spread of COVID-19. Growth has been weak to recover so far. Apart from the negative impact of external events, the country's "dynamic zero-COVID" policy also disrupts economic activities and adds uncertainty.

China has reacted to this year's economic slowdown with uncharacteristic restraint. Previously, the government had pumped up credit and public investment when events threatened its annual target. It implemented stimulus measures early and forcefully. This has not been the case so far this year (see chart 1).

Chart 1

Sensing a future with less-predictable government support for the economy, consumers and businesses have turned cautious. Bank and bond investors have become reluctant to finance most developers, so construction activities slowed. Buyers have cooled toward new home purchases despite restrictions falling away in most places. Many businesses have slowed new investment as uncertainty grows.

These changes in behavior have led to another round of confidence-sapping developments. Consumer demand has slowed on economic uncertainty. Some home buyers stopped mortgage payments when they saw little construction activity at their newly purchased apartments. And distressed asset management companies whose activities could help to stabilize the financial system announced large losses, partly owing to their real estate exposures.

Officials have not sat back as the economy softens, of course. They have rolled out several measures to stimulate demand and support businesses (see table 1). And very senior officials have traversed the country to ensure effective implementation. Nevertheless, most analysts view these measures as insufficient to reach the economic target of 5.5% growth this year. The measures helped, but they don't address the relevant issues as quickly as we believe the government could.

Table 1

Government Tolerance For Slower Growth Surprised Many

The absence of stronger policy support measures was a surprise. Many had assumed the government would do more to meet its economic growth target in the year of the 20th Party Congress (which begins mid-October). Instead, it has reiterated it will refrain from a flood of economic stimulus and measures that trade off future growth for a near-term revival.

These surprises have cost some investors dearly. The economic slowdown and pandemic disruptions this year have hit stock prices. The valuations of listed companies directly affected by policy restrictions plunged, especially real estate developers. Debt defaults by some developers have brought down bond prices across the sector. The Financial Times recently reported that investors "are pricing in almost $130 billion in losses on Chinese property developers' dollar debt."

Support, Yes, But Not At The Cost Of Perpetuating Moral Hazard

We believe the government's restrained responses are deliberate. Policymakers have emphasized a few times this year that economic development is a fundamental and crucial factor to solving all the country's problems. However, their focus seems to be on the long term, rather than in the immediate future. They are tackling some of the underlying weaknesses of the Chinese economic growth model--moral hazard, corruption, an excessive reliance on debt financing and speculation in the real estate sector.

The key to addressing these problems is for the relevant parties to bear the costs. The central government likely sees past decisions by local governments and businesses as reasons for the recent instances of financial distress. These past actions often contravened central government instructions and resulted in excessive debt. While the central government is reluctant to see things develop into financial crisis or social unrest, it is also keen to see the responsible entities bear some of the consequences.

Policymakers likely judged some resulting financial volatility to be inevitable. We believe the government aims to further weaken expectations of government bailouts of troubled well-connected enterprises. If most investors and lenders emerge from this situation with minimal losses, they are likely to continue to count on government support in their future decisions. Moral hazard and excessive credit growth will remain.

Expectations Among Businesses And Consumers Are Shifting

Recent observations--including restrained credit growth and infrastructure investment growth--suggest early signs of success in moderating expectations of government bailouts. The losses may have helped upend deeply held assumptions of many investors. These include assumptions that:

• Despite their high leverage, China's real estate developers are too important for the country's economic growth to be allowed to default in large numbers.
• In times of financial stress, the government will support large companies in industries identified as strategic sectors.
• The government will ease up on reform policies that have contractionary economic effects when economic growth threatens to stall.

Under Control: A Crisis Remains Unlikely

Some market participants interpret the lack of forceful policy stimulus in China more negatively. In the present situation, they see a potential economic crisis brewing. They view Chinese policies as suppressing private sector businesses in recent years. They also believe that economic growth in the period derived support from unsustainable real estate and public sector activities, funded by credit growth. They see in the government's tepid response to the slowdown the increasing difficulty of using debt to keep growth going.

In our opinion, those scenarios seem less likely. Despite the oft-cited observation that China is heavily indebted for a middle-income economy, the country finances itself almost entirely with domestic savings. The national saving rate has remained strong even though economic growth has slowed. The large current account surpluses (see chart 2) indicate that China generates more than enough in savings to fund its immense investment needs.

Chart 2

And the decline in onshore interest rates (see chart 3), amid the rising trend globally, shows that monetary policymakers maintain strong control over Chinese savings. The central bank is still able to exert firm influence over domestic funding costs even as the financial sector faces uncertainty today. This suggests the defaults and financial stress some borrowers faced remain--in the parlance of Chinese officials--"under control".

Chart 3

Confidence Could Deteriorate

Even so, the potential for a further slide in economic performance persists. This is possible if confidence about the country's economic outlook weakens materially from already diminished levels. And there is no lack of likely triggers.

Key external uncertainties are the direction of the war in Ukraine, inflationary trends in the developed economies, and the potential for greater volatility in financial flows. Unless China's domestic demand picks up strongly, these risks could choke demand for exports that have recently been a crucial source for economic growth.

Another risk is the worsening of U.S.-China tensions. Events since August this year have further strained ties between the two economic giants. The risk of encounters between U.S. and Chinese military assets in the South China Sea could step up in the coming months. In the meantime, key communication channels between the two sides recently closed. And upcoming important political events in both countries reduce the room for leaders on both sides to compromise. Should an accident between military assets of the two countries happen, it could escalate to levels that affect regional trade and economic activities.

China's policy stance on COVID-19 could also have increasingly unpredictable social and economic consequences. The cumulative burden on businesses, local governments and workers will increase. In the absence of a totally effective vaccine, let alone a cure, there is little chance the pandemic will fade away in the foreseeable future. Meanwhile, the government has not announced an exit strategy. Businesses and consumers struggle to plan. If the dynamic zero-COVID policy persists confidence in the economy could slide at some point.

Policy Restraint Likely To Weaken In The Face Of A Serious Economic Threat

If economic pressures become severe, there will be more proactive policy actions, in our view. The central government will still be wary of storing up trouble for the economy with excessively strong economic stimulus. However, if events threaten to cause a widespread loss of confidence and financial volatility worsens, it could become expensive to return growth to a comfortable level.

We believe authorities would wind back the main curbs on credit demand to prevent such a situation occurring. Credit growth remains the fastest means of injecting stimulus into the Chinese economy. And the most eligible borrowers are those who worry less than most others about the long-term financial burden of debt. Hence, the central government would likely reduce credit restrictions on local government projects and the infrastructure building companies they own.

Policymakers are also likely to implement firmer measures to help the stronger developers access credit. However, we don't expect the changes to allow them to return to aggressive expansion again, for instance, by permanently removing the credit restrictions on real estate companies. Even if short-term economic stability is a priority, we expect the central government will try to maintain some of the progress it has made in structural reforms.

Longer-Term Credit Outlook Is Uncertain

Whether these structural reforms will be positive for credit risk for the sovereign and other borrowers in China is uncertain for now. The central government's actions appear to have reined in some of the risk of excessive leverage. We expect lenders to be much more careful about relying on government support in making their credit decisions.

Many local governments have also seen their extra-budgetary financial resources diminished over the past few years. At the same time, the anti-corruption drive should reduce instances of officials obtaining unauthorized means of financial support. The tighter constraints on local governments should improve compliance with central government policies and reduce the risks of hidden leverage. If these changes persist, China could see stronger sovereign credit support as risks to fiscal and financial stability recede. The weight of contingent liabilities from the financial system and state-owned enterprises would also diminish.

The flip side of this is that China's economy could lose some support from real estate and public investment activities. And it is not clear if private consumers and private businesses can offset this decline. The central government has done much to try to bolster household income and support small businesses in recent years. These efforts include tax cuts, reduced bureaucracy, and a smoother path to financing for private businesses. However, the anti-corruption drive and high-profile penalties on companies have cast doubt on the government's attitude toward private businesses. If private sources of growth do not increase significantly in importance, China's economic trend growth could fall from levels we currently expect.

Such an outcome will weaken China's sovereign credit metrics. If we believe the future trend growth will fall to levels on par with other economies of similar income levels, China will lose a source of strength for the ratings. Furthermore, with its population set to decline, weaker growth would add to demographic pressures on public finances.

The stability of the current sovereign rating on China (A+/Stable/A-1), therefore, depends on policymakers' ability to bring about greater economic and financial stability without a deterioration in long-term economic vitality.

Related Research

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• Credit FAQ: What Does China's 2022 National Party Congress Say About Policy Direction?, March 10, 2022

Editor: Lex Hall

Designer: Halie Mustow