Fitch Downgrades China’s Credit Rating

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Soros: They have two years left to bring credit expansion under control

Apr. 11 – Fitch, one of the “Big Three” credit rating agencies, has cut the credit rating on China’s local currency sovereign debt from AA- to A+. To compare, that is four rating levels lower than the United Kingdom. Fitch affirmed China’s Long-Term Foreign Currency Issuer Default Rating (IDR) at A+, downgraded the Long-Term Local Currency IDR to A+ from AA-. The Short-Term Foreign Currency IDR was affirmed at F1 and the Country Ceiling at A+, with the agency stating that the China “outlook is stable.”

Below is the main portion of Fitch’s assessment:

“Risks over China’s financial stability have grown. Credit has grown significantly faster than GDP since 2009. China experienced the second-fastest expansion of credit in real terms, behind only Qatar, between end-2009 and end-June 2012. The stock of bank credit to the private sector was worth 135.7 percent of GDP at end-2012, the third-highest of any Fitch-rated emerging market. Fitch believes total credit in the economy including various forms of “shadow banking” activity may have reached 198 percent of GDP at end-2012, up from 125 percent at end-2008. Only 55 percent of new social financing took the form of bank lending in the 12 months to February 2013, down from 76 percent in 2009. The proliferation of other forms of credit beyond bank lending is a source of growing risk from a financial stability perspective.”

When compared to the United Kingdom, a far smaller economy, the downgrade and levels below Britain that China is graded at may seem surprising. However, the issue China faces is that it’s track record of repaying sovereign debt is less established and it has in the past reneged on debts, such as the failure to bail out Guangdong Province’s “GITIC” in 1999, citing at the time “technical misunderstandings” over foreign investors who had purchased such debt “not understanding” the Chinese system. It’s probably not a ploy China could be expected to get away with again, and just because the Chinese economy appears strong today doesn’t mean it will always honor its debts – as the GITIC case proved.

The other reality is that China has bought its relatively smooth passage through the wider Global Economic Crisis by means of massive expansion in credit and government spending. As was pointed out by Sidney Rittenberg during his speech at the Asia-Pacific Business Outlook conference earlier this week, that doesn’t bode well for future economic health. To some extent, China may not appear to have much of a credit risk as it essentially borrows in its own currency, meaning China can always print extra money needed to service and repay debts. This brings inflationary risks, but the default risk is negligible. However, Fitch’s actions ring some alarm bells. Credit expansion in China is running at levels that caused European economies to tip over into the current Global Financial Crisis. China is not immune, as George Soros pointed out at the Asian Davos Conference this week.

“China has only a couple of years left to bring non-traditional sources of credit expansion back under control,” Soros commented. “The rapid growth of China’s shadow banking has some disturbing similarities with the subprime-mortgage market in the U.S. that caused the financial crisis of 2007-2008.”

Although Soros was kind to the talents of China’s leaders to get them out of this hole, preventing a China crash will take some adept and internationally savvy maneuvering by the Chinese to deflect an accumulating problem. Sovereign debt in China has long been suspected of being higher than officially acknowledged. General government debt is around 50 percent of GDP, with local government debt at around 25 percent. However, Fitch also believes that Chinese local governments also have significant contingent liabilities from linked corporate activity and the constant bailing out and loaning of money to SOEs who are never likely to repay the capital.

It remains a guessing game to know the true extent of debt in the Chinese economy, but it would be safe to assume that it is much higher than it appears. China needs to show it can manage what look to be some potentially dark clouds on the horizon. Fitch’s assessment is an early warning.

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