Fitch cut its outlook on China’s sovereign credit rating to negative on Wednesday, citing risks to public finances as the economy faces increasing uncertainty in its shift to new growth models.

The outlook downgrade follows a similar move by Moody’s in December and comes as Beijing ratchets up efforts to spur a feeble post-COVID recovery in the world’s second-largest economy with fiscal and monetary support.

Fitch’s outlook revision reflects the more challenging situation in China’s public finance regarding the double whammy of decelerating growth and more debt.

This does not mean that China will default any time soon, but it is possible to see credit polarization in some LGFVs (local government financing vehicles), especially as provincial governments see weaker fiscal health.

Fitch expects China’s explicit central and local government debt to rise to 61.3% of gross domestic product (GDP) in 2024 from 56.1% in 2023 – a clear deterioration from 38.5% in 2019.

A protracted property downturn has weighed heavily on debt-laden local governments as their revenues from land development plunged, rendering debt levels in many cities unsustainable.

At the same time, the rating agency expects China’s general government deficit – which covers infrastructure and other official fiscal activity outside the headline budget – to rise to 7.1% of GDP in 2024 from 5.8% in 2023, the highest since 8.6% in 2020, when Beijing’s strict COVID curbs weighed heavily on the economy.

While it lowered its ratings to negative outlook from “stable”, indicating a downgrade is possible over the medium term, Fitch affirmed China’s issuer default rating at ‘A+’, its third-highest category.

S&P, the other major global rating agency, also rates China A+, the equivalent of Moody’s current A1 rating.

Fitch forecast China’s economic growth would slow to 4.5% in 2024 from 5.2% last year, while the International Monetary Fund expects China’s GDP to grow 4.6% this year.

The ratings warning comes despite tentative signs China’s economy is finding its footing.

Factory output and retail sales topped forecasts in January-February, following better-than-expected exports and consumer inflation indicators.

Those data points have shored up Beijing’s hopes that it can hit what analysts have described as an ambitious GDP growth target of around 5.0% for 2024.

The outlook revision reflects increasing risks to China’s public finance outlook as the country contends with more uncertain economic prospects amid a transition away from property-reliant growth to what the government views as a more sustainable growth model.

Wide fiscal deficits and rising government debt in recent years have eroded fiscal buffers from a ratings perspective. Contingent liability risks may also be rising, as lower nominal growth exacerbates challenges to managing high economy-wide leverage.

China plans to run a budget deficit of 3% of economic output, down from a revised 3.8% last year. Crucially, it plans to issue 1 trillion yuan ($138.30 billion) in special ultra-long term treasury bonds, which are not included in the budget.

The special bond issuance quota for local governments was set at 3.9 trillion yuan, versus 3.8 trillion yuan in 2023.

China’s overall debt-to-GDP ratio climbed to a new record of 287.8% in 2023, 13.5 percentage points higher than a year earlier, according to a report by the National Institution for Finance and Development (FIND) in January.

The planned treasury bond issuance signals Beijing’s willingness to shoulder a higher share of the burden of meeting growth targets, as local governments struggle to cope with slower fiscal revenues and depressed land sales.

The Fitch revision has reflected the fundamental concern over China’s fiscal health and its ability to drive growth in the long term.

With lagging private investment, state-backed funding has become even more important in driving growth, either in terms of infrastructure spending or in local government guidance funds for high tech industries.

China’s finance ministry said following the announcement it regretted Fitch’s ratings decision, vowing to take steps to prevent and resolve risks from local government debt.

In the long run, maintaining a moderate deficit size and making good use of valuable debt funds is beneficial for expanding domestic demand, supporting economic growth, and ultimately maintaining good sovereign credit.

Moody’s in December slapped a downgrade warning on China’s credit rating, citing costs to bail out local governments and state firms and control its property crisis.

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