Fitch Signals Red Alert on China's Economy, Downgrades Outlook

Fitch Ratings has downgraded China's long-term foreign debt outlook from "stable" to "negative." Although the rating remains at A+, the agency projects that in 2024, the deficit in the public finance sector will surge to 7.1 percent, marking the highest level since the pandemic year of 2020.

The downgrade reflects growing concerns over China's market confidence and the escalating challenges to the stability of its public finances.

As China transitions from an investment-driven growth model to one focused on sustainable development, it faces increasing economic uncertainty. This shift, accompanied by high fiscal deficits and rising public debt, has depleted budgetary reserves.

Fitch anticipates that fiscal policy will play a crucial role in bolstering economic growth in the near future. However, this approach might lead to further increases in indebtedness. Additionally, the economy might face heightened contingent risk challenges, as lower nominal growth could exacerbate the difficulties of managing high financial leverage.

Despite these concerns, Fitch acknowledges China's strengths that support the A+ rating. These include its large and diverse economic potential, solid GDP growth prospects, a significant role in global commodity trade, a stable external position, and the yuan's status as a reserve currency. Yet, these advantages are counterbalanced by concerns over high indebtedness, escalating fiscal issues, and levels of per capita income and governance quality that fall below those of A-category countries.

The Chinese economy is grappling with a growing deficit. Fitch forecasts the public finance sector deficit will climb to 7.1 percent of GDP in 2024, up from 5.8 percent in 2023, reaching its highest level since 2020. Public debt is also on an upward trajectory. Fitch's projections suggest the debt-to-GDP ratio in the public finance sector will increase to 61.3 percent in 2024 from 56.1 percent in 2023, marking a significant deterioration from the 38.5 percent seen in 2019. The forecasted debt trajectory is now seen as steeper than previous estimates, with debt expected to reach 64.2 percent of GDP in 2025 and approach 70 percent by 2028.

Local and regional governments in China are under financial strain, grappling with diminished real estate market revenues and high indebtedness. Some local government financing vehicles (LGFVs) are experiencing debt refinancing pressures, although authorities are making efforts to support these entities. The risk of contingent liabilities materializing remains a concern.

On a positive note, Fitch suggests that financial markets and rating agencies might become increasingly tolerant of China’s gradually rising public debt relative to GDP in the forthcoming years, given the expected robust economic growth. However, the recent adjustment of the rating outlook signals growing concerns over China’s financial and fiscal stability.

According to Reuters, the market reaction to Fitch's decision has been relatively calm. Gains were observed in the Asian market on Wednesday, and European indexes also showed small increases.