China upgraded by Moody's from A2 to A1 on strong strong external payments position, economic reform progress

Moody's Investors Service on July 26, 2007 upgraded to A1 from A2 the rating for the Chinese government's long-term foreign currency bonds in light of the exceptional strength of China's external payments position, favorable government debt trends, and continued progress in economic reform.

The rating agency also assigned an A1 rating to long-term local currency obligations of the government, and China's country ceilings for foreign and local currency bank deposits and foreign and local currency bond ceilings were raised to A1 from A2. The outlook on the ratings and ceilings is stable. These ceilings act as a cap on ratings that can be assigned to domestic or foreign currency obligations of other entities domiciled in the country.

"China's very strong external payments position provides insulation from external shocks and allows the authorities time to expand and deepen structural reform" said Moody's Senior Vice President Tom Byrne. "Official foreign exchange reserves continue to grow and now exceed $1.3 trillion, and external obligations of the government and state-owned banks are a small fraction of that sum."

He said the performance of the export sector has been "formidable," despite the appreciation of the renminbi yuan against the dollar, and that WTO accession and foreign investment have improved competitiveness, moving China up the global ranks to the third largest exporter. Byrne said that "we expect that China's external payments position will remain resilient to domestic and external pressures."

He explained that the newly assigned rating for local-currency obligations of the government reflects the striking progress made in fiscal performance and the containment of government debt. State revenues have grown rapidly and are likely to reach 20% of GDP in 2007 from less than 10% of GDP a decade earlier.

"Budget deficits have been very small, government indebtedness trends favorable, and Chinese government debt ratios have declined in recent years and are below the median of A-rated countries, providing headroom for possible future fiscal contingencies," said Byrne. "Moreover, the share of foreign currency debt in total debt is among the lowest of A-rated countries, which reduces vulnerability of government finances to external shocks."

Moody's noted that substantial improvement has been seen in the intrinsic financial strength and supervision of the large state-owned commercial banks. Although non-performing loans and unrecognized impaired assets are still somewhat high, contingent fiscal liabilities embedded in the financial sector are not as high as previously thought. The cost of banking system recapitalization to date is largely offset by the value of MOF and government agency holdings of shares of listed state-owned commercial banks.

"Continued progress in these areas will reduce financial-sector contingent liabilities," said Byrne. "The fact that the state-owned banks have a net foreign asset position ultimately reduces vulnerability of the government's fiscal position to external shocks that could be channeled through the banking sector."

Moody's said that while rapid growth has not produced balance-of-payments or fiscal imbalances, and inflation is moderate, management of domestic liquidity, in large part fueled by balance-of-payments inflows, presents challenges not only for domestic monetary policy but also for exchange rate policy.

"Still, financial or economic turbulence would not likely damage the government's creditworthiness," said Byrne. "Future upward movement to China's ratings will depend on the sustainability of macroeconomic stability, which would need to be supported by continued improvement in governance and in institutional strengthening."

He said China's ability to carry on a successful opening of its economy to foreign participation and to maintain access to foreign markets will also influence the future ratings trajectory. He noted that while trade friction with the U.S. and the E.U. have increased and that verbal skirmishes are increasing, especially with the U.S., mutual national interests will likely forestall the creation of a serious rift.

"Nevertheless, the possibility of heightened trade frictions poses some risk to the sustainability of China's exceptional economic growth performance," said Byrne. "And China's ratings will continue to remain sensitive to the state of cross-strait relations with Taiwan, the stability of which would be necessary to forestall geopolitical tensions from undermining the country's credit fundamentals."

(This is the press release of Moody's Investors Service)

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