Note: Listeners are advised to actively reference Fitch's rating commentary as they listen to this podcast (by clicking the link above).Table of Contents: 1. AI-generated summary 1 (GPT) 2. AI-generated summary 2 (Claude) 3. Transcript (AI-assist) 4. Counterpoint
AI-generated summary 1 (GPT):
• Fitch revised China's outlook to negative from stable, keeping the rating at A+, mainly due to concerns over high LGFV (local government financing vehicle) debt and potential contagion risks.
• China faces challenges transitioning from property-driven growth to a more sustainable, service-based model. Fiscal deficits are widening, and government debt is rising steadily.
• LGFVs, which are ostensibly private entities controlled by municipal governments, issue high-yield wealth management products (WMPs) to households. The proceeds are invested in public-private partnership (PPP) projects like roads, roping in banks and asset management companies.
• If these projects fail to generate sufficient returns, LGFVs may default, impacting households, banks, and local governments. In 2023, local governments absorbed ¥1.4 trillion ($200 billion) in LGFV debt.
• Fitch forecasts moderate GDP growth of 4.5% in 2024 and through 2028, with low inflation risk. However, rising public debt, fiscal deficits, and crystallization of LGFV liabilities could lead to a rating downgrade.
• Improving debt metrics, such as maintaining credit growth below nominal GDP growth, could lead to a rating upgrade. The situation bears some resemblance to the 2008 US subprime crisis, with systemic financial risks and potential contagion effects.
AI-Generated summary 2 (Claude):
Hi, this is Aaron. You're listening to Value Investing Substack, and today's news is about Fitch revising its outlook on China to negative from stable. Most of you are already aware of this, but Fitch basically downgraded its outlook. It's important to recognize that Fitch only downgraded its outlook on China Sovereign, but it's keeping its rating as At, in line with Pierce. It's not actually downgrading the rating. I think this is worth pointing out because the doom and gloom is coming from an actual assumption of the rating being downgraded. It's not actually happening. This is basically just like a warning. We might downgrade it later.
I have a link below to Fitch's actual website with their rating as well as their explanation of it. I invite you to pause this podcast and go click the link there because it'll make it a lot easier to follow as I speed through this. I have this website in front of me. Without further ado, let's dive right in.
I've actually gone through this, and you'll realize that what Fitch is really worried about is the LGFV debt, and of course, there are a lot of related factors, like household debt, household wealth being tied to the property sector, the state-owned enterprise, as well as local private sector being somehow exposed to the LGFV, as well as just a wider negative sentiment in China. But this is very much an LGFV story because that's like the note that everything spreads out from. I'm just letting you know upfront because you'll be able to paint the map in your mind once I actually go into it. Just imagine LGFV in the middle like a spider web and all the related factors sprawling out from it.
At first, I wanted to do a point-by-point highlight of Fitch's rating commentary, but I later realized that it would take too long. I'm actually just going to point out and highlight the relevant part, really highlight the important things that you would highlight on a piece of paper. And then just jump straight into the interpretation as well as the inference of where Fitch is really coming from in downgrading the outlook.
The first key rating driver on Fitch's website is negative outlook. What they're saying here is that there are more uncertain economic prospects as the government is trying to transition away from the former property-driven growth to a more sustainable growth model. As we all know, they popped the bubble. The property sector is in decline. They need something to make it up. Normally you transition to a service sector. But the problem for China's economy is that the service sector is still relatively young.
There's been a lot of news in the past week over how Chinese manufacturing is recovering. That's good, for the short term, because it provides relief to a mostly manufacturing-driven economy, as far as the private sector is concerned, as well as households. But the underlying problem is that China is leaning a bit too heavily on industrial-driven growth when it really needs to transition to a service-based growth. And there's a lot of uncertainty there.
Fitch is also concerned about the same thing because if they don't do that and your industrial sector is declining, what does that mean for your debt? Your debt rating. There are wide fiscal deficits, rising government debt, and Fitch believes that fiscal policy will play an increasing role in supporting growth in the coming years, which implies higher debt. And there's contingent liability risk, which I will go into later.
The second point of the rating driver, Fitch is very clear that there are actually ratings are affirmed. China's A-plus rating is affirmed for several reasons, which I'll just very quickly speak through. A large diversified economy, solid GDP growth relative peers, integral role in the global goods trade, robust external finances, referring to the reserve, foreign reserves, as well as the reserve currency status of the yuan.
The main point is the wider fiscal deficit. It says that 7.1% GDP growth in 2024 from 5.8% of GDP in 2023. The 2024 deficit will be the highest since 8.6 percent in 2020. Deficits have been running at roughly double the pre-pandemic average of 3.1 percent of GDP. The central government will shoulder a greater share of the fiscal burden. Local and regional government finances are constrained due to declines in land-related revenue and high debt burdens. Fitch also points out an uncertain consolidation path. We expect deficit reduction to be gradual, balanced against economic growth objectives. There is little clarity on reform measures to support medium-term fiscal consolidation.
The next key rating commentary by Fitch is that government debt is rising steadily. It's risen to 61.3% of GDP in 2024 from 56.1% in 2023. This is a clear deterioration from 38.5% in 2019. Debt as a share of revenue is forecast to be 234% in 2024, and the debt ratio will rise to nearly 70 by 2028. China's a quasi-command economy, so it can administrate debt through its SOEs as well as through large commercial players. Therefore, the headline government debt does not tell the full story of what the actual government debt burden is.
Fiscal risk from LGFVs. The local and regional governments have been affected by property slowdown and some local government financing vehicles, the LGFVs, which are facing refinancing pressures in 2023. Some highly indebted regions were permitted to issue about 1.4 trillion in refinancing bonds to bring the Igfe debt directly onto their balance sheets. The government is uniquely positioned to be able to take on a greater share of the debt burden than private sector participants.
These LGFVs offer something called wealth management products, WMPs. WMPs are notorious for giving very high interest yields, sometimes 8% to 9%. The municipal governments are taking the debt proceeds and using it to build roads, utilities, stuff like that. And that of course contributes to GDP, but it's not non-productive GDP if it's an oversupply situation which China is facing and ultimately the ones who suffer in the event of a default from these LGFVs will be the households.
These PPP projects rope in the likes of banks and asset management companies into the LGFV project. If the total is actually not really necessary, the total revenues will not have enough cash flows to repay the debt interest and principal payments. And so the LGFV goes into default. And if you're investing in what is functionally equity or something like equivalent, which the WMPs kind of are, they're not really guaranteed against anything. Then yeah, you can see how this is a real problem that hits everybody.
Fitch forecasts a moderate 4.5 percent GDP growth in 2024 from 5.2 percent in 2023. Fitch does not really see deflationary risk and expects 0.7 percent inflation by 2024. Fitch forecasts growth to remain at 4.5 percent through 2028.
Rating sensitivities could lead Fitch to actually reduce its sovereign rating of China? If it sees public finances go up then, in the fall that's GDP, it will imply persistently high fiscal deficits. The rise in probability of contingent liabilities. If all those LGFV debts actually crystallize or they actually get caught in, or rather they actually default, that could be a lot of contagion risks.
Conversely, if these metrics actually show improvement, a faster reduction deficit through a stabilization of the government debt ratio, then which might improve the rating. Fitch has a qo notch KPI, which is basically measuring whether credit growth is below nominal GDP growth. This is important because if you've been paying attention to macro at all over the past few years, you know that one of the US's, as well as the EU's, means of improving the debt GDP ratio is by basically encouraging inflation.
In summary, this entire rating commentary by Fitch can the title can be changed to LGFV debt high contagion risk possible. I haven't thought about it well long enough to decide if this is actually like analogous to the US subprime crisis in 2008, but it does kind of sound like it. Fitch is basically downgrading the outlook based on a repeat of the US subprime crisis in China.
Transcript (AI-assist):
Hi, this is Aaron. You're listening to Value Investing Substack, and today's news is about Fitch revising its outlook on China to negative from stable. So most of you are already aware of this, but Fitch basically downgraded its outlook. And it's important to recognize that Fitch only downgraded its outlook on China Sovereign, but it's keeping its rating as At, in line with Pierce. It's not actually downgrading the rating. And I think this is worth pointing out because the doom and gloom is coming from an actual assumption of the rating being downgraded. I think that's what people are basically saying. It's not actually happening. This is basically just like a warning. We might downgrade it later. And we'll go on to the reasons why.
So I actually have a link below to Fitch's actual website with their rating as well as their explanation of it. I invite you to pause this podcast and go click the link there because it'll make it a lot easier to follow as I speed through this. You know, not waste your time. You can read, and I can point out the relevant parts that I'm referring to. So I actually have this website in front of me. And without further ado, let's dive right in.
I've actually gone through this, and you'll realize that what Fitch is really worried about is the LGFV debt, and of course, there are a lot of related factors, like household debt, household wealth being tied to the property sector, the state-owned enterprise, as well as local private sector being somehow exposed to the LGFV, as well as just a wider negative sentiment in China. But this is very much an LGFV story because that's like the note that everything spreads out from. And I'm just letting you know upfront because you'll be able to paint the map in your mind once I actually go into it. Just imagine Igfv in the middle like a spider web and all the related factors sprawling out from it.
At first, I wanted to do a point-by-point highlight of Fitch's rating commentary, but I later realized that it would take too long. So I'm actually just going to point out and highlight the relevant part, really highlight the important things that you would highlight on a piece of paper. And then just jump straight into the interpretation as well as the inference of where Fitch is really coming from in downgrading the outlook.
The first key rating driver on Fitch's website is negative outlook. And what they're saying here is that there are more uncertain economic prospects as the government is trying to transition away from the former property-driven growth to a more sustainable growth model. As we all know, they popped the bubble. The property sector is in decline. They need something to make it up. So normally you transition to a service sector. But the problem for China's economy is that the service sector is still relatively young.
There’s been a lot of news in the past week over how Chinese manufacturing is recovering. So that's good, to be clear, for the short term, because it provides relief to a mostly manufacturing-driven economy, as far as the private sector is concerned, as well as households. But the underlying problem is that China is leaning a bit too heavily on industrial-driven growth when it really needs to transition to a service-based growth. And there's a lot of uncertainty there.
Without digressing too far, I think Fitch is also concerned about the same thing because if they don't do that and your industrial sector is declining, what does that mean for your debt? Yeah, your debt rating. So there are wide fiscal deficits, rising government debt, and Fitch believes that fiscal policy will play an increasing role in supporting growth in the coming years, which implies higher debt. And there's contingent liability risk, which I will go into later.
And the second point of the rating driver, Fitch is very clear that there are actually ratings are affirmed. So China's A-plus rating is affirmed for several reasons, which I'll just very quickly speak through. A large diversified economy, solid GDP growth relative peers, integral role in the global goods trade, robust external finances, I think this is referring to the reserve, foreign reserves, as well as the reserve currency status of the yuan. Okay, that's subjective, but that's rich.
Okay, I won't go step by step into everything. I just did because clearly it's going to take too long if I do that. I'm just going to highlight the main point, and because I've already read through this, I already know what they're covering. So it's great if you actually have the Fitch website in front of you or even better if you could print it out so that you can basically follow which part of the rating commentary I'm referring to, okay? Which is concerned with wider fiscal deficit.
So it says that 7.1% GDP growth, sorry, 7.1% of GDP in 2024 from 5.8% of GDP in 2023, right? This is debt-to-GDP ratio. The 2024 deficit will be the highest since 8.6 percent in 2020. And deficits have been running at roughly double the pre-pandemic average of 3.1 percent of GDP. So obviously, that's not good. Is this going to be persistent? Is it going to be sustainable? I mean, we can think of other countries which are doing worse, but from an absolute standpoint, you know, if you have 4 percent GDP growth and 6 percent, uh, you know, debt growth, right? Debt-to-GDP growth, that means you're growing credit at a net 2 percent faster than you're growing GDP. That's never great.
It's saying that the central government will shoulder a greater share of the fiscal burden. So we'll go into this a little bit deeper later, right? Because local and regional government finances are constrained due to declines in land-related revenue and high debt burdens. This one needs a bit of context from Igfe which I'll go into soon. But very quickly, the local and regional governments are very, very highly indebted, right? Due to the Igfe situation. So we'll go on to it a bit later, but right now it would seem that the central government will also need to play a greater role in shouldering a debt burden. And Fitch also points out an uncertain consolidation path. So basically, this means uncertainty about how they're actually going to pay back that incredible amount of debt, right? We expect deficit reduction to be gradual, balanced against economic growth objectives. There is little clarity on reform measures to support medium-term fiscal consolidation. You know, a lot of the tax revenue, okay, I'm not really sure about this, but I imagine a lot of the government income is somehow related to the property sector which is declining and also other sectors which are declining, right? So basically what Fitch is saying here is that we don't know how they’re going to pay it off, right? Which is kind of the same as the US, but I digress.
The next key rating commentary by Fitch is that government debt is rising steadily. It's risen to 61.3% of GDP in 2024 from 56.1% in 2023. This is a clear deterioration from 38.5% in 2019. Debt as a share of revenue is forecast to be 234% in 2024, and the debt ratio will rise to nearly 70 by 2028. So all these are real scary numbers. It's important to remember, which Fitch actually does cover later on, that China's a quasi-command economy, so it can administrate debt through its SOEs as well as through large commercial players. Therefore, the headline government debt does not tell the full story of what the actual government debt burden is.
So we'll go into this a bit deeper later. But the next point is contingent liabilities. So I think we'll combine this with the following point as well. Fiscal risk from LGFVs. The local and regional governments, according to Fitch, have been affected by property slowdown and some local government financing vehicles, the LGFVs, which are facing refinancing pressures in 2023. Some highly indebted regions were permitted to issue about maybe 1.4 trillion in refinancing bonds to bring the Igfe debt directly onto their balance sheets. So if you recall, this is kind of what Japan did. They brought the corporate balance sheets onto the government balance sheets so that they could stimulate the private sector. You need good balance sheets before people will invest, will take risks. The government is uniquely positioned to be able to take on a greater share of the debt burden than private sector participants. So we're seeing the same thing here. As in Japan all those years ago, China is basically moving the Igfv debt, which is technically a private sector, although I'll explain a little bit more why it's not later on, to the municipal or local government balance sheets, which ultimately falls on the central government balance sheet.
So in case you're wondering what these LGFVs are, you can think of them as sort of like mutual funds or what some countries call unit trusts. They are technically not controlled by the government. And what they do is they offer something called wealth management products, WMPs. WMPs are notorious for giving very high interest yields, sometimes 8% to 9%. For context, I think that's what Dubai is offering on their sovereigns. So that's really high interest yields. And they are issuing these WMPs to households who will then invest in these LGFV entities. And guess who's controlling or rather administrating the debt proceeds? It's the municipal governments. They're taking the debt proceeds. They're using it to build roads, you know, build utilities, stuff like that. Government kind of stuff. And that of course contributes to GDP, but it's not non-productive GDP if it's an oversupply situation which China is facing and ultimately the ones who suffer in the event of a default from these LGFVs will be the households. And if you thought that was all right, it's actually not. That's not all right.
These PPP, sorry, remember how I was saying the debt proceeds were invested in government kind of stuff, like building roads? So these road projects are actually private-public partnerships, PPP, which are very common across the world. But what this does is it ropes in the likes of banks and asset management companies into the Igmv project. So let's just give a very cursory example. Say the municipal government wants to build a road, right or a highway to which, you know, based on certain projections is going to connect two key cities and basically create value between the two cities, which will show up as higher GDP growth. That's a normal municipal thing, right? And what these LGFVs do is that they will ostensibly be created as a private sector company, for instance, and then it will issue these wealth management products which are very popular with the Chinese local households. And the proceeds will be used to invest in. I mean, so, sorry, let me take a step back.
So part of the proceeds will be from households and then the LGFVs will also invite private sector banks as well as asset management companies to invest in the same project. So that will be in the form of debt or equity. And then the LGMV, which is being actually functionally controlled by the municipal government, will then take the proceeds to build the road, set up a toll booth, and then the revenues will be used to pay back the debt with interest. And you can see where the problem lies. Let's say that total is actually not really necessary. It's not productive. So the total revenues will not have enough cash flows to repay the debt interest and principal payments. And so the LGFV goes into default. And guess what? If it's a mutual fund equivalent, the households are out of luck. I mean, at least some of the senior, senior preferred debtors would have some sort of collateral to claim. But if you're investing in what is functionally equity or something like equivalent, which the WMPs kind of are, they're not really guaranteed against anything. Then yeah, you can see how this is a real problem that hits everybody. So it becomes a too-big-to-fill situation. And what Fitch is saying is that last year alone, there was RM1.4 trillion worth of. So that comes up to about 200 billion US dollars more or less, worth of LGFV debt that has been subsidized by the actual local government.
So while in the past it was only ostensibly private sector, now it's like straight up government debt. Because the government will then issue debt to buy up the LGFV debt and make the private sector whole, which is necessary, right? And these sort of problems are very widespread across the whole of China, at least as far as I understand. And it's really a no-life end of the tunnel situation. It's like with respect to LGFV alone. I think it's not wrong to compare it to a Japan situation, even though Japan was not really in like PPP kind of situation where they were building infrastructure. It was very much a private sector to government sector debt transfer to heal the private sector and basically stimulate the economy. And that's kind of what we're seeing now.
Let's move on. There are some near-term growth headwinds. Fitch forecasts a moderate 4.5 percent GDP growth in 2024 from 5.2 percent in 2023. So, that's not too bad, 4.5 percent, much better than a lot of its peers. We can criticize it from a different angle in a different episode, but we're not going to do that now. So there are deflationary risks. Fitch does not really see deflationary risk and expects 0.7 percent inflation by 2024.
Medium-term growth prospects. Fitch forecasts growth to remain at 4.5 percent through 2028. So basically, for the medium term, supported by several things and challenged by several things, it's quite straightforward. If you have the website in front of you, you can just refer to it.
Also, finally, wrapping up the commentary by pointing out China's central role in global supply chains. So what rating sensitivities could lead Fitch to actually reduce its sovereign rating of China? So if it sees public finances go up then, in the fall that's GDP, it will imply persistently high fiscal deficits. And, you know, you could argue that the US is going through the same thing, but this is about China, so let's just talk about it from an absolute standpoint.
The rise in probability of contingent liabilities. So, if all those LGFV debts actually crystallize or they actually get caught in, or rather they actually default, that could be, like I described, there were like many. So remember the metaphor I was giving you at the beginning of this podcast? It was LGFV in the middle of a spider web where all the other parties are branched out. So there's a household, there's the private sector banks, there's local asset management companies, and there's the larger regional banks as well as, finally, the central government. If the LGFV collapses, there's a lot of contagion risks.
So I think really this whole article can be pointed out can be tighter. The headline can be changed to LGFV debt high contagion risk on the horizon. And, conversely, if these metrics actually show improvement, so a faster reduction deficit through a stabilization of the government debt ratio, then which might improve the rating.
And of course, macro plays a part here, but that's quite straightforward. It also highlights structural features such as macro financial risks as well as associated contingent liabilities being a factor that could affect Fitch's rating. For example, by maintaining credit growth below nominal GDP growth over a multi-year period, which would cause the removal of Fitch's own negative 1qo notch on structural features.
So Fitch has a qo notch KPI, which is basically measuring whether credit growth is below nominal GDP growth. And this is important because if you've been paying attention to macro at all over the past few years, you know that one of the US's, as well as the EU's, means of improving the debt GDP ratio is by basically encouraging inflation so that would reduce the denominator, increase the denominator faster than the numerator, which is increased GDP faster and debt.
And since sovereigns tend to be more concerned about the relative difference rather than the absolute default of the sovereign debt, that's a very legitimate way that the US could try and get out of the debt burden. And it actually was how they did it after World War Two.
So it may only be a very one sentence thing here in and then amidst the whole article. I think which is correct to highlight this part and basically say that this is the metric to observe. We need to see an improvement in China's sovereign as well as, you know, other sector debt to GDP ratio, that's really what it boils down to.
But, you know, in summary, as I said just now, this entire rating commentary by Fitch can the title can be changed to LGFV debt high contagion risk possible, like that explains the whole rating commentary by Fitch. And if you remember recall, we actually spent a lot of time explaining LGFV side because I was trying to show you the spiderweb scenario where the LGFV is in the middle and there's a contagion risk to all the other related entities like the households, the private sector banks, the state-owned banks, larger banks, the local asset management companies, the municipal governments, as well as the central government, it's pretty much a too-big-to-fill situation.
I haven't thought about it well long enough to decide if this is actually like analogous to the US subprime crisis in 2008, but it does kind of sound like it, doesn't it? You have systematically important financials facing default, which leads to potential contagion risk that spills over to everybody and finally hits the central government, like, you know, that's kind of how you would do an elevated pitch of the 2008 subprime crisis.
So Fitch is basically downgrading the outlook based on a repeat of the US subprime crisis in China. I hope this was helpful, I would have loved if someone actually summarized it this way to me before I actually spent my time reading the whole thing. But, you know, if you like this kind of commentary, please like and subscribe. Looking forward to doing more of these kinds of podcasts because they're actually quite helpful in terms of getting things out fast on a timely basis, right?
So I also want to talk more about value investing. I have a lot of stuff of value investing in my head, like say, you know, Buffett's old carry exploits, successors, you know. And since this is a very investing substack, I would love to share more of it with you. So thank you for listening. It's been 25 minutes. I hope to see you in the next episode.
Signing out, this is Aaron from Value Investing Substack.
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Deep-dive: Fitch's Downgrade of China's Rating Outlook