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Fitch Downgrades Hong Kong to 'AA' from 'AA+'; Outlook Negative

05 Sep 2019 11:55 PM ET

Fitch Ratings - Hong Kong - 05 September 2019:

Fitch Ratings has downgraded Hong Kong's Long-Term Foreign-Currency Issuer Default Rating (IDR) to 'AA' from 'AA+'. The Outlook is Negative. A full list of rating actions can be found at the end of this commentary.

Key Rating Drivers

The downgrade of Hong Kong's IDRs and the Negative Outlooks reflect the following key rating drivers:

Months of persistent conflict and violence are testing the perimeters and pliability of the "one country, two systems" framework that governs Hong Kong's relationship with the mainland, underscored by mainland officials taking a more public stance on Hong Kong affairs than at any time since the 1997 handover. Fitch expects the "one country, two systems" framework to remain intact, but the gradual rise in Hong Kong's economic, financial, and socio-political linkages with the mainland implies its continued integration into China's national governance system, which will present greater institutional and regulatory challenges over time. In Fitch's view, these developments are consistent with a narrowing of the sovereign rating differential between Hong Kong and mainland China (A+/Stable).

Ongoing events have also inflicted long-lasting damage to international perceptions of the quality and effectiveness of Hong Kong's governance system and rule of law, and have called into question the stability and dynamism of its business environment. These features are integral to Fitch's assessment of the territory's creditworthiness, and while still strong in a global context, are at risk of being further eroded as a result of enduring social strife.

The Negative Outlook reflects our view that even with concessions to some protestor demands, a degree of public discontent is likely to persist. The potential for renewed eruptions of social unrest could further undermine confidence in public institutions, and tarnish perceptions of Hong Kong's governance, institutions, political stability, and business environment.

A more challenging economic landscape has emerged as a result of the blow to domestic activity precipitated by continued unrest, as well as the already-existing external headwinds brought on by the US-China trade conflict. Fitch now forecasts real GDP growth of 0% in 2019, implying an outright contraction during the second half of this year, and 1.2% in 2020. We also expect the budget surplus will narrow to roughly zero this year, in light of recently announced fiscal support measures, and our anticipation that revenues will underperform budget forecasts.

Fitch expects Hong Kong's considerable financial buffers to nevertheless remain intact. These include a large fiscal reserve equivalent to 40% of GDP, the territory's status as the third-largest net external creditor among Fitch-rated sovereigns (283% of GDP), and a more than 20-year record of current account surpluses. The agency also believes the authorities have ample resources to maintain the Hong Kong dollar peg to the US dollar, given foreign-reserve holdings of USD441 billion, equivalent to roughly 2x the monetary base. Other factors that continue to support Hong Kong's credit profile include its strong record of public-finance management, high income levels, and its resilient and flexible economy.

Sovereign Rating Model (SRM) and Qualitative Overlay (QO)

Fitch's proprietary SRM assigns Hong Kong a score equivalent to a rating of 'AA+' on the Long-Term Foreign-Currency (LT FC) IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

- Public Finance: +1 notch to reflect that Hong Kong's government debt stock is not fiscal in nature and primarily constitutes notes issued by the Hong Kong Monetary Authority to manage the currency board. The territory's fiscal reserves also add an additional buffer to the credit profile.

- Structural Features: -2 notches to reflect Hong Kong's integration into China's national governance system, and associated rise in economic, financial, and socio-political linkages with lower-rated mainland China (A+).

RATING SENSITIVITIES

The main factors that could lead to negative action are:

- Erosion in the autonomy of the Hong Kong Special Administrative Region government.

- Continued social instability that further undermines perceptions of rule of law and the soundness of the business environment.

- Evidence that Hong Kong's economy is susceptible to heightened spillovers from mainland China, in light of its considerable economic and financial linkages with the mainland.

The main factors that could lead to positive action are:

- A resolution of ongoing social strife that leads to a sustained recovery in business confidence.

- An improvement in mainland China's sovereign credit profile.

Key Assumptions

- Hong Kong maintains the Linked Exchange Rate System with the US dollar.

ESG Considerations

Hong Kong has an ESG Relevance Score of '4' for Human Rights and Political Freedoms, as World Bank Governance Indicators have the highest weight in the SRM and are relevant to the rating and a rating driver.

Hong Kong has an ESG Relevance Score of '5' for Political Stability and Rights, as World Bank Governance Indicators have the highest weight in the SRM and are therefore highly relevant to the rating and a key rating driver with a high weight.

Hong Kong has an ESG Relevance Score of '5' for Rule of Law, Institutional and Regulatory Quality, and Control of Corruption as World Bank Governance Indicators have the highest weight in the SRM and are therefore highly relevant to the rating and a key rating driver with a high weight.

Hong Kong has an ESG Relevance Score of '4' for International Relations and Trade, as Hong Kong's relations with China and its deep economic, financial, and sociopolitical linkages with the mainland expose it to potential shocks and are relevant to the rating and a rating driver.

Hong Kong has an ESG Relevance Score of '4' for Creditor Rights, as willingness to service and repay debt is relevant to the rating and a rating driver.



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