Fitch Affirms Hong Kong at 'AA+'; Outlook Stable 

Fitch Ratings has affirmed Hong Kong's Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDR) at 'AA+' with a Stable Outlook. The issue ratings on Hong Kong's senior unsecured local-currency bonds are also affirmed at 'AA+'. The Country Ceiling is affirmed at 'AAA'. The territory's Short-Term Local-and Foreign-Currency IDRs and the issue ratings on its senior unsecured short-term local-currency notes have also been affirmed at 'F1+'.

KEY RATING DRIVERS

Hong Kong's ratings are underpinned by its exceptionally strong external and public finances, credible policy framework, high income levels and resilient and flexible economy. The ratings are principally constrained by the territory's deeper integration with lower-rated mainland China (A+/Stable).

Hong Kong's external finances are among the strongest across Fitch-rated sovereigns. The territory has run consistent current-account surpluses for nearly two decades and is a net external creditor equivalent to approximately 260% of GDP. Fitch forecasts a current-account surplus of 3.2% of GDP in 2016, broadly unchanged from 2015. Our forecast reflects further declines in service export receipts, largely linked to subdued mainland Chinese tourist inflows, with a large narrowing of the merchandise trade deficit. Merchandise exports fell by 4.1% yoy through July 2016, but imports fell by an even greater 5.2% over the same period.

Pressure on the Hong Kong dollar has abated after the currency traded near the weak side of the convertibility band in early 2016, due to market concerns over mainland China's new currency basket. Fitch believes the Hong Kong authorities remain fully committed to the currency board arrangement and have sufficient financial resources to defend it, if required, as exemplified by USD363bn in foreign-exchange reserve holdings as at end-July 2016, equivalent to 1.8x the monetary base.

Public finances are a key support for the territory's credit profile, exemplified by its consistent budget surpluses for over a decade. Hong Kong recorded a budget surplus of HKD14.4bn (0.6% of GDP) for the fiscal year ended-March 2016 (FY15), down from HKD82.5bn (3.6% of GDP) a year prior. Funds of HKD45bn were injected into the housing reserve in December 2015 to support the government's long-term public-housing strategy. These proceeds were redirected from the government's FY15 investment income, which would otherwise have been recorded as fiscal revenue and resulted in a larger surplus.

Outstanding government debt totalling 40% of GDP is not fiscal in nature and primarily constitutes notes issued by the Hong Kong Monetary Authority to facilitate management of the currency board. Fiscal reserves grew to HKD843bn (35% of GDP) in FY15 due to the budget surplus, equivalent to 21 months of budgeted FY16 government expenditure. Hong Kong established a Future Fund in January 2016 with an initial endowment of HKD220bn from the Land Fund to enhance investment returns on the government's fiscal reserves. This underscores some of the forward-looking policy measures undertaken by the government to address the long-term fiscal challenges posed by an ageing population and lower trend growth.

Macroeconomic performance has slowed in recent quarters, alongside subdued global demand and spill-overs from mainland China's rebalancing. Real GDP grew by 1.7% during 2Q16, up from 0.8% in 1Q16. Private consumption slowed to 0.6% yoy in 2Q16 (2Q15: 6.8%) and gross capital formation contracted by 4.9%. Tourist arrivals continued falling, but appear to have nearly bottomed. Employment conditions have nevertheless remained stable, with unemployment at 3.4%. Fitch expects economic growth to remain subdued for the remainder of the year, as reflected in our 2016 full-year growth forecast of 1%, which is at the lower-end of the government's official forecast range of 1%-2%.

Fitch estimates that Hong Kong's banking sector exposures to mainland China declined to 27% of system-wide assets (239% of GDP) at end-1Q16, down from 31% (293% of GDP) a year prior. The classified loan-ratio of these exposures stood at 0.9%, compared to 0.8% for the system as a whole. The majority of China-related exposures appear to be to high-quality borrowers, including Chinese state-owned entities and multinational companies, and are backed by credit enhancements. While we expect the system's liquidity and capitalisation to remain sound, a rapid deceleration of economic growth in mainland China or a hard landing remain key tail-risks, due to the magnitude of these exposures relative to the size of Hong Kong's economy and banking system.

Property prices have fallen by 8% from their historical peak in September 2015, but appear to have stabilised, with city-wide property prices posting modest month-on-month gains since April 2016. Fitch believes further price corrections are plausible, as property values have effectively doubled since 2010, facilitated by low mortgage-rates and investment demand. While a sharp decline in property values has the potential to impact household consumption through a negative wealth effect, the agency believes direct risks to the banking sector are limited in light of tight macro-prudential measures and low loan/value caps.

The rise of the Hong Kong 'localist' movement highlights unresolved social disagreement over the pace and style of the territory's political development. The disqualification of several Legislative Council election candidates due to their public advocacy of Hong Kong independence has sparked tensions in the last few weeks. There is a risk of renewed political protests around the September 2016 Legislative Council and March 2017 Chief Executive elections, but Fitch believes these are unlikely to take the size and form experienced during the 2014 Occupy Central movement.

SOVEREIGN RATING MODEL AND QUALITATIVE OVERLAY

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

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final Long-Term Foreign-Currency IDR by applying its Qualitative Overlay, relative to rated-peers, as follows:

• Public Finances: +1 notch, reflecting that Hong Kong's government debt stock is not fiscal in nature and primary constitutes notes issued by the Hong Kong Monetary Authority to manage the currency board. Hong Kong's fiscal reserves also add an additional buffer to the credit profile.
• Structural Features: -1 notch, reflecting Hong Kong's significant financial-sector linkages with mainland China.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a Long-Term Foreign-Currency IDR. Fitch's Qualitative Overlay is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable or not fully reflected in the SRM.

RATING SENSITIVITIES

The Stable Outlook reflects Fitch's assessment that upside and downside risks to the rating are currently balanced.

The main factors that could lead to negative action, individually or collectively, are:

• Heightened risk of a hard landing in China or evidence that China's structural rebalancing will have a destabilising effect on Hong Kong's financial sector or broader economy
• Political disruption sufficiently large and prolonged to disrupt Hong Kong's long-term economic growth or attractiveness as an international financial centre.

The main factors that could lead to positive action, individually or collectively, are:

• Confirmation that Hong Kong's economy is resilient to mainland China's transition away from debt-fuelled growth or resilient to a full economic cycle in mainland China.

KEY ASSUMPTIONS

• China avoids a hard landing or banking sector crisis.
• Hong Kong maintains the present Linked Exchange Rate System with the US dollar.