OREANDA-NEWS. Fitch Ratings has affirmed Hong Kong's Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) 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' and the Short-Term Foreign-Currency IDR at 'F1+'.

KEY RATING DRIVERS

The affirmation of Hong Kong's IDRs with a Stable Outlook reflects the following key rating drivers:

Hong Kong's ratings are underpinned by a resilient and flexible economy, high income levels, a credible policy framework, and exceptionally strong public and external finances. The ratings are constrained by the territory's large financial and corporate sector exposures to mainland China (A+/Stable).

Hong Kong's macroeconomic performance has remained resilient over the past 12 months. Real GDP grew by 2.8% during the second quarter of 2015, up from 2.4% in the first quarter. Private consumption and gross capital formation were the main drivers, as net exports continued to be a drag on growth due to a weakening tourism sector. Fitch forecasts real GDP growth of 2.4% in 2015, broadly in line with the Financial Secretary's expectation of 2%-3% announced in August, but slightly below the 2014 real GDP growth of 2.5%.

External finances are among the strongest across Fitch-rated sovereigns. The territory is a large net external creditor (250% of GDP forecasted for 2015) and has run current account surpluses for nearly two decades. Fitch does not believe the sharp rise in the one-year implied volatility in USDHKD option markets caused by recent equity and currency volatility in mainland China represents a risk to Hong Kong's currency regime. The currency board has been in place since 1983 and is supported by USD340bn in foreign exchange reserves, equivalent to 1.87x the monetary base.

Fiscal reserves grew to HKD829bn (36% of GDP) in the fiscal year ended 31 March 2015 (FY14) on the back of a budget surplus of 3.6% of GDP. The territory has run consistent budget surpluses since FY04 and has a track record of budget outperformance, which has averaged 3.3% of GDP over the past five years. The outstanding stock of government debt (38% 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.

The government is already working to address the long-term fiscal challenges posed by lower trend growth and an ageing population. In 2014, the Working Group on Long-Term Fiscal Planning estimated the territory will face a structural deficit within the next 10 years without policy action. The Treasury has already implemented a programme to reduce operating expenditure by 2% over the coming three years and will establish a Future Fund to enhance the investment returns on the government's existing fiscal reserves. The Financial Secretary also said he may revisit the feasibility of implementing a Goods and Services Tax, though Fitch believes the likelihood of implementation in the near term is low.

Fitch continues to view Hong Kong's sizeable banking sector exposures to mainland China as its primary rating constraint. We estimate the territory's gross mainland China exposures were USD854bn as of March 2015 (31% of banking sector assets), up from USD179bn in 2009 (11% of assets). The majority of exposures are supported by credit-enhancements, but bankruptcy procedures are largely untested in China and Fitch believes recovery rates to offshore creditors will be much lower than expected despite the use of collateral arrangements.

The Occupy Central protests from September to December 2014 and the defeat of a proposed new electoral system in the Legislative Council in June 2015 reflect broader social disagreement over the pace and style of Hong Kong's political development, but have not impacted our assessment of its sovereign creditworthiness. Fitch's base case is that future protests are unlikely to reach the size and scale achieved during Occupy Central, though we do expect the political climate for universal suffrage to be tested once again in the run-up to the 2017 Chief Executive elections.

Domestic housing prices continued their ascent during the first half of 2015, and have effectively doubled since 2010. While values appear unbalanced from a fundamental supply/demand and affordability perspective, Fitch views direct risks to the banking sector in the event of a price correction as limited given seven rounds of macro-prudential tightening measures and loan-to-value ratios on residential mortgages averaging 55% since 2012.

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 positive action, individually or collectively, are:
- A longer track record demonstrating that Hong Kong's economy is resilient to mainland China's transition away from debt-fuelled economic growth, potentially through a strengthening of the stand-alone strength of Hong Kong's financial system.
- A non-disruptive transition away from debt-fuelled economic growth in mainland China and a rebalancing of its economy toward consumption.

The main factors that could lead to negative action, individually or collectively, are:
- Further concentration of banking sector exposures to mainland China that makes it increasingly difficult to distinguish financial sector risks in Hong Kong from those in mainland China, or a severe economic deterioration in mainland China that jeopardises Hong Kong's economic and financial stability.
- A political disruption sufficiently large and prolonged to disrupt Hong Kong's long-term economic growth prospects or status as an international financial centre.

KEY ASSUMPTIONS

- China avoids a hard landing or banking sector crisis.
- Hong Kong's business climate remains stable and attractive.
- Hong Kong maintains the present Linked Exchange Rate System with the US dollar.