For the first time since 1989, Moody’s Investors Service has downgraded China’s long-term local currency and foreign currency issuer ratings to “A1” from “Aa3”, on expectations that the republic’s financial strength will erode somewhat over the coming years due to rising economy-wide debt as potential slows.
China’s local currency bond and deposit ceilings, as well as the foreign currency bond ceiling, both remain at Aa3.
While the foreign currency deposit ceiling is lowered to A1 from Aa3, China’s short-term foreign currency bond and bank deposit ceilings remain Prime-1 (P-1).
In a Thursday announcement, Moody’s explains its rationale for its rating downgrade to A1:
- Government debt. With monetary policy limited by the risk of fuelling renewed capital outflows, the burden of supporting growth will fall largely on fiscal policy, with spending by government and government-related entities – including policy banks and state-owned enterprises (SOEs) – rising. The importance the authorities attach to maintaining robust growth will result in sustained policy stimulus, given the growing structural impediments to achieving current growth targets. Such stimulus will contribute to rising debt across the economy as a whole, adds the ratings agency.
- Indirect debt. Moody’s is also expecting indirect and contingent liabilities to increase, with estimations that the 2016 outstanding amount of policy bank loans and of bonds issued by Local Government Financing Vehicles (LGFVs) increased by a combined 6.2% of 2015 GDP. Additionally, the agency notes that investment by other SOEs increased markedly. As such, similar increases in financing and spending by China’s broader public sector are likely to continue in the next few years, in order to maintain GDP growth around the official targets.
- Economy-wide debt. More broadly, the agency forecasts that economy-wide debt of the government, households and non-financial corporates will continue to rise, from 256% of GDP at the end of last year according to the Institute of International Finance. This will happen because economic activity is largely financed by debt in the absence of a sizeable equity market and sufficiently large surpluses in the corporate and government sectors, it explains.
- Insufficient impact from reforms. While noting that the Chinese authorities’ commitment to reform is clear, Moody’s does not think that the reform effort will have sufficient impact to contain the erosion of credit strength associated with the combination of rising economy-wide leverage and slower growth, or arrest the rise in economy-wide leverage. In particular, it believes the key reform measures introduced to-date will have limited impact on productivity and the efficiency with which capital is allocated over “the foreseeable future”.
- Underdeveloped financial sector. Beyond the corporate sector, it is in Moody’s view that China’s financial sector remains underdeveloped – not withstanding reforms introduced. Furthermore, the capital account remains largely closed with increased scrutiny of capital outflows. While this move insulates China’s economy and financial system and global volatility, the agency points out that it also constrains the development of domestic capital markets by limiting the flow of inward and outbound capital.
Moody’s has, however, changed its outlook on China to “stable” from “negative” to reflect its assessment that the risks are balanced at the A1 rating level.
“Evidence that structural reforms are effectively stemming the rise in leverage without an increase in risks in the banking and shadow banking sectors could be positive for China’s credit profile and rating,” explains the agency.
“Conversely, negative rating pressures could stem from leverage continuing to rise faster than we currently expect and continuing to involve significant misallocation of capital that weighs on growth in the medium term. In particular, in this scenario, the risk of financial tensions and contagion from specific credit events could rise, potentially to levels no longer consistent with an A1 rating.”
This article first appeared in The Edge Singapore Market Report.