It took less than a day for China’s financial markets to recover from the credit rating downgrade by Moody’s Investors Service on 24 May, the country’s first sovereign rating downgrade from the rating agency since 1989.
However, the downgrade is far from a non-event in China: The warning shot from Moody’s will likely alert political leadership to the economy’s current trajectory and give reformers at the People’s Bank of China (PBOC), the Ministry of Finance and the financial regulatory agencies ample ammunition to further rein in the excess debt accumulation that has supported the economy for some time.
Since the fourth quarter of last year, President Xi Jinping and China’s policymakers have called for a shift to tighter policy to curb rising systemic risks and the property bubble. The move to tighter policy has marked a structural shift from sustaining the 6.5% GDP growth target to “maintaining financial stability” and reviving structural reform.
Following Moody’s downgrade, we expect Chinese policymakers will feel a sense of urgency to intensify financial regulation of the huge shadow banking system, maintain a hawkish monetary policy stance and somehow restore the fiscal discipline that has loosened in the past two years. This policy shift may become more pronounced after the power reshuffle expected at the 19th National Congress of the Communist Party this autumn.
Although the long overdue policy shift is positive from a structural standpoint, it will put more pressure on Chinese growth, financial markets and commodities prices in the coming year.
Limited short-term market impact from the downgrade
The downgrade to A1 from Aa3 was not surprising after both Moody’s and Standard & Poor’s had warned in March 2016 that they were reviewing China’s ratings. And the market impact of the downgrade is limited: China has not issued sovereign external debt for more than a decade, and local currency bonds are not included in the widely tracked global indexes yet, so there was no index-related selling. (In addition, China is still rated above the credit thresholds for the major bond indexes.)
Bonds from state-owned enterprises and local government financing vehicles (LGFVs) that rely on some form of government support may feel the impact, and those with low investment grade ratings could risk slipping below investment grade (becoming “fallen angels”).
On the positive side, Moody’s restored its outlook on China to “stable.” China’s A1 rating is supported by very high domestic saving, a locally financed system (which minimizes currency mismatching and the sudden stop risk seen in emerging markets), and high public confidence in the government-controlled financial system. Nominal GDP growth is high at 6%–10% (with potential GDP at a real rate of 4%–6%) and compares favorably with public sector funding costs of around 4%–5%. A semi-closed capital account and very low external debt also reduce China’s vulnerability.
China’s longer-term issues
Still, Moody’s downgrade is another signal that China’s current debt-intensive growth model is risky over the long term. Despite the short-term stabilization China has achieved in 2017 through massive debt-financed stimulus and property reflation, the secular trajectory is slowly deteriorating. The waves of excess credit stimulus over the past several years – designed to counter aging demographics, stalled structural reform, slowing productivity and various global headwinds – have clearly raised systemic risks.
China now faces lower growth potential, rapidly rising public sector debt (albeit from a low 70% of GDP), high corporate debt (130% of GDP), property bubble risk and rising household leverage (though from less than 50% of GDP). The financial sector is increasingly vulnerable, with worsening asset quality, surging reliance on wholesale funding and a poorly regulated shadow banking system.
In addition, there has been little progress over the past two years in transitioning the yuan from a crawling peg to a free-floating currency. Although China’s foreign exchange reserves remain adequate at $3 trillion and its external debt is quite low, the PBOC is still using $10 billion–$20 billion monthly to maintain the yuan’s crawling peg, which could limit its flexibility to deal with future shocks. The rigid crawling peg and the quickly dwindling current account/basic balance pose long-term risks to macro stability, particularly if domestic financial risks continue to accumulate at the same rate.
Isaac Meng is an emerging markets portfolio manager with a focus on macroeconomic and financial analysis of China.