China’s economy is healthy, credit growth is decelerating and the government is cracking down on financial system risks, making this an odd time for rating agency Moody’s Investors Service to downgrade China’s sovereign rating to A1 from Aa3, while also changing its outlook to stable from negative. The May 24 Moody’s Credit Opinion even sounds somewhat defensive—it highlights the strengths of the Chinese economy and reports that “financial stability risks will remain low.” Importantly, our fixed income team believes that this downgrade will have limited impact for investors since this is already priced in the credit spread.
According to Moody’s, its downgrade reflects their “expectation that China’s financial strength will erode somewhat over the coming years,” due in part to “high leverage at state-owned enterprises (SOEs).” And while the agency estimates that approximately 10% of SOEs are particularly highly leveraged, large parts of the SOE sector are financially robust, implying that “the total size of SOE liabilities overstates the risks to the sovereign.”
The Moody’s report describes China’s economic strengths in notable detail, and the agency also acknowledges that the Chinese government has made recent progress in managing some potential risks.
Additionally, we note that the government has been making progress in slowing the growth of aggregate credit, and in reducing the gap between the growth rates of credit and of nominal GDP.
Unlike downgrades from investment grade to non-investment grade, we believe a single notch downgrade from Aa3 to A1 by Moody’s is likely to have very little impact on investor’s positioning. The risks highlighted by Moody’s have long been understood by the investment community, and the downgrade moves China from the “very low” credit risk bucket to the “low” credit risk bucket. As a result, we do not believe the downgrade will have a material impact on the success of the China-Hong Kong Bond Connect program, which is scheduled to be launched later this year.
Finally, we want to remind investors of our view on China’s debt problem, as detailed in our September 2016 issue of Sinology. At the time, we made the assessment that while China’s debt problem was serious, we believed the risk of a hard landing or banking crisis to be low considering that the potential bad debts are corporate, not household debts, and made at the direction of the state—by state-controlled banks to state-owned enterprises.
We continue to believe that the state has the ability to manage the timing and pace of recognition of nonperforming loans. It is also important to note that the majority of potential bad debts are to state-owned firms, while the privately owned companies that employ the majority of the workforce and account for the majority of economic growth have been deleveraging. Additional positive factors are that China’s banking system is very liquid, and that the process of dealing with bad debts has begun.
Cleaning up China’s debt problem will be expensive, but this process is likely to result in gradually slower economic growth rates, greater volatility, and a higher fiscal deficit/GDP ratio, not the dramatic hard landing or banking crisis scenarios that make for a more sensational media story.
Teresa Kong, CFA
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