Yesterday’s downgrade of Chinese debt by credit rating agency Moody's reflects widespread negative sentiment towards the country’s central bank movements, according to investment professionals.
However, some believe the People’s Bank of China (PBoC) is taking a step in the right direction and that fears of an imminent credit crisis are overblown.
Moody’s Investors Service reduced China’s sovereign credit rating for the first time in almost three decades from Aa3 to A1 with stable outlook, due to expectations for rising debt levels over the long term and reforms looking likely to further slow the country’s growth rate.
The accompanying report from the rating agency’s global credit research team noted: “Underpinning the rating action was Moody’s concern over China’s deteriorating leverage condition, and that the official reform program, as it currently stands, won’t be enough to completely arrest the build-up of debt.
“Concerning the sovereign rating, in particular, Moody’s expects China’s central government debt to rise to 40 per cent of GDP by end-2018, before reaching 45 per cent by 2020 (in line with the debt burden for the median of A-rate sovereigns at circa 41 per cent).
“Beyond public debt, the agency also expects continued debt accumulation by the private sector, particularly state-owned enterprises [SOEs] but also households, partly because of the official desire to maintain a high growth target.”
Combined with expectations of growth slowing towards 5 per cent by the end of the decade, Moody’s warned that the economy will become more and more dependent on credit-charged stimulus.
The news was not well received by markets and negative sentiment has been building for some time, with the Shanghai Composite index already down by 9.38 per cent in sterling terms over the last three months as concerns have mounted.
Performance of index over 3months
Source: FE Analytics
Given China is the world’s second-largest economy and accounts for significant weightings across numerous benchmarks, how concerned should global investors be?
Aidan Yao, senior emerging Asia economist, and Jim Veneau, head of Asia fixed income, of AXA Investment Managers said Moody’s downgrade is unsurprising given concerns are well-recognised by the Chinese government and international agencies such as the IMF.
“From an aggregate standpoint, while debt is still being created in the economy, it is being created at a slower pace,” they reasoned. “Our calculation, using the Bank of International Settlements data – hence it is internationally comparable – suggests that total economy-wide debt has risen to 257 per cent of GDP by the end of 2016, but the pace of growth has slowed over the past year – even before the current deleveraging campaign started.
“Another measure of credit gap – also from the BIS – shows a similar picture, with the credit gap declining over the first three quarters of 2016.”
Given these slight improvements and the fact the government is actively seeking to mitigate financial risk, Yao and Veneau find the timing of Moody’s decision surprising, even if the decision itself appears logical.
“The combination of current actions – on financial deleveraging – and long-term hopes – on structural reforms – is supportive to our cautiously constructive view on China, and is perhaps the key reason why Moody’s has placed China on outlook stable after today’s rating cut,” they added.
Luc Froehlich, head of investment directing within Asian fixed income at Fidelity International, shared this sentiment and is confident that China’s central bank and its regulators are firmly in control. He pointed out that China’s recent regulatory tightening should help deflate credit markets and eventually lead to long-term market stabilisation.
“Following years of monetary loosening and fiscal stimulus, in February 2017, China seemed to reverse course. Since then, the People’s Bank of China has raised interest rates on multiple monetary policy tools – including open market operations and medium-term lending facilities – which is a de facto tightening of liquidity. Market rates such as the overnight SHIBOR have reacted,” he explained.
Source: DataStream, Fidelity International Limited
“It is this move that has led some international investors to start fretting about an imminent crisis; after all, the potential consequences of it include an imminent liquidity crisis for small lenders and/or slowdown in China’s medium-term growth.”
While Froehlich sees scope for the consolidation of lenders, he believes China’s central bank is in control. While the short-term reaction to regulatory tightening is for yields to rise, he argued that the intent is to deflate a highly-inflated credit market as opposed to “starving corporates”.
“While we do not see the risk of an immediate crisis unfolding, we do closely monitor what we consider to be leading indicators,” he said.
Potential risks he is looking out for include policy mistake, increased capital outflows and a loss of confidence by savers, as a run on the banks would weaken their position.
Will Ballard, head of emerging markets and Asia Pacific equities at Aviva Investors, said Moody’s downgrade should have been largely expected by investors. Now on par with Fitch’s credit rating, he said S&P will be next to make the same move.
“The first stage impact is that once the sovereign rating is downgraded, it is likely that most Chinese banks will have to be downgraded as well,” he argued. “A rising cost of funding for the banks, unless it can be passed on, results in falling net interest margins.
“That in turn to the average equity investor, means lower earnings for banks stocks. Considering international investors are already having misgivings about investing in Chinese banks, with ICBC’s H-shares trading on only 6x earnings, any fall in earnings is going to do nothing to help confidence.”
Ballard said it is also important to consider the reasons behind Moody’s downgrading of the debt. If it is correct and Chinese GDP growth slows, he warned that future earnings of Chinese companies could be lower than most investors expect.
“Is it all as bad as that? Well the first thing to say is that this downgrade isn’t unexpected,” he said. “In fact the Chinese are well aware of some of the concerns highlighted by Moody’s. Xi Jinping has already called for increased action from the government to control financial risks and improve co-ordination between the various regulatory authorities. Valuations are also already low.
“The HSCEI, which represents Chinese companies listed in Hong Kong, is one of the cheapest equity indices. It trades on only 8.5x expected earnings, compared to the broader MSCI Emerging Markets index on 13x. With that in mind, perhaps it’s no surprise that it was only off 0.06 per cent on this announcement.”
Craig Botham, emerging markets economist at Schroders, said the downgrade is simply a case of Moody’s “catching up with reality” and believes direct implications of the downgrade are limited.
“External debt in China is just 13 per cent of GDP, so reliance on foreign lenders is limited,” he explained. “We would also argue that markets had already priced in the risks arising from higher leverage and slower growth.
“However, the move may serve to reawaken markets to China risk, in a year in which many had assumed stability ahead of the party congress in the autumn. The economic impact then is small, but the sentiment impact could be large.
"Our own expectation is that the policy tightening already under way will weigh on parts of the economy later in the year. But will not be sufficient to bring growth below target – or to begin a deleveraging process. Property, and as a consequence commodities, are likely to feel the impact first.”