China downgrade not end of the miracle
Subdued market reaction indicates logic of Moody’s analysis, writes Joe Chidley.
Moody’s Investor Service downgraded China’s credit rating on Wednesday, and the investing world yawned. Is this a classic case of under-reaction?
Certainly, a downgrade of the creditworthiness of sovereign debt (technically, it applied to China’s local and foreign currency senior unsecured debt) doesn’t look good. And Moody’s put the blame squarely on a hot-button issue for China pessimists: the country’s mounting debt, built up by years of credit expansion.
In its release, the rating agency said it expects the Chinese government’s direct debt burden to hit 40 per cent of GDP in 2018 and 45 per cent by 2020. It noted that economywide debt — government, household and corporate — is currently coming in at more than 250 per cent of GDP, and looks set to rise. And it expressed some skepticism that the state’s efforts to clean up the financial sector and stem credit expansion would be enough to stop the bubble from getting even bigger.
The problem, as Moody’s apparently sees it, is that while the government talks a good reform game, it is still tied to boosting growth for “the maintenance of economic and social stability.” With the economy slowing for structural reasons — growth is still strong, at 6.9 per cent in the first quarter, but way down from the double-digits at the beginning of the decade — the burden will increasingly fall on government stimulus. That means more borrowing by the state and more lending to Chinese companies, counteracting efforts to eliminate bad debt and curb industrial overcapacity (the progeny of socalled zombie companies).
In short, China’s reforms, though laudable and perhaps effective over the long term, “will not fully offset the rise in economic and financial risk,” as Moody’s put it.
One measure of how serious this kind of downgrade can be is the level of response from the downgraded. In this, China did not hold back, its finance ministry issuing a statement to the effect that Moody’s didn’t know what the hell it was talking about.
And yet, markets yawned. The yuan took a hit against the U.S. dollar in early trading, but recovered by end of day. The Shanghai composite tumbled at first, but turned around to close higher. Global markets were pretty much flat.
It might be a simple case of inattention. With so much world focus on the goings-on in the United States over the past few months, China stories have fallen below the fold on the financial pages.
But there might be other, better reasons for the subdued market reaction. One is that the Moody’s analysis really didn’t contain any news — Chinawatchers have long noted the precariousness of Beijing ’s balancing act between growth and reform. As well, the rating agency had signalled a potential downgrade last year, when it maintained China’s Aa3 grade but changed its outlook to negative. Now, in giving China the new A1 rating — which is still firmly in the investment-grade universe — Moody’s has shifted its outlook to stable.
China is hardly an economic basket case — which Moody’s notes, too. Most of its sovereign debt is held domestically, limiting its exposure to currency and systemic risk. Its economy is huge, and still growing fast by global standards. The household savings rate is super-high, at around 40 per cent, meaning there’s plenty of liquidity out there. And let’s not forget — Moody’s doesn’t — that China still holds $US3 trillion in foreign reserves, even after spending a good chunk to prop up its currency and combat capital flight.
More to the point, if you believe that China’s economic transformation from investment-driven (unsustainable) growth to consumer-driven (sustainable) growth is real, then there are going to be some bumps along the way. And what looks like bad news now might be good news later.
For instance, Moody’s notes that China’s labour participation rate has fallen over the past few years, which detracts from GDP growth. Yet declining labour participation, a measure of the percentage of people aged 16 to 65 who have or are looking for a job, might actually be a sign of better times ahead. Younger Chinese are entering the workforce later, some observers note, because they are staying in school longer and earning advanced degrees.
In the end, then, the Moody’s downgrade hardly signals the demise of the China miracle. True, it can no longer boast of being in the ranks of other Aa3rated countries, like Belgium and Taiwan. Now it will have to make do rubbing shoulders with Japan and Saudi Arabia in the A1 club.
That ain’t exactly slumming it.