China’s Downgrade Reflects Its Fundamentals

This week, global ratings agency Moody’s downgraded China’s sovereign rating to A1 from Aa3, citing expectations of financial conditions eroding in coming years amid slower growth and rising debt. This move was largely anticipated by market participants and to a certain effect had little impact on onshore or global markets. “We expect other agencies to follow suit,” Paulina Argudin, a senior analyst with 4CAST-RGE, a financial analytics and research firm, co-wrote in a note to clients on May 24th.

Reflecting the expectation that China‘s financial strength will eventually erode, with economy-wide debt continuing to rise as potential growth slows, this was the agency’s first move on China since 1989. In changing the country outlook to stable from negative, Moody’s assess the risks are balanced.

“We’ve long highlighted the risk of a downgrade in China, as we’ve seen discrepancies between the ratings of the three main agencies (AA-) and our shadow credit rating (BBB+),” Rachel Ziemba, managing director of emerging market research at 4CAST-RGE and Argudin’s co-author said. “Economic and financial risks have risen and debt has built up, reaching 260 percent of GDP in Q3 2016. High-frequency data suggests these trends increased in 2017 before the recent deleveraging wave.”

The shadow rating held by 4CAST-RGE suggests fundamentals may be consistent with a BBB+ rating, “though we doubt China’s rating will get there quickly,” Ziemba wrote in the client note. “China has little external debt and sizeable government assets. Nonetheless, its policy-driven volatility and weakening quality of growth is concerning.”

The firm sees a risk of more downgrades ahead, most likely by SP Global, which currently maintains a negative outlook on the country. It is widely believed that China’s economy is slowing after an overheated and aggressive property and infrastructure boom in late 2016. A property market correction could be a catalyst for further downgrades. In more ways than one, Moody’s was just catching up to macro conditions that have been visible for some time.

After the announcement, Chinese stocks and the yuan (China’s official currency) slipped, but the moves were modest and had few global ripples. A lower rating is unlikely to have much effect on China’s ability to issue debt due to its large surplus, little government foreign exchange (FX) debt and sizeable government assets. However, a downgrade will likely pose further challenges in attracting bond inflows, a current government priority.

“We expect tighter financial conditions for state-owned enterprises, banks and private-sector issuers looking to attract foreign capital into the bond market.”