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Moody’s Investors Service cut China’s long-term local and foreign currency debt ratings by one notch to A1 from Aa3 yesterday (24 May 2017) and changed the outlook to stable from negative.

Moody’s cited the likelihood of a “material rise” in economy-wide debt and the burden that will place on the country’s finances.

The impact of the downgrade on China’s debt market has been muted for the simple fact that China’s debt is mostly funded by domestic savings and, thus, is more stable than most analysts have realised. China’s foreign debt is equivalent to around 12% of GDP, while FX reserves are close to 30% of GDP.

The downgrade still leaves China’s rating comfortably within the investment grade bracket in Moody’s rating framework and is on par with the rating of Japan, which has a much larger debt burden.

There is nothing particularly new in Moody’s downgrade decision, as the problems it cited have been known to the markets for a long time.

In my view, it is likely that, like most of other analyses of China’s debt risk, the Moody’s analysis has confused China’s private-sector obligations with public-sector debt.

In China, a large share of company borrowing that is often counted as private sector debt is actually lending to China’s State-owned enterprises (SOEs) and their affiliates that enjoy implicit guarantees.  These are not really private debt entities.  The distinction is crucial when it comes to assessing the risk of systemic defaults.  These are far less likely when the bulk of the debt is owed by the public sector that has a strong balance sheet, as is the case in China.

Arguably, the downgrade lacks foresight as the Chinese authorities are well aware of the debt problem and have started tackling it through practical means.  They started a debt-swap programme in 2015 to pare the debt burden of the local government financing vehicles, implemented a debt-equity scheme to deal with non-performing bank loans and set up provincial asset management companies to absorb regional bank loan losses*. Despite the stock market’s volatility, authorities have also encouraged equity financing to channel domestic savings into the economy to reduce its reliance on debt for growth.

The downgrade nevertheless serves as an international warning on the “China risk” at a time when Beijing is opening its onshore bond market to foreign investors and striving to have A-shares included in the MSCI and other international market indices.  It sheds new doubt on the gradualist approach that Beijing is taking to address the debt problem and its ability to simultaneously cut debt in the financial system and keep GDP growth steady at 6.5% a year.

It is likely that the immediate effect of the downgrade may be felt by the China-Hong Kong Bond Connect scheme, which is expected (not confirmed) to be launched in July this year in celebration of the 20th anniversary of Hong Kong’s reversion to China.  At a lower credit rating, it may be more expensive for the authorities to get the scheme off the ground or risk a launching delay.

Written on 24 May 2017

*China’s debt-equity swap scheme only serves as a stop-gap measure to deleverage under the constraint of protecting GDP growth and it does not address the incentive problems in the system.  See “Chi Time: China’s Debt-Equity Swap and Incentive Problems

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