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Moody’s downgrades China rating to A1 from Aa3, citing concerns over a slowing economy and growing debt

  • Moody's downgraded China's rating to A1 from Aa3 and changed its outlook to stable from negative.
  • Moody's said China's economy-wide debt levels were expected to increase further in the years ahead, with reforms only likely to slow the growth rate.
  • It estimated the government debt burden would rise toward 40 percent of GDP by 2018.

Moody's Investors Service on Wednesday downgraded China's credit rating to A1 from Aa3, changing its outlook to stable from negative, citing concerns efforts to support growth will spur debt growth across the economy.

Marie Diron, senior vice president for Moody's soverign rating group, told CNBC's "Street Signs" on Wednesday that the catalyst for the downgrade was a combination of factors, including expectations that potential growth would fall to 5 percent by the end of the decade. It was Moody's first downgrade for the country since 1989, according to Reuters.

"Official growth targets are also moving down, but probably more slowly. So the economy is increasingly reliant on policy stimulus," she said, adding that was likely to spur increasing debt levels for the government.

"It's really the size of the leverage, the trends in leverage as well as the debt servicing capacities of the institutions that have that debt. When growth slows, then that points toward slower revenue growth, probably slower profitability and somewhat weaker debt servicing capacity," she added.

Unsurprisingly, China's finance ministry didn't agree with the move.

In a statement on its website, the ministry said the downgrade was based on an "inappropriate method" and that Moody's was overestimating the difficulties China's economy faced, while underestimating the government's efforts to tackle structural reforms and overcapacity.

Foreign-exchange markets reacted to the downgrade, with the Australian dollar dropping from levels around $0.7480 to as low as $0.7452 in the wake of the announcement. China is among Australia's largest export markets.

But China's yuan didn't react much, with the dollar fetching 6.8940 yuan at 9:38 a.m. HK/SIN, compared with Tuesday's close of 6.8890 yuan.

"Moody's expects that economy-wide leverage will increase further over the coming years. The planned reform program is likely to slow, but not prevent, the rise in leverage," Moody's said in a statement. "The importance the authorities attach to maintaining robust growth will result in sustained policy stimulus, given the growing structural impediments to achieving current growth targets. Such stimulus will contribute to rising debt across the economy as a whole."

It expected that while economic growth would remain relatively high, potential growth rates were likely to fall in the years ahead.

Moody's estimated that while the government budget deficit in 2016 was "moderate" at around 3 percent of gross domestic product (GDP), it expected the government's debt burden would rise toward 40 percent of GDP by 2018 and 45 percent by the end of the decade.

It also expected contingent and indirect liabilities would rise, pointing to policy bank loans, bonds issued by Local Government Financing Vehicles (LGFV) and other state-owned enterprises' (SOE) investments.

Moody's added that it expected economy-wide debt of the government, households and non-financial companies would rise, as economic activity tends to be financed with debt in the absence of a sizeable equity market.

It said that the recent focus on capital outflows has constrained the development of domestic capital markets by restricting the cross-border flows of capital.

It noted that the financial sector remained under-developed despite recent reforms.

"Pricing of risk remains incomplete, with the cost of debt still partly determined by assumptions of government support to public sector or other entities perceived to be strategic," it said.

But Moody's shifted to a stable outlook, from negative, citing balanced risks.

The government's control of much of the economy, the financial system and cross-border capital flows offers the ability to maintain stability in the near term, Moody's said.

It also pointed to large household savings estimated at around 40 percent of income and the country's "sizeable" foreign exchange reserves of around $3 trillion.

Analysts differed on the importance of Moody's move.

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Macquarie noted this was the first time a ratings agency downgraded China in 25 years and the first time in seven years that one of the Big Three agencies have changed their rating. It said the move brought Moody's rating in line with Fitch.

"This news is a clear China negative in our view (even though the rationale for the downgrade contained nothing new)," Macquarie said in a note on Wednesday.

"The next question is whether S&P will follow Moody's. S&P has had China on outlook negative since February 2016, indicating there is a potential downgrade brewing. But S&P currently rates China one notch above Moody's and Fitch, so a cut would not break new ground."

ANZ saw the potential for the downgrade itself to spur on China risks.

"Downgrade(s) by rating agencies could potentially erode the financial soundness of China, creating the risk of a negative feedback loop," analysts at ANZ said in a note on Wednesday. "The downgrade will likely lift the cost of financing of Chinese issuers, especially in the offshore market."

That will likely spur those borrowers to onshore platforms, which would increase the domestic monetary system's loan exposure to local companies, making the central bank more cautious of tightening policy and extending debt concerns, ANZ said.

ANZ also expected the downgrade could dampen offshore interest for China's "bond connect" plan to further open up its bond market to foreign investors.

But one analyst noted that the downgrade wasn't necessarily a surprise.

"I don't think it's going to be earth-shattering or shift investors' sentiment toward China," Song Seng Wun, an economist at CIMB private banking told CNBC.

"Everyone on the planet has flagged the risk of Chinese debt and the risk that is associated with the current policymakers' strategy and attempt to deleverage."

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