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Downgrade will not burst China’s bubble, says analyst

Moves to downgrade China's credit rating do not indicate imminent trouble for the world's second-largest economy but instead point to the country's "worrisome" long-term direction of travel, global economic analysts have said.

Markets saw an initial sell-off in early Asian trading Wednesday after Moody's Investor Services downgraded China's credit rating one notch to A1 from Aa3, though losses were largely recovered by the close.

"I don't think one responds specifically to this news, I think it just confirms what we know, which is that there's an awful lot of debt in China," Chris Watling, chief executive of Longview Economics, told CNBC Wednesday.

"If you look at it rationally I think it's the biggest credit bubble I've seen in terms of build-up of debt relative to GDP in five, six, seven years that I've seen in my short 25-30 year career," Watling noted.

"It's the biggest one I can find relative to GDP of any major economy and it's a troubling situation. There's clearly way too much debt and at some stage it will become a real issue and I think the financial system is the place to focus."

Moody's said the move reflected its loss of conviction in the ability of the Chinese government to manage "economy-wide" debt levels while embarking on its ambitious reform agenda.

What to watch

China has typically managed this slowdown in economic growth – both realised and anticipated – by tapering its monetary policy in accordance. However, Watling warned that its ability to do so may be weakened as the U.S. Federal Reserve takes steps to further raise interest rates.

"The real question is when do they lose control of managing the interest rates and managing that nip and tuck? In my opinion, because of the managed exchange rate with the rest of the world, it's when the Fed policy starts getting properly tight that China really comes under pressure.

"That's the thing to watch and for me that's probably the trigger," Watling said.

The bigger picture

The Chinese government is in the midst of an ambitious reform agenda which it hopes will move the country away from its traditional dependence on manufacturing and towards a services-led economy.

However, with the focus on reigning in lending and maintaining and improving jobs, there is a risk of the government losing sight of another factor which could impede the country's potential for future growth – the environment.

"The real issue could yet prove to be a third factor in China – the inability of government to address the environmental damage caused by the last 30 years of rampant growth," Bill Blain, strategist at brokerage services firm Mint Partners, said in a research note Wednesday.

"The government's success in addressing smog, air quality, heavy metal pollution, water quality and desertification could prove far more a challenge that reining in lending while keeping the populace in check with jobs."

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