Moody's Investors Service has downgraded China's long-term local currency and foreign currency issuer ratings to A1 from Aa3 and changed the outlook to stable from negative.
The downgrade reflects Moody's expectation that China's financial strength will erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows.
While ongoing progress on reforms is likely to transform the economy and financial system over time, it is not likely to prevent a further material rise in economy-wide debt, and the consequent increase in contingent liabilities for the government.
The stable outlook reflects Moody’s assessment that, at the A1 rating level, risks are balanced. The erosion in China's credit profile will be gradual and, Moody’s expects, eventually contained as reforms deepen.
The strengths of China’s credit profile will allow the sovereign to remain resilient to negative shocks, with GDP growth likely to stay strong compared to other sovereigns, still considerable scope for policy to adapt to support the economy, and a largely closed capital account.
China's local currency and foreign currency senior unsecured debt ratings are downgraded to A1 from Aa3. The senior unsecured foreign currency shelf rating is also downgraded to (P)A1 from (P)Aa3.
China's local currency bond and deposit ceilings remain at Aa3. The foreign currency bond ceiling remains at Aa3. The foreign currency deposit ceiling is lowered to A1 from Aa3. China's short-term foreign currency bond and bank deposit ceilings remain Prime-1 (P-1).
Rising debt will erode China’s credit metrics
While China's GDP will remain very large, and growth will remain high compared to other sovereigns, potential growth is likely to fall in the coming years. The importance the Chinese authorities attach to growth suggests that the corresponding fall in official growth targets is likely to be more gradual, rendering the economy increasingly reliant on policy stimulus.
At least over the near term, with monetary policy limited by the risk of fueling renewed capital outflows, the burden of supporting growth will fall largely on fiscal policy, with spending by government and government-related entities -- including policy banks and state-owned enterprises (SOEs) -- rising.
GDP growth has decelerated in recent years from a peak of 10.6% in 2010 to 6.7% in 2016. This slowdown largely reflects a structural adjustment that we expect to continue.
Looking ahead, Moody’s expect China's growth potential to decline to close to 5% over the next five years, for three reasons.
First, capital stock formation will slow as investment accounts for a diminishing share of total expenditure. Second, the fall in the working age population that started in 2014 will accelerate. Third, Moody’s does not expect a reversal in the productivity slowdown that has taken place in the last few years, despite additional investment and higher skills.
Official GDP growth targets have also adjusted downwards gradually and the authorities' emphasis is progressively shifting towards the quality rather than the quantity of growth.
The stable outlook reflects our assessment that, at the A1 rating level, risks are balanced.
China's credit profile incorporates a number of important strengths, most notably its very large and still fast-growing economy. The government's control of parts of the economy and financial system and cross-border financial flows provides policy and financial scope to maintain economic, financial and social stability in the near term.
In particular, China's largely closed capital account significantly reduces the risks that financial instability could arise as it attempts to reduce leverage when the economy has been reliant on new debt.
Large household savings at around 40% of incomes, according to the IMF and OECD, reinvested within China, provide ample financing for new debt. As long as liquidity can be quickly funneled to where it is needed, financial stability risks will remain low.
In addition, China's sizable foreign exchange reserves of around $3 trillion give the central bank abundant financial power to preserve the stability of the currency and thereby avoid financially destabilizing scenarios of capital flight.
The stable outlook denotes broadly balanced upside and downside risks. Evidence that structural reforms are effectively stemming the rise in leverage without an increase in risks in the banking and shadow banking sectors could be positive for China's credit profile and rating.
Conversely, negative rating pressures could stem from leverage continuing to rise faster than Moody’s currently expects and continuing to involve significant misallocation of capital that weighs on growth in the medium term. In particular, in this scenario, the risk of financial tensions and contagion from specific credit events could rise, potentially to levels no longer consistent with an A1 rating.
“Today’s downgrade is yet another sign of the challenges faced by China, which is juggling rising leverage issues, declining economic growth rates and ongoing structural reforms,” comments Luc Froehlich, Head of Investment Directing, Asian Fixed Income, Fidelity International.
“Despite these mounting pressures, we are confident that China’s central bank and its regulators are firmly in control of the situation. In particular, China’s recent regulatory tightening should help deflate the country’s credit markets and lead to long-term market stabilization.”