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25 May 2017, Gateway House

Moody’s China verdict

This is the first time in 30 years that Moody’s has made a change in China’s rating. Coming close on the heels of the high-profile Belt and Road Forum, this was an embarrassment that was avoidable

former Adjunct Senior Fellow, Geoeconomics Studies

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Moody’s downgraded China’s sovereign credit rating from Aa3 to A1 and upgraded its outlook for the rating to ‘stable’ from ‘negative’. That is, it does not expect to downgrade China again anytime soon.

As soon as it happened, many dismissed it: the Chinese government does not borrow in foreign currency, and hence, a credit rating action by an international agency does not really matter. Well, not so fast. Even the Indian sovereign does not borrow in foreign currency. Yet, its credit rating is just above junk bond rating and is often cited in many commentaries on India’s fiscal health. So, let us not be too nonchalant about it, on behalf of China. Certainly, the Chinese government won’t be.

The fact is that this is the first change in nearly 30 years in China’s rating by Moody’s. It does make people sit up and take notice. Second, China has just come away from the Belt and Road Forum where it assembled many foreign leaders–it was much like an emperor’s durbar, with the little chieftains in attendance. Hence, to have this happen within a week of that jamboree is avoidable embarrassment.

For China, ‘face’ matters much, and hence, a foreign credit rating agency from a country that is, in its view, fast losing pre-eminence is a reminder that the world order has not changed yet. That is annoying.

For India, this is schadenfreude, because it had raised questions about the debt burden that OBOR will create for the countries involved. Moody’s downgrade offers vindication in a way.

Second, Arvind Subramanian, Chief Economic Advisor to the government of India, had been fiercely critical of the credit rating agencies for their lopsided credit rating of India and, say, China. He called the chasm between the sovereign credit ratings of both countries indefensible. India was baerly above junk bond rating and China’s credit rating was Aa3. He might be mollified although he was batting for an upgrade for India, and not so much a downgrade for China.

As for China’s economic fundamentals, they had justified more than a one-notch downgrade a long time ago. In its Article IV report last year, the International Monetary Fund had pointed out that China’s ‘augmented fiscal deficit’ was slightly above 10% of GDP in 2016 (p.43). Its public debt ratio too is, correspondingly, much larger and rising. Even so, no one has the faintest idea how much debt China’s local governments have taken on and how much of it will devolve on Beijing.

Further, China’s banks are swimming in a sea of bad debts to local government funding vehicles, to State-owned enterprises and, further, on their part, have sold these debts as Wealth Management Products to their private clients, looking for a higher yield with no risk. Their official non-performing asset ratio is less than 2%. But, private estimates range from 5% to 25%. Fitchratings, another credit rating agency, puts it at 15%. Therefore, objective fundamentals warranted a lower credit rating for China.

A colleague had a legitimate question: why did this downgrade not come earlier, when China’s fundamentals were dodgy, like at the beginning of, or in August 2016? The answer is simple. The credit rating agencies did not want to pour oil into the fire and turn China’s turbulence into a self-fulfilling rout. This is better done when times are quieter.

Second, the scale of the estimates being touted for the OBOR initiative might have influenced Moody’s. It is our guess. The number is variously estimated at $900 billion to $1.0 trillion. Hence, this downgrade comes as a pre-emptive warning.

The downgrade, while being meaningfully negative for those borrowers that rely on the sovereign rating to price their own debt, may also make the Chinese government think a bit harder about the next round of debt-funded reflation once it gets bored or frightened of the current round of de-leveraging that it is supposedly pursuing.

In all, Moody’s downgrade of China’s sovereign debt might not be a surprise but its timing was unexpected. If anything, the surprise is that it took so long for them to act. And the question is: why only one notch down?

This article in the Wall Street Journal comparing China and Japan is a good read. Moody’s rates both countries alike now.

Dr. V. Anantha-Nageswaran is Adjunct Senior Fellow, Geoeconomics Studies, at Gateway House.

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