Moody’s one-notch downgrade of China’s long-term credit rating last week came as something of a shock to the market, although it didn’t take a crystal ball to see it coming.
Slower growth combined with soaring - and what appears in China’s case to be unsustainable - debt, will generally earn your average sovereign issuer a thumbs down from the big three Western credit rating agencies.
“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,” said Moody’s in a statement explaining the rating action, which took China’s long-term local and foreign currency ratings from Aa3 to A1.
There was a somewhat predictable sense of outrage from the Chinese authorities, with the country’s finance ministry suggesting that China’s first downgrade since 1989 was based on “inappropriate methodology”.
WELL YES, THEY would say that wouldn’t they? It may be that a lot of sovereign ratings action is quintessentially political - one recalls Dagong cutting the US’s rating to Single A as early as 2010 - but on this one I reckon the call is absolutely justified.
It’s difficult to look at China’s economy, the cosy relationship of its banks with the state and the authorities’ willingness to provide monetary stimulus, and fail to see the situation as one big kick of the can up the hill.
The authorities counter this perception by vociferously insisting there is a massive supply-side restructuring going on in the country, which will shift the basic economic model from reliance on exports to one driven by domestic demand.
I’m sure over time that process will yield the structural change which the economy so desperately requires. But the problem is that the country retains a died-in-the-wool short-termism, based on targets and the need to meet them.
Moody’s ratings report points out the reliance on stimulus measures to achieve those targets, and the underpinning of that mechanism on the build-up of debt.
China’s debt is now estimated to be nearly 300% of GDP, and it’s now assumed by a plethora of economists that the central government will end up owning around 40%-45% of debt issued by state-owned enterprises by 2020, from around 35% currently.
The state-owned banks seem to have had a reasonable time of it, with the biggest three reporting modest profit, solid net interest margins and reasonably contained non-performing loans.
Still, many analysts caution that a surge in bad debt is inevitable and that conventional means of restructuring, such as debt-for equity swaps, may be insufficient to address the problem.
I WOULD SUGGEST a bad debt bank along the lines of the model Sweden adopted at the height of its banking crisis in 1992 needs to be put in place in China, to help clean up banks’ balance sheets. But then again, upon reflection, is it really necessary?
China is a unique beast in that it engages with the global economy via a closed capital account and is able to control the flow of cash in its banking system any time it wants. And it can do so with impunity, apart from having to endure a brief walk of shame thanks to the foreign credit rating agencies.
That’s a reasonable price to pay for having access to the offshore capital markets. And in the midst of the Moody’s downgrade, the only thought that should cross the mind of a holder of Chinese offshore debt is just how defaulting companies will treat their bondholders in the event of debt restructuring.
Spreads on Chinese offshore bonds were reasonably steady in the aftermath of the ratings action, and it would seem that with the country’s credit rating comfortably in the investment-grade universe, investors will not have to worry about a ratings collapse for China. The outlook on the new Moody’s rating is stable - a reason to be cheerful.
No, the thing to worry about is whether the approach taken by Asia Aluminum eight years ago - when offshore bondholders received 19 cents on the dollar and PIK noteholders less than one cent - is a precedent which might be repeated en masse by Chinese issuers of offshore debt.
I suspect that there is indeed an inherent risk that the capital structure will not be honoured in the event of mass restructuring of offshore corporate debt issued by Chinese entities. But it will be granular and perhaps hard to predict for individual credits. The SOEs have more “face” to protect and in the event of strained debt service will be propped up by the central government.
Whether or not there are further downgrades to come, last week’s action felt like a non-event.
That’s what happens when you’re dealing with a vast planned economy that marches to its own drumbeat. Something truly systemically, catastrophically dreadful would have to happen to China’s economy for a ratings downgrade to really challenge that anodyne feeling.
