Moody's Serves Warning to China

By Mark Magnier Features Dow Jones Newswires

China's first downgrade by Moody's Investors Service since 1989 was a direct warning to Beijing that its growth model isn't working and an illustration of the disconnect between the view inside and outside China of its economic management.

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While China acknowledges it has built up significant debt and excess production capacity, it has projected confidence in its ability to contain those risks. Moody's move Wednesday was a reminder that some outside analysts see great danger in Beijing's buildup of debt for the sake of growth.

China quickly struck back: Beijing's top planning agency said Wednesday that China's debt risk is controllable, adding that with structural reform under way and higher recent profit margins, companies will be in a stronger position to repay what they owe. The Finance Ministry called the methodology behind the downgrade "inappropriate" and said that Moody's overestimates China's economic difficulties.

The repercussions of the downgrade are likely to be muted given that an overwhelming portion of China's debt is held domestically. China continues to have a high savings rate, largely closed capital account and close links among ministries, banks and companies. That makes it less vulnerable to the outside world's assessment of its credit risks and limits the impact of Wednesday's downgrade on global capital markets.

The downgrade news triggered an early selloff in Chinese stocks on Wednesday, with shares in Shanghai falling more than 1% before recovering and largely shrugging off the move.

David Rubenstein, co-founder and co-CEO of Carlyle Group, in an interview in Beijing on Wednesday said Carlyle, which has invested $1 billion a year in China on average over the past four years, is increasing its investment. "The U.S. was downgraded a few years ago as well, and that hasn't stopped us from investing in the U.S.," he said.

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Mr. Rubenstein called China "the second-greatest place to invest" after the U.S., pointing to the size of the Chinese economy, its population growth and rising entrepreneurship.

China's foreign debt at $1.42 trillion is tipped to rise this year but remains, at 13% of GDP, among the lowest globally. Yet the International Monetary Fund, World Bank and Bank for International Settlements, among others, have long expressed concern about China's surging debt levels.

In March 2016, S&P followed Moody's lead in downgrading China's financial outlook. S&P declined to comment Wednesday on whether it would review its China rating.

China's tendency to insulate itself from market forces is reflected in the assessments by its major state-owned ratings firms, which tend to be more sanguine than their international counterparts. One of the biggest agencies -- China Chengxin International Credit Rating Co., in which Moody's has 30% -- said Wednesday it is sticking to its AAg+ sovereign rating for China.

Moody's downgrade, to A1 from Aa3, puts China on par with Japan. It is a symbolic moment, after China overtook Japan in the past decade as the world's second-largest economy. Problems in the Chinese economy that Moody's cited for its downgrade -- slowing growth, worsening debt and an aging workforce -- echo those Japan faced by the early 1990s.

The downgrade reflects an assessment that China's ability to service its surging debt burden is being eroded, said Moody's sovereign-debt analyst Marie Diron.

Beijing disputes that view. In recent weeks, senior Chinese officials have played down concerns over mounting debt levels. Nonetheless, Beijing has unleashed a flurry of moves and regulations this year to slow the pace of borrowing, including an increase in short-term interest rates and restrictions on speculative property markets. Moody's cited such moves as positives.

But market gyrations in reaction to those moves have underlined Beijing's bind: Moving too rapidly to deleverage could create its own instability. "We're hoping now to avoid risks that have resulted from the regulations to resolve risk," said Xiao Yuanqi, a bank regulator, earlier this month.

This follows hard-won lessons on the power of markets in mid-2015 after a stock meltdown prompted a heavy-handed response by Beijing to prop up the market. A few months later, global currency markets were roiled by a surprise devaluation of the yuan.

What China isn't tackling is a problematic growth model at the root of its mounting debt load.

Beijing's massive spending spree after the global financial crisis righted the economic ship and helped prevent worse global fallout. But its continued reliance on stimulus to prop up growth and meet its annual targets has seen China's total debt rise to 255.6% of GDP by the third quarter of 2016, up from 141.3% at the end of 2008, according to BIS. That has put China's ratio on par with the U.S. in the same quarter, at 256%, according to BIS.

China's politically driven growth targets can create problems in their own right, as they encourage officials to spend and boost debt to hit their numbers. In 2014, Beijing started citing a "new normal" of slower, better-quality growth, but such talk has subsided, giving way to a new emphasis on growth and stability in advance of a once-in-five-years Communist Party Congress this fall.

The largest share of China's debt, at around 164% of GDP, is held by companies, built up over years of loose monetary policy and aggressive fiscal spending. That has fueled excess production capacity in industries from steel to glass and increased the number of "zombie" companies unable to meet their interest payments.

Moody's on Wednesday also downgraded the ratings of 26 state-owned companies. Ms. Diron said the agency expects state and local government debt to reach 45% of GDP by the end of 2020, up from 37.6% at year-end 2016, though the government is unlikely to face trouble servicing its debt given that state interest payments make up just 6% of government revenue.

China's economy grew 6.7% year on year in 2016, its slowest pace in a quarter-century. Stimulus and a strong property sector saw first-quarter growth increase to 6.9%, although output is expected to slow for the remainder of this year and into 2018 as these two engines lose steam.

Household debt remains relatively low in China at around 43% of the economy, roughly half of U.S. levels, but that is up from around 27% in 2011 as consumers borrow more to finance property.

After Moody's downgraded China's financial outlook in March 2016, Vice Finance Minister Zhu Guangyao said the firm lacked a long-term view and that "reality will prove it wrong." Mr. Zhu said Western credit-rating firms have monopolized the market for too long and their credibility has been tarnished by criticism of their practices leading up to the global financial crisis.

--Lingling Wei, Liyan Qi and Grace Zhu contributed to this article.

Write to Mark Magnier at mark.magnier@wsj.com

(END) Dow Jones Newswires

May 24, 2017 12:11 ET (16:11 GMT)