The market may have long since moved on from Moody’s downgrade of China to A1 from Aa3 (by now even long-only funds have learned that in a world with $18 trillion in excess liquidity, the opinion of Moodys is even more irrelevant), but for Beijing the vendetta is only just starting, and in response to Tuesday’s downgrade, China’s finance ministry accused the rating agency of applying “inappropriate methodology” in downgrading China’s credit rating, saying the firm had overestimated the difficulties faced by the Chinese economy and underestimated the country’s ability to enhance supply-side reforms.
In other words, Moody’s failed to understand that 300% debt/GDP is perfectly normal and that China has a very explicit exit strategy of how to deal with this unprecedented debt load which in every previous occasion in history has led to sovereign default.
The Ministry of Finance reaction came after Moody’s first, and very, very long overdue, downgrade of China since 1989 citing concerns about risks from China’s relentlessly growing debt load as shown below.
“China’s economy started off well this year, which shows that the reforms are working,” the ministry said in a statement on its website. Actually, it only shows that China had injected a record amount of loans into the economy at the start of the year, and nothing else. And now that the credit impulse is fading, the hangover has arrived.
Moody’s on Wednesday also downgraded the ratings of 26 Chinese government-related non-financial corporate and infrastructure issuers and rated subsidiaries by one notch. It also downgraded the ratings of several domestic banks, including the Agricultural Bank of China Limited’s long-term deposit rating from A1 to A2. It also eventually downgraded Hong Kong and said credit trends in China will continue to have a significant impact on Hong Kong’s credit profile due to close economic, financial and political ties with the mainland.
So how did China defend its position? The same way US companies fabricate their own numbers to confuse shareholders: with “pro forma” arguments.
For example Moody’s noted that the importance Chinese authorities have attached to maintaining robust growth would result in sustained policy stimulus, and such government spending would contribute to rising debt across the economy. “We expect the government’s direct debt burden to rise gradually toward 40 percent of GDP by 2018 and closer to 45 percent by the end of the decade,” Moody’s noted.
To this, the MOF responded that government bonds reached 27.33 trillion yuan ($3.97 trillion) at the end of 2016, or about 37% of the country’s GDP. The proportion is much lower than the 60% picket line delimited by the EU, the ministry said. Liu Xuezhi, a senior analyst at the Bank of Communications, said that the proportion of government bonds to GDP has been continuously dropping since peaking in 2013, largely due to the government efforts to manage debt.
“I think Moody’s reasons are debatable,” he said.
Of course, what the MOF forgot to mention is the roughly 200% in corporate debt issued in large part by entities that are State-owned enterprises, and which the government for mostly refuses to go bankrupt over fears of mass riots, civil disobedience and even war. As a result virtually all of China’s corporate debt is effectively sovereign.
That did not prevent China from spinning more propaganda.
Zheng Xinye, associate dean of the School of Economics at the Renmin University of China, also told the Global Times on Wednesday that the government has taken effective measures, such as bond swaps and perfecting the issuance and management system of local government debt, to rein in bond risks. Liu added that China’s fiscal revenue has been rising since 2009. “Besides, the Chinese government has income channels which other countries don’t, such as land transfer money and State assets. Therefore, I don’t think China would be facing serious financial pressure, at least not in the next few years,” he told the Global Times on Wednesday.
Zheng also said that the government wouldn’t need to use fiscal measures to stimulate growth, as the effects of supply-side reforms would sustain the economy’s momentum. He may have even said it with a straight face.
Additionally, China took offense at Moody’s forecast that China’s growth will slow to 5% in five years, because of a smaller working-age population and continuing production slowdown.
To this, Liu said the chances are very slim for China’s economy to slip to 5 percent in the next five years. “I believe China’s GDP growth will remain above 6.5 percent at the end of 2020, as China has abundant room for policy adjustments to support economic growth,” Liu said. It has even more abundant room to goalseek its data to whatever it wants, however, without the benefit of “creating” 40% of GDP in the form of new credit, China’s economy will implode.
Zheng disagreed, and said the economy has not shown any signs of sliding.
One place where China’s apparatchiks were right is that Moody’s downgrade would hurt overseas investor confidence in the Chinese market or collaborations with domestic companies.
“It would also make it more difficult for domestic companies to seek financing in overseas markets,” Liu noted. But Liu said domestic financial markets would not be affected as much, because they’re not entirely open. And for a good, if scary, explanation of what happens as China’s debt issuance shift domestically, read this morning Bloomberg piece “China’s Downgrade Could Lead to a Mountain of Debt.”