How Will Moody’s Downgrade Of China’s Sovereign Rating Impact Its Economy?

Moody’s Investors Service downgraded China’s sovereign rating to A1 from Aa3 today, with a stable outlook. The downgrade comes almost 15 months after Moody’s placed China on negative outlook on March 2, 2016.

Despite China posting better than expected GDP growth during the first quarter, Moody’s decision to downgrade stems from their expectation that China’s debt will continue to rise while potential growth slows, eroding the country’s credit metrics. Moody’s does not see the government’s reforms as fully offsetting the rise in economic and financial risk.

Moody’s downgrade to A1 puts its China’s rating on the same level as Fitch’s A+ rating. However, S&P has China one notch higher at AA- with a negative outlook since March 31, 2016. Another downgrade event by another credit rating agency is possible, says an ANZ research report.

From a macro perspective, downgrades by rating agencies could potentially erode the financial soundness of China, creating the risk of a negative feedback loop.

The downgrade will likely lift the cost of financing for Chinese issuers, especially in the offshore market. They will likely turn to onshore financing platforms, including banks, shadow banks and onshore bond markets as these channels pay less attention to rating actions of international agencies.

As the loan exposure of the domestic monetary system to local borrowers increases, the central bank will likely be more cautious in its policy tightening in the future, further extending the lingering debt concerns.

On the RMB-denominated bond market, there is perhaps only a marginal negative influence as the market is dominated by local investors who are not sensitive to international credit ratings. In addition, around 90% of the foreign holdings of China Government Bonds and Policy Bank Financial Bonds are held by central banks and sovereign wealth funds, which are long-term buy-and-hold investors.

However, bonds issued outside China, especially those issued in foreign currencies, will see a negative impact from the downgrade. Demand for the upcoming Hong Kong-Mainland bond connect scheme will be affected, as will efforts by the authorities to attract capital inflows.

On the foreign exchange front, the authorities have been setting the daily Yuan fixings stronger in an attempt to ward off outflow pressure. But the onshore spot rate has been consistently trading weaker than the fix, a sign that onshore dollar demand remains strong.

Today’s much stronger than expected fixing, 0.2% stronger than yesterday’s spot closing level, even though the dollar was up 0.2% against the basket currencies, is likely an attempt to contain the forex impact from the downgrade.

But while capital outflows have been contained during the first quarter this year, there has been a pick-up in April and ANZ expects to see onshore dollar demand rise. The authorities will have to revert to forex intervention if they want to bridge the gap between the spot and fix, as merely setting stronger fixings by itself is unlikely to have much effect.

The impact of today’s downgrade will also dent sentiment in the region as well. There could be some unwinding of the strong inflows that have driven the rally in Asian currencies. Korean and Taiwanese currencies are the most susceptible to any equity outflow pressures. India’s currency is also at risk of a positioning unwind.

China Expert network