Moody’s Downgrades China, Warns of Fading Financial Strength

The downgrade comes as the Chinese government grapples with challenges of slowing growth soaring from rising debt.

Moody's Investors Services downgraded China's long-term local and foreign currency issuer ratings on Wednesday, for the first time since 1989.

The downgrade to an A1 rating from Aa3 comes as the Chinese government grapples with challenges of slowing economic growth and rising financial risks stemming from soaring debt.

The ratings agency also changed its outlook for China to stable from negative.

The downgrade reflects Moody’s expectation that China’s financial strength will erode somewhat over the coming years, with economy-wide debt rising as potential growth slows. While ongoing progress on reforms is likely to transform the economy and financial system over time, it is not likely to prevent a further material rise in economy-wide debt, and the consequent increase in contingent liabilities for the government.

Moody’s Investors Services

China's top leadership has identified containment of financial risks and asset bubbles as a top priority this year. All the same, authorities have moved cautiously to avoid knocking economic growth, gingerly raising short-term interest rates.

While the downgrade is likely to modestly increase the cost of borrowing for the Chinese government and its state-owned enterprises, it remains comfortably within the investment grade rating range.

China's Shanghai Composite index fell more than 1 percent in early trade, while the yuan currency in the offshore market briefly dipped nearly 0.1 percent against the U.S. dollar after the ratings agency announced its decision. The Australian dollar, often seen as a liquid proxy for China risk, also slipped.

It’s quite clear that it’s going to be quite negative in terms of sentiment, particularly at a time when China is looking to de-risk the banking system and potentially restructure SOEs.

Vishnu Varathan, Asia head of economics and strategy, Mizuho Bank’s Treasury division.

Growth to Slow

In March 2016, Moody's had cut its outlook on China's credit ratings to negative from stable, citing rising debt and uncertainty about the authorities' ability to carry out reforms and address economic imbalances.

Moody's said its now stable outlook reflected the assessment that risks were balanced.

Rival ratings agency, Standard & Poor's, had also downgraded its outlook to negative in the same month. S&P's AA- rating is one notch above both Moody's and Fitch Ratings' A+ rating.

China's potential gross domestic product growth was likely to slow towards 5 percent in the coming years, but the slowdown is likely to be gradual due to expected fiscal stimulus, it said.

Authorities have stepped up efforts over the last several months to curb debt and housing risks, and a raft of recent data has signalled a cooling in the economy, which grew a solid 6.9 percent in the first quarter.

Government-led stimulus has been a major driver of economic growth over recent years, but the pump-priming has also been accompanied by runaway credit growth and has created a mountain of debt – now standing at nearly 300 percent of GDP.

Moody's said it expects the government's direct debt burden to rise gradually towards 40 percent of GDP by 2018 “and closer to 45 percent by the end of the decade.” Economy-wide debt of the government, households, and non-financial corporates would also continue to rise, it said.

(This article has been published in arrangement with Reuters.)