One of the "big three" rating agencies took the sovereign credit rating of China down a notch. Wealth managers give their reactions.

For some time there has been nervousness among some wealth managers about how robust China’s economy and financial system is, particularly its resilience in the face of sharp deceleration in growth or some adverse shock. Yesterday, one of the “big three” credit rating agencies cut the credit ratings of the country. Moody’s Investors Services cut China’s sovereign credit rating by one notch to A1 from Aa3, with a stable outlook. Prior to this, China had been put on negative rating outlook since March 2016. Compared to other agencies, S&P has China on AA- with negative outlook, while Fitch assigns China A+ with stable outlook, same as Moody’s after today’s decision.

Here are some responses from wealth managers about the move:

Mark McFarland, chief economist for Asia, Union Bancaire Privée
This was widely expected and symbolizes growing acceptance that Beijing’s attempts to rein in rapid credit growth and contingent liabilities has only been partially successful. This month’s Ministry of Finance (MOF) Circular #50, which attempts to curtail the ability of local governments to increase bond-financed liabilities, comes two years after Beijing recognised that local government finances were much more impaired than had been previously recognized. National debt/GDP doubled to 38 per cent in 2014 when Beijing officially changed its accounts to recognise off-balance sheet financing by local governments. 

At the same time, the banking regulator and the Peoples’ Bank of China have been working to reduce the growth of off balance sheet liabilities in non-bank financial institutions much of which is known as shadow finance and is partly there to increase returns for depositors and partly to reduce the implied risk in loan books. It is important to remember that China has three characteristics which vastly reduce the risk of a sizeable default, despite credit / GDP of over 250 per cent. 

First, China’s large savings ratio (46 per cent) and closed capital account mean that there are abundant onshore resources to service debts and limited ability for capital flight. Second, China’s growth rate is sufficiently rapid to allow the overall debt level to plateau, providing that reforms accelerate from here. Three, the main financial institutions in China (e.g. ICBC and BOC) and State Owned Enterprises (SOEs) are public institutions with an implicit sovereign guarantee. Capitalists may not like the close links between the state, banking and industry but in this case it vastly reduces the probability of a systemic default.

Aidan Yao, Senior Emerging Asia Economist, Jim Veneau, head of Asia fixed income, and Honyu Fung, senior portfolio manager, at AXA Investment Managers.
Underpinning the rating action was Moody’s concern over China’s deteriorating leverage condition, and that the official reform program, as it currently stands, won’t be enough to completely arrest the build-up of debt. Concerning the sovereign rating, in particular, Moody’s expects China’s central government debt to rise to 40 per cent of GDP by end-2018, before reaching 45 per cent by 2020 (in line with the debt burden for the median of A-rate sovereigns at around 41 per cent).

Beyond public debt, the agency also expects continued debt accumulation by the private sector, particularly State Owned Enterprises but also households, partly because of the official desire to maintain a high growth target. With declining potential growth (slowing towards 5 per cent by end-decade), however, this will make the economy increasingly reliant on credit-charged stimulus. To break the debt curse, China needs to undertake more decisive steps towards structural reforms. However, the current programme, with its gradual pace, is deemed insufficient to do the trick. 

Luc Froehlich, head of investment directing, Asian fixed income, Fidelity International
Today’s [yesterday’s] downgrade is yet another sign of the challenges faced by China, which is juggling rising leverage issues, declining economic growth rates and ongoing structural reforms. Despite these mounting pressures, we are confident that China’s central bank and its regulators are firmly in control of the situation. In particular, China’s recent regulatory tightening should help deflate the country’s credit markets and lead to long-term market stabilization. 

Sean Taylor, chief investment officer, Asia-Pacific, Deutsche Asset Management
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. So far, market reaction this morning has been limited to IG financials (~1-2bps wider) and corps (3-5bps wider). The CNH space looks unaffected.

We stay cautious on any potential credit spread widening in the following sovereign-linked sectors. 

Financials: Big five banks, policy banks, insurance, AMCs, leasing companies. We stay cautious on Chinese financials in general, in view of the wider macro concern. Big five banks’ sub-debt (some could potentially move to HY). Commercial state-owned enterprises, especially those in the BBB/crossover category. Policy SOEs like Chinese oil majors should do better relatively.

We do not expect a huge selloff in the Chinese credit market and the Chinese space should continue to be supported by the robust domestic bid. However, this downgrade as well as the currently inverted CGB [Chinese government bond] curve in view of the ongoing deleveraging and tight liquidity, could remain a drag on the overall sentiment, therefore presenting potential buying opportunities upon any weakness.