Moody's cuts China outlook to 'negative', cites reform and fiscal risks

The ratings agency felt that China's fiscal strength will continue to decline and forex reserves will also see a fall

Moody's downgraded its outlook on Chinese government debt to "negative" from "stable" on Wednesday, citing uncertainty over authorities' capacity to implement economic reforms, rising government debt and falling reserves.

"Without credible and efficient reforms, China's GDP growth would slow more markedly as a high debt burden dampens business investment and demographics turn increasingly unfavourable. Government debt would increase more sharply than we currently expect," Moody's said in a note on Wednesday.

Moody's said its rating committee had discussed China's status at a meeting on Feb. 9, during which the country's institutional and fiscal strength, as well as its susceptibility to event risks, were reviewed.

The agency said the downgrade was driven by expectations that China's fiscal strength will continue to decline, and the fall in its foreign exchange reserves which have shrunk by $762 billion over the last 18 months.

It also said that policymakers' credibility was at risk of being undermined by incomplete implementation or partial reversals of some reforms.

"Interventions in the equity and foreign exchange markets over the past year suggest that ensuring financial and economic stability is also an objective, but there is considerably uncertainty about policy priorities," Moody's said.

Moody's, however, retained China's Aa3 rating, noting the country's sizeable reserves gave it time to implement reforms and gradually address economic imbalances.

But the agency warned that it could further downgrade China's rating if it saw slowing down of reforms needed to support sustainable growth and to protect the government's balance sheet.

"It's not a worrying sign yet, but rather a negative direction. That's what Moody's is flagging," said Trinh Nguyen, senior economist for emerging Asia at global asset manager Nataxis.

"But they have room to do this. They have one of the lowest government debt as a share of GDP in comparison to other emerging nations. And most importantly, as China has a current account surplus it can fund its own fiscal expansion."

High and rising corporate debt

A major rationale for the falling outlook, Moody's said, was the large stock of contingent sovereign liabilities such as state-owned corporations' debt, local government debt, 

and the debt of China's big "policy" banks - the Agricultural Development Bank of China, China Development Bank, and the Export-Import Bank of China.

While Moody's put actual government debt at only 40.6% of GDP at the end of 2015, Standard & Poor's estimated in July that corporate debt had already risen to 160% of GDP in 2014, twice that of the United States and up from only 120% in 2013. 

High and rising levels of debt at state-owned enterprises raised the risk of either a sharp slowdown in economic growth, as debt servicing curbed other spending, or a marked deterioration of bank asset quality, Moody's said.

"There has been a lot of poor credit allocation, with too much credit directed at inefficient state firms and not enough going towards smaller efficient firms."

"Ideally, we'd like to see a bigger overhaul of the state sector including a lot more privatisation," said Julian Evans-Pritchard, China Economist at Capital Economics in Singapore.

The cost of insuring Chinese government debt against default was slightly higher. Five-year credit default swaps (CDS) on Chinese sovereign debt were trading at 133.5 to 135.5 in early morning trade, up 1 basis point and underperforming the broader CDS market. The benchmark iTraxx index was 2.5bps lower at 152-154 bps.