Last month, Moody’s downgraded China’s credit rating from AA3 to A1 for the first time since 1989. Investors have long feared the world’s second largest economy is heading toward a “hard landing,” so the downgrade does not come as a surprise. However, Moody’s cautionary outlook once again puts the spotlight on Beijing’s difficulties, which officials in there argue are a natural by-product of rebalancing of its economy.
In its statement, the ratings agency cited a weaker growth outlook and mounting debt pressure as the most urgent issues for the Chinese economy. Here, we’ll examine the numbers behind those concerns and the prospect of a turnaround.
For more, see our previous post: How to Measure and Manage Your True Exposure to the Slowdown of China.
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Slow GDP Growth Leads to a Slow Re-Balancing Act
China’s Q1 GDP growth reached 6.9%, the highest growth rate in two years and marginally higher than expectations. While the economy grew in Q1 (which can also be seen in China’s alternative measure of growth, the Li Keqiang Index), Q2 expectations suggest that GDP will grow by only 6.7% and that 2017 annual growth will decrease to 6.5%. After a period of rapid growth and an ongoing rebalancing of its economy from an investment-driven to a consumption-based model, lower Chinese growth rates are, perhaps, to be expected. Officials in Beijing have repeatedly stressed that lower growth rates are probable during this period of transition, reflected in the GDP target cut to 6.5% for 2017. The medium-term outlook suggests that GDP growth will decline further to 6.2% in 2018 and 5.8% in 2019.
The latest GDP figures also suggest that reform is proceeding slower than expected, particularly in the service sector, which is expected to play a crucial role in the country’s economic future. The service industry accounts for more than 50% of China’s total GDP according to 2016 figures, compared to 42% 10 years ago and 34% 20 years ago. Despite the impressive growth, this is significantly lower than the global average of 74% for developed countries. Chinese GDP growth in the tertiary industry (service sector) grew at a slower pace in Q1 than the secondary industry (construction and manufacturing sector); tertiary GDP saw a slight increase from 7.6% to 7.7% compared to last year while secondary GDP grew at a faster pace of 6.4% vs 5.8% in the previous year. Despite the slower growth in tertiary GDP, recent key releases suggest that Q2 values will see a steady rise; retail sales increased 10.7% compared to last year and fixed asset investments in the tertiary industry recorded one-year growth of 11.6%.
At the same time, recent PMIs confirm continued optimism within the services sector, with the Caixin Services PMI increasing to 52.8 and the Caixin Manufacturing PMI slipping to 49.6, just under the 50-point mark that indicates contraction versus expansion. Official PMI figures also suggest that the services sector is on an upward trajectory, while the manufacturing sector may be showing signs of cooling. Official PMIs still remain above the 50-point mark; the May figure for the manufacturing index remains at 51.2, while the non-manufacturing index increased to 54.4.
Together, the Caixin and official PMIs are reliable leading indicators, as they survey a central sector of the manufacturing industry that covers small- to medium-sized companies and larger state-owned firms. In the coming months, despite their inherent volatility, the manufacturing PMIs may provide a good measure of China’s near-term growth momentum.
Ballooning Chinese Debt Creates Challenge for Growth
In addition to lower GDP growth, Moody’s also warned of a ballooning debt situation, which, if left unaddressed, could spiral out of control. China’s total social financing, a broad government measure of credit and liquidity, stands at 1.06 trillion CNY, while outstanding loans grew by 12.9% in May. This growth is slower than seen in previous months, but the overall trend still highlights the challenges that lie ahead: a fine balancing act between financial stability and continued growth.
Moody’s is certainly not the only institution that has expressed concerns about China’s so-called debt bubble. The International Monetary Fund and Bank for International Settlements, among others, have also issued warnings. An explosion of debt has been the main engine for growth in recent years. The credit-to-GDP ratio is currently at almost 260% of GDP, of which around 160% comes from the corporate sector, and the credit-to-GDP gap is 24.5%. Having these debt ratios at record highs is a potential precursor to a deleveraging similar to that of Greece and Spain during the credit crises of 2008. A credit-to-GDP gap of 10 or higher is an indication for higher risk to the banking sector; China has now sustained a reading of 10 or higher for almost 10 years.
China Too Big to Fail?
There are risks and opportunities when an economy seeks to change its path towards sustainable growth. Chinese finance ministers believe Moody’s downgrade exaggerates its economic woes and underestimates China’s reform attempts. After all, China has a $3 trillion stockpile of foreign reserves and a current account surplus of $200 billion. Furthermore, its external debt to GDP ratio is only 13%, meaning reliance on foreign creditors is low. The unemployment rate recently fell below 4%, a positive sign that slower growth and the country's rebalancing has thus far not caused an increase in unemployment, which could lead to social unrest and further complicate reform attempts. The numbers suggest that China should be well equipped to handle a potential credit crisis.
How, then, should we interpret Moody’s downgrade? The change, which still keeps China’s credit rating within investment grade terrain and at the fifth highest rating on the Moody’s scale, was not intended to cause widespread panic, but to send a warning signal to Beijing’s policymakers that reforms are necessary to tackle an unsustainable credit-driven investment growth model.
Restructuring the most populous economy in the world cannot happen quickly nor would it be an easy task. If Chinese leadership is committed to the tightening of monetary policy in combination with stricter regulations and continued structural reform, then the need to panic may be unfounded. The 19th National Congress of the Communist Party will be held later this year. Perhaps only then will we see whether President Xi Jingping will opt for lower but sustainable growth or for stimulus-filled higher growth. The political stakes are high.
Article by Katarina Bonn, FactSet