Ratings agency Moody’s today placed China’s sovereign rating on watch negative, suggesting a one-in-three chance that the group may downgrade the nation’s Aa3 rating in the months ahead.
Moody’s provided three reasons behind the decision: weakening fiscal metrics, a continued fall in reserve buffers due to accelerated capital outflows along with uncertainty about authorities capacity to implement reforms, something the group believes are required to address imbalances in the economy.
In regards to the government’s fiscal position, Moody’s believes it will likely deteriorate further, albeit from “very high levels”.
“The government’s balance sheet is exposed to contingent liabilities through regional and local governments, policy banks and state-owned enterprises (SOEs),” said Moody’s. “The ongoing increase in leverage across the economy and financial system and the stress in the SOE sector imply a rising probability that some of the contingent liabilities will crystallize on the government’s balance sheet.”
They also suggest the sharp decline in the nation’s FX reserves, something that rattled financial markets earlier this year, may also pressure China’s sovereign rating.
“China’s foreign exchange reserves have fallen markedly over the last 18 months, to $3.2 trillion in January 2016, $762 billion below their peak in June 2014,” says Moody’s.
“Their decline highlights the possibility that pressure on the exchange rate and weakening confidence in the ability of the authorities to maintain economic growth and implement reforms could fuel further capital outflows. In particular, a fall in reserves – corresponding to sustained deposit outflows – could raise pressure on the deposit-funded banking sector.”
The group also highlights concerns over the government’s ability to implement “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. These developments would likely fuel further capital outflows,” it said.
Moody’s suggests that a moderation in capital outflows, as well as advancement of reforms, would be consistent with returning the outlook to stable.
At Aa3, China’s sovereign rating is the fourth highest on Moody’s scale of creditworthiness, some four rungs above junk bond status.
Although a formal ratings action, Moody’s decision to place the nation on watch negative largely reflects the increased level of concern expressed by financial markets over China’s mounting debt levels.
Some prominent investors, such as famed hedge fund manager Kyle Bass, believe that a financial crisis in China is likely to hit later this year, creating a scenario where the government will be forced to sell down its FX reserves in order to bailout the nation’s state-owned banks, leading to a steep devaluation in the value of the Chinese renminbi.
While Bass is at the bearish end of the spectrum, other analysts believe China’s financial system, while likely to see a modest increase in bad debts, will not endure anything resembling a collapse.