Ratings agencies downgraded China, and analysts warn it could trigger a 'negative feedback loop'

Chinese protesters in Beijing, China. Photo: Guang Niu/ Getty Images.

After placing China’s sovereign credit rating on watch negative 15 months ago — laying the potential trigger for a ratings downgrade — ratings agency Moody’s followed through today, downgrading the nation’s credit rating one notch from Aa3 to A1 with a steady outlook.

A1 is the fifth-highest rating assigned by Moody’s, and is deemed to be investment grade.

According to Khoon Goh, David Qu and Raymond Yeung, researchers at ANZ, Moody’s decision to downgrade stems from “their expectation that China’s debt will continue to rise while potential growth slows, eroding the country’s credit metrics”.

“Moody’s does not see the government’s reforms as fully offsetting the rise in economic and financial risk,” the trio wrote in a note released following the decision.

This, they say, has the potential to create a negative feedback loop within the Chinese economy.

They explain:

From a macro perspective, downgrade by rating agencies could potentially erode the financial soundness of China, creating the risk of a negative feedback loop. The downgrade will likely lift the cost of financing of Chinese issuers, especially in the offshore market. They will likely turn on onshore financing platforms, including banks, shadow banks and onshore bond markets as these channels do pay less attention to rating actions of international agencies. As the loan exposure of the domestic monetary system to local borrowers heightens, the central bank will be cautious in policy tightening in the future, extending the lingering debt concerns further.

Goh, Qu and Yeung say that bonds issued outside China, especially those issued in foreign currencies, will see a negative impact from the downgrade, making it harder to attract capital inflows.

In a statement explaining the rationale behind the downgrade, Moody’s said that it “expects that economy-wide leverage will increase further over the coming years”.

“The planned reform program is likely to slow, but not prevent, the rise in leverage,” it said.

“The importance the authorities attach to maintaining robust growth will result in sustained policy stimulus. Such stimulus will contribute to rising debt across the economy as a whole.”

Along with stoking debt concerns further, Goh, Qu and Yeung say that Moody’s decision could also prompt a ratings downgrade from Standard and Poor’s.

“Today’s Moody’s downgrade puts its A1 rating for China equivalent to Fitch’s A+ rating. However, S&P has China one notch higher on AA- with a negative outlook since 31 March 2016.,” they say.

“Another downgrade event is possible.”

ANZ says that the impact of the downgrade is also likely to be felt across the Asian region, something that has already been seen during Wednesday’s trading session.

“We could see some unwinding of the strong inflows that have driven the rally in Asian currencies,” they say.

“The Korean won and Taiwanese dollar are the most susceptible to any equity outflow pressures. The Indian rupee, which has benefitted from very strong foreign inflows since the March, is also at risk of a positioning unwind.”

Chinese stocks and commodity futures, along with the Australian dollar, have also come under selling pressure today.

NOW WATCH: Money & Markets videos

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.