Jake's View

Here’s why S&P may be on to something with its cut of China’s sovereign credit rating

The important question is not the quantity of debt, but the quality of how it is invested, and on this ground, I think S&P may be on the right track.

PUBLISHED : Monday, 25 September, 2017, 2:51pm
UPDATED : Monday, 25 September, 2017, 11:05pm

China has hit back strongly at S&P Global’s “perplexing” decision to downgrade the country’s sovereign credit rating... S&P was “neglecting China’s sound economic fundamentals and development potential”, the finance ministry said on its website yesterday, calling it a “wrong decision.” -- SCMP, September 23

I agree that it was the wrong call if S&P made it purely on the basis that debt levels in the mainland are high relative to the size of the economy.

This is a frequent criticism with aggregate debt financing now at 163 trillion yuan (US$24.7 trillion/), the equivalent of more than 200 per cent of gross domestic product, but it is also a case of comparing apples to oranges.

Debt is a balance sheet figure. Gross domestic product is a cash flow figure. To put it in an equivalent personal context, if you are a homeowner, you at some point may have carried a mortgage debt of up to 1,000 per cent of your annual income and yet your bank thought this was just fine and you lost no sleep over it.

Of the two categories of financing -- debt and equity -- debt can easily be the better when interest rates are unusually low. The important question is not the quantity of debt, but the quality of how it is invested, and on this ground, I think S&P may be on the right track.

S&P pours cold water on Beijing’s upbeat economic narrative

Take, for instance, the estimated 5 trillion yuan spent on the high speed rail system. I say “estimated,” but I might as well say “wildly guessed”, as the financial picture is murky. Yet we are officially given to understand that high speed rail is a profitable investment.

I don’t believe it. Profit to me means what is left over after operating costs, maintenance (calculated in Europe for high speed rail as 10 per cent annually of capital invested), depreciation and amortisation, interest charges and tax. I say that these last three at least are ignored in the official “profits”.

And this would suggest that the banks which provided all the money can kiss it goodbye. They will never see it again and they will never get a return on it.

They won’t say so, however. At Beijing’s behest, they will just throw good money after bad to keep up the pretence.

I think this sort of thing is happening across the entire economy at the moment, particularly in rust belt industries like steel and shipbuilding, but likely in housing construction as well, with its huge oversupply, and in many others.

Beijing’s apparent game is to make credit conditions easier for these industries so that they can work their way out of their fix. All that this seems to have done is encourage them to work their way further into it.

Moody’s cuts China’s credit rating over worsening debt outlook

Meanwhile, more weak loans pile up on the balance sheets of the banks while the central government, which was in fiscal surplus 10 years ago, is now running a fiscal deficit of 3.3. trillion yuan a year with all its Band-Aid help.

And then you get the danger that few people can see it because everyone is holding their financial cards close to their chests. “Sound economic fundamentals,” says the finance ministry man. I think he believes it. He doesn’t know.

They all find out when a recession strikes, of course, but the problem here is that the Chinese economy has not been allowed this corrective phase of the cycle for a long time, which means the problems only build up further.

When it all unravels, however, it does so very rapidly. I remember watching the non-performing loan ratio of Thailand rise to 45 per cent from low single digits in less than a year during the 1998 Asian Financial Crisis. Jaws dropped to the floor in the Thai finance ministry then. They never saw it coming.

In these things you just don’t. They always come as a shock. Hindsight later reveals all and then it’s not surprising any longer. But don’t expect foresight when the mandarins in Beijing say, as we quoted them over the weekend, that “ratings agencies have been misreading the Chinese economy with their old mindsets.”

The old mindset I have in mind here is that of the Japanese bureaucracy in the 1980s making the same defence of the overblown Japanese economy.

And where is Japan now?