Moody’s downgrading of China’s credit rating is without basis amid ‘new normal’ in the economy
Lawrence J. Lau says the mainland Chinese economy remains stable, with structural reforms under way, and if demand or debt are concerns, the central government has a proven ability to mobilise resources to achieve its goals
Moody’s recently downgraded China’s sovereign credit rating for the first time since 1989, and changed the outlook for its economy from stable to negative. It also downgraded Hong Kong on the basis of its close economic relationship with mainland China. Are these downgrades justified?
First, central government debt is only about 20 per cent of gross domestic product, with more than 99 per cent denominated in renminbi.
China should have no difficulty in meeting these obligations, just as the US, with a public debt-to-GDP ratio approaching 100 per cent, should have no difficulty meeting its obligations – which are all denominated in US dollars. Both countries can simply print more money to service their respective debts.
Thus, to the extent that the credit rating should reflect the ability to service the debt, there has been no substantive change for China.
Moreover, unlike the US public debt, the vast majority of the Chinese public debt is held by Chinese nationals, so that even if they were to sell the Chinese debt, the money would mostly remain in China, and it would have little impact on the foreign exchange market or the renminbi exchange rate.
In a way, it is like intra-family debt. The son borrows from the father; when the father demands repayment, the son asks the mother for the money, and the mother in turn asks the father for the money, thus completing the circle. This arrangement can be sustained indefinitely, especially if the rate of interest is low, as the Japanese experience has demonstrated.
Second, credit ratings have not proved to be useful predictors of economic and financial stresses. No credit agency foresaw the 2008 collapse of Lehman Brothers, the ensuing global financial crisis, or the European sovereign debt crisis. My view has always been that if the analysts at the rating agencies are really that good, they should be out there investing for asset management firms and making real money, instead of simply doing the ratings.
Then why is there still a demand for credit ratings, and for credit rating agencies to supply them?
That is because most asset managers want some protection – an acceptable excuse – if they wind up losing money for their clients. The typical defence would be: “This firm was rated AAA. What do you expect me to do? Besides, the other asset managers also bought the bonds of this firm.” There is safety in numbers if one makes mistakes.
Third, it is true that the annual rate of growth of the Chinese economy has declined from near-double digits to around 6.5 per cent today – it has entered a “new normal”.
But this has been going on since 2010. Why did Moody’s change its credit rating now, when the economy, the renminbi exchange rate, and other economic indicators all seem to have stabilised?
One concern is whether aggregate demand is sufficient to sustain the growth of real GDP. There is no doubt that China has excess capacity in almost all of its traditional manufacturing industries, such as steel, cement, glass, aluminium smelting, solar panels, ship-building, and even coal mining. However, this problem received the attention of the central government – excess capacity is being reduced in an orderly way and supply-side structural reform has been designed so as to prevent new excess capacity. Moreover, excess capacity in itself is a silver lining: it implies that supply is not a constraint, if there is aggregate demand, there will be output.
The challenge lies in finding the appropriate source or sources for growth of aggregate demand.
Neither exports nor fixed investments in traditional manufacturing industries are economically viable sources. Instead, the economy should rely on fixed investments in basic infrastructure and in public goods provision, such as environmental preservation, protection and restoration; education, health care and elderly care.
Cleaning up the air, water and soil in China can create a great deal of aggregate demand. The demand for these is huge among the public, and these can effectively narrow the inequality in real income. The central government has proved that it is uniquely able to mobilise resources to achieve the goals that it sets.
Another concern is the level of total debt. Some reports suggest that the total debt-to-GDP ratio in China has been growing rapidly and is approaching 300 per cent. This figure is severely overstated.
As mentioned above, central government debt is very low, as is Chinese household debt, as a percentage of GDP. The focus is on possible contingent liabilities of the central government. These would include provincial and local government debt as well as state-owned enterprise debt. Official total provincial and local government debt is not very high either – it is of approximately the same order of magnitude as the central government debt. So it should likewise not be a major source of worry.
The real concern is enterprise debt. However, the centrally controlled state-owned enterprises collectively have significant positive net worth, as well as positive market capitalisations, and their debt should not be considered in the same way as public debt, which is not backed by any marketable assets. Moreover, because of the rising prevalence of shadow banking, total enterprise debt is overstated because of the failure to net out inter-enterprise debt.
For example, a Chinese bank may lend to a centrally controlled state firm, which is perceived to be a safe risk. But since these firms have no good investment projects in their industries, they re-lend the funds to perhaps a trust company to earn an interest rate spread. The trust company in turn lends to a private enterprise that needs the money, marking up the rate of interest even more. In this process, total net enterprise debt is not increased, but gross debt is tripled.
This double- and triple-counting accounts for a substantial part of the recent increase in gross enterprise debt. The net enterprise debt-to-GDP ratio is actually no higher than if the bank lends directly to the final borrower.
This is not to say that the rise in the leverage ratio due to shadow banking is not a problem. It is, but it is not as serious as it may sound.
One ready way to stop this form of shadow banking is to require the banks to disburse loans on the completion method and only for the intended purposes, leaving no room for the diversion of the funds to be re-lent to another borrower.
Finally, it is doubtful whether the central government will feel obligated to assume the liabilities of all its state firms, let alone all Chinese enterprises. An important example to remember is the bankruptcy of Guangdong International Trust and Investment Corporation in 1999.
In conclusion, I believe the Chinese economy remains stable and controllable, and an average annual growth rate of 6.5 per cent should be feasible, and in fact likely, over the next five years. There is little basis to justify Moody’s downgrade of the credit rating of China and therefore also that of Hong Kong.
Lawrence J. Lau is the Ralph and Claire Landau Professor of Economics at the Lau Chor Tak Institute of Global Economics and Finance, the Chinese University of Hong Kong