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
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.
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.
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.
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.
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.
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