China’s credit downgrade could spook equity and bond investors, economists say

China-Hong-Kong-Asia-700x450.jpgMoody’s downgrade of China’s credit rating today could lead to investors shunning the region, emerging market economists warn.

In an anticipated move, the credit rating agency cut China’s sovereign credit rating for the first time since 1989, taking it to A1 from Aa3, on concerns the country’s increasing debt levels and stalling growth will be detrimental to China’s financial strength. The downgrade is now in line with fellow ratings provider Fitch’s rating.

Moody’s says it expects China’s central government debt to rise to 40 per cent of GDP by the end of 2018, before reaching 45 per cent by 2020.

Schroders emerging market economist Craig Botham warns the attempts by China’s authorities to tighten policy have contributed to significant moves in bond yields, which highlights how difficult it will be for the Chinese government to deal with the debt issue.

“It is evident that policy tightening is disruptive, and at odds with the growth targets pursued by the ruling party,” Botham says. “The statement from Moody’s that accompanied the downgrade hinted at this. It referred to ‘institutional strength’ in China as moderate, to reflect the challenge of reducing leverage while preserving robust GDP growth.”

Botham says that while China is not over-reliant on foreign lenders – external debt represents 13 per cent of GDP – the downgrade may destabilise the markets.

“The move may serve to reawaken markets to China risk, in a year in which many had assumed stability ahead of the party congress in the autumn. The economic impact then is small, but the sentiment impact could be large.”

Will Ballard, head of emerging markets and Asia Pacific equities at Aviva Investors, says rating agency S&P will likely follow Moody’s downgrade while both equity and fixed income investors could question if there a further underlying issues at play.

“The first stage impact is that once the sovereign rating is downgraded, it is likely that most Chinese banks will have to be downgraded as well,” Ballard says.

“A rising cost of funding for the banks, unless it can be passed on, results in falling net interest margins. That in turn to the average equity investor, means lower earnings for banks stocks. Considering international investors are already having misgivings about investing in Chinese banks any fall in earnings is going to do nothing to help confidence.”

Luc Froehlich, head of investment directing, Asian Fixed Income at Fidelity International, warns “the risk of a loss of confidence by savers should not be underestimated,” adding that “a run on the banks would considerably weaken their position.”

After a drop in early trading, the Shanghai Composite equity index closed with a marginal gain of 0.06 per cent at 3,063.79.