Less than two weeks after China said it would open its domestic market to US rating agencies, Moody’s cut its credit rating for the first time in a quarter of a century.

It cited financial and economic risks flagged in recent months by Chinese officials, who were nonetheless quick to criticise the move. There followed automatic Moody’s downgrades of 26 state-owned enterprises with ratings tied to the government’s.

But while Moody’s decision on Wednesday will complicate efforts to attract foreign investors to the third-largest bond market, investors said it was unlikely to have a significant impact.

The immediate reaction on China’s bond market was limited because domestic investors, which dominate, pay scant attention to foreign ratings. After a surge at the open, yields on benchmark five-year government bonds returned to 3.8 per cent.

After a surge at the Wednesday's open, yields on benchmark five-year government bonds returned to 3.8 per cent.
After a surge at the Wednesday’s open, yields on benchmark five-year government bonds returned to 3.8 per cent.

Foreign penetration remains tiny, with overseas investors owning about Rmb424bn ($US61.5bn) of government bonds at the end of April, equal to just 4 per cent of the outstanding total, according to China Central Depository and Clearing.

But that is expected to change as Beijing takes steps to open the market to foreign capital, including a “bond connect” scheme allowing foreign investors to buy through Hong Kong brokers.

Luke Spajic, head of Pimco’s emerging Asia portfolio in Singapore, noted Moody’s simultaneous decision to soften its China outlook from “negative” to “stable”. “This downgrade does not really derail China’s inevitable integration of bonds and equities with global capital markets,” he said. “That’s a secular story. A punchier move would have been to keep a negative outlook.”

Many sovereign wealth and pension funds have mandates that require them to invest in bonds above a certain rating. The downgrade puts China’s sovereign rating on a par with those of Israel, Saudi Arabia and the Czech Republic.

China’s non-financial corporate debt is about 170 per cent of GDP, or about $18.9tn, according to the Bank for International Settlements.

Foreign penetration remains tiny, with overseas investors owning about $US61.5bn of government bonds at the end of April.
Foreign penetration remains tiny, with overseas investors owning about $US61.5bn of government bonds at the end of April.

Moody’s action underscores the possibility that if US agencies start rating local bonds, a two-track system will result in which local and foreign agencies apply different standards.

Dagong Global Credit Rating, one of the four main domestic rating agencies, has never rated China below the US, Japan or Britain. It downgraded the US further in 2010 and 2013

The unhappy response of the finance ministry raises the possibility that foreign agencies could face pressure if they issue a high-profile downgrade of a national champion. Alternatively, foreign agencies could find themselves unable to attract business if bond issuers, which pay for ratings, do not want to face tougher standards.

The ministry said Moody’s had not given the economy enough credit for its “steady upward momentum”, with first-quarter growth coming in at a higher than expected 6.9 per cent. “This year’s strong beginning shows the achievement of China’s reforms,” it said.

China’s bond market is already in turmoil. Banks and other investors are grappling with new regulations designed to limit the use of borrowed money for bond investment.

As a result, the yield curve for government bonds inverted in mid-May after a short-term funding squeeze caused investors to dump short-dated paper.

Zhu Ning, a finance professor at Tsinghua University in Beijing, said the Moody’s decision was “sensible” in view of tightened liquidity in China’s capital markets and economic growth that was still at its lowest since 1990. “Bond defaults are likely to rise because of the deterioration in the external environment,” Professor Zhu said.

But in a bond market that at its peak last autumn was widely seen as a bubble, some foreign investors consider the shakeout positive.

“China’s recent regulatory tightening should help deflate the country’s credit markets and lead to long-term market stabilisation,” said Luc Froehlich, head of Asian fixed income at Fidelity International in Hong Kong.

by Tom Mitchell, Gabriel Wildau and Don Weinland

Additional reporting by Xinning Liu

Financial Times

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