Recently, Moody’s downgraded China from Aa3 to A1. They cited several rationales for the downgrade. Moody’s is wrong for the following reasons.
- The concerns of China’s “economy-wide” leverage is misplaced.We all know about China’s so-called debt problem. Here is a typical story. Moody’s seems worried about this problem too. But when you look at the data, it is often aggregated. In reality, the debt in China is concentrated. For example, most of the corporate debt is held by a small subset of firms, the state-owned enterprises (SOEs). So, my views of China’s debt situation is more in line with this story, which also points out that much of the corporate debt in China is concentrated with the SOEs. If the SOEs are in danger of collapsing due to their heavy debt burden, then the Chinese government will likely assist them in one form or another, or the government may use this as an opportunity to convert some of the debt to equity (i.e., transfer the capital from one stakeholder to another). If the latter occurs, that would be a huge move in the right direction, as I have previously explained (look at my Fix #2 in that column). So, in summary, there really isn’t an “economy-wide” debt problem, and whatever debt problem that exists in China may be an overblown or misunderstood problem.
- It is okay if China’s growth rates fall.We also all know that China’s growth rate is slowing down. Moody’s seems worried about this too. However, a slowing growth rate is to be expected once an economy has become quite developed. In the U.S., I think we’d be thrilled with a 3% annual growth rate of GDP. This is because the U.S. economy is already so mature. Because China’s GDP is so large and per capita is higher, maintaining such high growth rates is harder. Instead, the key thing to focus is on is that China is still growing, even after it has already grown so much. So, Moody’s giving China a downgrade despite the country’s continuing growth seems odd.
- It is okay if China mostly relies on debt financing instead of equity financing.Moody’s seems to blame China’s relatively small equity market on China’s growing debt. That is, those who need capital in China tend to borrow. For China, this is fine (for now), for the following two reasons: First, the marginal investors in China are speculative individual investors. A marginal investor is the investor that can move market prices. In the U.S., the marginal investors are institutional investors. This is not the case in China. In China, individual investors affect market prices. We saw evidence of this back in January 2016 when the Chinese market’s bubble burst. In China, individual investors are mostly speculators, which means that we often cannot trust their stock valuations, especially when the country’s accounting transparency is so poor. When stock valuations are untrustworthy, then I’d actually prefer that firms do not raise capital in the stock markets. Second, Chinese firms do not pay much in dividends. When firms do not pay dividends, it often means they are not held accountable to shareholders. Sometimes this is okay (for growing firms), and sometimes it is not okay (for mature firms). Given that it is the large SOEs that are doing the bulk of the borrowing, I’d prefer that they pay regular interest payments to their debt holders and be held accountable for their financing rather than not have to pay dividends to equity holders. In summary, in China, I feel debt is currently a much better form of financing than equity, so I feel it is okay for firms to borrow as long as they have growth prospects and are credit worthy.
- China’s financial sector is growing.Moody’s also seems to be critical that China’s financial sector is not growing. This is a shock to me. China’s financial sector is growing. They have many more national commercial banks and provincial commercial banks than 10 years ago. So, there are now many institutional creditors in China. And, the number of other types of financial institutions (e.g., insurance companies, investment companies, etc.) in China is also growing. In fact, China could even be considered the global leader in financial technology or fintech (I am long overdue for a column on this, so please stay tuned). If there is a consistent theme when it comes to China’s ever-changing and ever-growing economy, it is that it’s financial sector is growing and maturing.Oddly enough, Moody’s also upgraded China’s overall outlook from “negative” to “steady”. That’s weird. Why downgrade China from Aa3 to A1 if China’s outlook has improved? By the way, I agree with Moody’s in this regard. China’s outlook is steady.
By Kenneth Kim