China may have suffered a high profile ratings downgrade, but that does not mean those predicting a debt crisis are any closer to being right.
Indeed, the China bears are as wrong today as they were before Moody’s cut the country’s foreign and local currency rating by one notch to A1 on Wednesday.
That does not mean the ratings agency did not highlight some very sizeable issues facing policy makers in Beijing.
Moody’s bigger point is that China’s overall debt load is set to get larger at a time of slowing economic growth, while the overall pace of reform is too slow to meaningfully contribute to the required structural change.
The reform point is crucial here. As Moody’s made clear it is all about China’s inability to efficiently allocate capital and how Beijing’s reform efforts have largely failed.
“The key measures introduced to date will have a limited impact on the productivity and efficiency with which capital is allocated over the foreseeable future,” it said.
Mark Williams from Capital Economics takes this point further, saying China’s loose credit policies, which prevent struggling companies from failing and capital from going to areas where it is most needed, have eroded the economy’s long-run growth potential.
“Without significant reform, China’s long run growth rate will drop to 2 per cent,” he said in a note to clients.
“We fully agree with Moody’s view that reform over the past year has been slow. As a result, that further slowdown in growth now appears increasingly likely.”
A Chinese economy growing at 2 per cent would be not only place extreme pressure on the Community Party and its legitimacy, but would also be sobering for Australia, which is increasingly reliant on demand from China to maintain economic momentum.
But such a narrative around slower growth is very different to those predicting a fully fledged financial crisis. Williams makes another strong point in this area, arguing that China can afford to bail out its banking sector. While costly, it is manageable and would result in an increase in overall government debt from 55 per cent of GDP to 90 per cent, he said.
“That is high, but still lower than the debt burdens of many other governments with slower rates of nominal GDP growth and so less capacity to service debt,” he said.
“China’s government also has more assets than most of its peers.”
Regardless of Beijing’s balance sheet strength, its institutional framework also makes it difficult to see how a banking crisis might eventuate. That’s because it has a closed financial system where the government directs state-owned banks to lend to state-backed companies using China’s large pool of domestic savings.
While this explains why capital is not allocated efficiently, it also means China is less vulnerable to an external shock.
“The debt problem is serious, but the risk of a hard landing or banking crisis is, in my view, low,” said Andy Rothman from fund manager Matthews Asia in a note to clients.
Rothman, a long-time China watcher and former State Department diplomat, said the central government’s control over the financial sector meant it can determine how and when the banking sector recognises non-performing loans.This means it should be able to conduct an orderly, albeit, expensive deleveraging of the economy.
“Additional positive factors are that China’s banking system is very liquid and the process of dealing with bad debts has begun,” he said.
“Cleaning up China’s debt problem will be expensive but . . . not [produce] the dramatic hard landing or banking crisis scenarios that make for a sexier media story.”
AFR Contributor | Financial Review