China's Economy Faces Blow As Moody's Downgrade Credit Outlook, Rising Debts Raise Concerns

Second largest economy in the world, China gets a setback as a leading rating agency Moody's Investors Services on Tuesday downgraded the country's government credit ratings to 'negative' from 'stable'. However, Moody's has affirmed China's A1 long-term local and foreign-currency issuer and senior unsecured ratings and the (P)A1 foreign-currency senior unsecured shelf rating.

Explaining the negative outlook action, Moody's expressed that in China, the rising evidence that financial support will be provided by the government and wider public sector to financially stressed regional and local governments (RLGs) and State-Owned Enterprises (SOEs), is posing broad downside risks to the country's fiscal, economic and institutional strength.

Also, Moody's outlook change takes into consideration China's increased risks related to structurally and persistently lower medium-term economic growth and the ongoing downsizing of the property sector.

In its research note, Moody's said, "These e trends underscore the increasing risks related to policy effectiveness, including the challenge to design and implement policies that support economic rebalancing while preventing moral hazard and containing the impact on the sovereign's balance sheet."

Although Moody's expects the financial support to the stressed entities would be more selective, yet contributes to protracted risks of further strains for SOEs and RLGs.

In regards to the affirmation of the rating, Moody's said it reflects China's financial and institutional resources to manage the transition in an orderly fashion. Its economy's vast size and robust, albeit slowing, potential growth rate, support its high shock absorption capacity. This is buttressed by low external risks and financing costs as large domestic savings foster high debt affordability.

In Moody's view, high economic strength also supports general government revenue which implies that financial resources can be mobilised to support RLGs and, indirectly, local government financing vehicles (LGFVs)if these resources can be effectively allocated.

And while policy effectiveness is being tested, a track record of effective policy actions in the past also supports the rating, it said.

Moody's has kept China's local- and foreign-currency country ceilings unchanged at Aaa and Aa1 respectively.

It said, the local currency ceiling, four notches above the rating, reflects limited external, broadly predictable institutions; offset by a large government footprint and influence in the economy and financial system which could lead to government decisions that are credit negative for non-government issuers.

Looking ahead, Moody's said, "Erosion in the predictability of executive institutions and government actions could point to a lower local currency ceiling. The foreign currency ceiling, one notch below the local currency ceiling, reflects the net impact of strong policy effectiveness, and low external debt but also a history of capital account controls which point to some, albeit limited, transfer and convertibility risks in a low probability scenario of the sovereign facing very significant financial stress."

Amidst China's government's consistently stated policy objective, over the medium term, Moody's expects its property sector to remain smaller in proportion to the entire economy than it was before the property correction that started in 2021.

Moody's pointed out that regions that relied most heavily on land sales are unable to materially offset the loss in revenue from other sources and will face financial strain for the foreseeable future, in Moody's view. Loss of land sales revenue reduces the ability of RLGs to support LGFVs and other local SOEs, including some entities highly reliant on RLG funding.

For this, Moody expects further evidence of the crystallization of contingent liabilities to materialize, which means that financial support to RLGs and SOEs will be provided by the government and the wider public sector.

According to Moody's, the risk is that, over the medium term, the crystallization of contingent liabilities comes at more significant costs to the sovereign than consistent with the rating; and/or that the effectiveness of government policies that aim to manage this transition period is lower than Moody's currently assumes, with negative consequences for the economy and, in scenarios that currently have a low probability, financial stability.

Further, Moody estimates that around one-third of the amount of SOE debt outstanding - equal to about 40% of GDP- has interest coverage below 1, which generally indicates weak debt sustainability. These estimates are consistent with those of the International Monetary Fund (IMF).

However, Moody's does not expect all SOEs to likely need direct government support, even a moderate proportion of doing so over the medium term would represent a significant crystallization of contingent liabilities for the sovereign, increasing the costs of financial support and diminishing fiscal strength.

Nevertheless, ensuring that support to local government or SOE debt happens in a timely and orderly, yet targeted fashion in a way that supports growth and investment, which Moody's believes "represents a significant policy challenge."

Overall, Moody's said that the risk of more significant contingent liability crystallisation has increased. Adding it said, absorbing a significant portion of these contingent liabilities across the public sector would come at material costs, which would undermine China's fiscal strength and potentially its creditworthiness.