Moody’s unfair China credit rating

Moody, the US-based credit rating agency, downgraded China’s rating from Aa3 to A3 but revised the country’s economic outlook from negative to stable in May 2017. The reasons behind the downward grading include: soaring debt would diminish long-term financial strength and the economy continues on its downward trajectory.

First, let’s put China’s debt in perspective and compare it with that of G7 countries. Country debt estimates vary from one agency to another. The US Central Intelligence Agency (CIA), for example, estimated China’s government debt/GDP ratio at 20% in 2016. China’s Ministry of Finance estimate was 36.7% and the IMF figure was 66%. Private agencies had higher estimates, but their figures were more speculation than official. For consistency, this article applies the IMF numbers. The government debt/GDP ratio included both central and local government debts. The table below is a comparison between China and G7 nations

Country                          Government Debt/GDP Ratio (2016)

China                                           66%

Canada                                        87

France                                          90

Germany                                      82

Italy                                              127

Japan                                           238

UK                                                   85

US                                                  107

On total debt/GDP ratio, the IMF put China’s at 250 of which over 150% is owed by non-financial corporations (mostly state-owned enterprises). This figure also compared favorably with those of the US and Japan, respectively estimated at 331% and 517%.

On external debt, the total amount of government and private debts owed to non-residents, China is also the lowest compared to the G7. According to IMF statistics, the amount of external or foreign debt in trillions of US dollars owed in 2016 was: US = 18.2, UK = 7.5, France =5.1, Germany = 5, Japan = 3.6, Italy = 2.3, and China =1.4.

China’s first-quarter growth rate was 6.9% in 2017 and most reputable organizations and analysts predicted 6.7% growth for the year. In addition, the government has put in place measures to cull and control the “soaring” debt. Last but not least, its Belt and Road Initiative (BRI) ended successfully with 130 participating nations and seven international organizations. There is no reason to believe that the Chinese economy will be encountering any headwinds anytime soon.

Even the corporate debt of over 150% of GDP (which includes the amount guaranteed by local governments for private-public partnership (PPP) development projects) is not a valid reason for the credit rating downgrade. To that end, the governments are really lending to itself since they own the banks and a partner in PPP projects. In the event of default payments, the assets would be taken over by the local governments or the loans rolled over.

Economic and financial system differences preclude “one-size-fits-all” rating methodology

The financial and economic systems of China are different from those of the West, in that government organs (be they government departments, enterprises or banks) exist to serve the people, not for profit. Banks and enterprises may not be as profitable as they like or even incur losses. But sustaining employment and social stability is “priceless.”

It is economic woes – attributed to economic and financial liberalization – that cause populism and protectionism in the West and political instability in underdeveloped economies. That is, the pursuit of profits over employment exacerbated the economic problems because they raise social costs, levels of family violence and crimes.

Moody appears to apply a double standard when it comes to rating China’s creditworthiness.

China’s credit rating should be higher than those of other major developed economies. In addition to lower debt levels and higher annual growth rates, China’s financial profile is stronger: over US$21 trillion in deposits, US$3 trillion in foreign reserves, consumer debt/income ratio at 26% (over 100% in the West and Japan). Its BRI would energize economic growth in China and the over 100 participating countries.

China’s credit rating should be higher than those of other major developed economies

Even more confusing was the Triple A credit rating given to US investment banks engaged in the developing and trading of risky derivatives such as collateral debt obligations (CDOs) in the years prior to the 2008 financial crisis. CDOs were made up of a basket of debts such as car loans and mortgages selling to investors. The Triple A rating implied CDOs were not only safe but yielded high returns. This “false advertisement” misled investors into believing CDOs were a good investment, culminating in a surge in both demand and supply. The rest as they say “is history.” To that end, it could be argued that the US rating agencies’ misleading rating might be the root cause of the financial crisis.

No reason to believe that the Chinese financial system will diminish

In view of China’s relatively bright economic prospects in relation to the G7 over the next five years, there is no reason to believe that its financial system will lose steam. Its economic restructuring and rebalancing policies appear to be working well in that the consumption/GDP ratio has climbed from less than 40% in 2014 to over 50% today. With a huge middle class numbering nearly 500 million and growing who are able and willing to spend, domestic consumption will drive the economy. The average consumer saves over 25% of disposable income and incurs very little debt. As indicated earlier, the BRI would spur export and import growth. But most important, government economic reform policies have unleashed the population’s “animal spirit,” taking chances and enduring hard work literally 12 hours a day seven days a week (12/7).

In that light, the Chinese economy will likely achieve its annual average growth rates of between 6% and 7% over the next five years. However, the growth path may be bumpy, encounter some challenges and difficulties due to fragile global economic recovery and domestic policy mistakes or missteps.

Illogical credit rating is not helpful

It could be concluded that Moody’s credit rating downgrade on China is illogical, inconsistent and even at odds with accepted economic and financial principles. For this reason, it is not helpful to China, investors or Moody’s itself. Though the downgrade does not reflect China’s true economic and financial prospects, it does influence investor sentiments, culminating in less confidence in the Chinese economy and raising borrowing costs. Investment decisions could be adversely affected because of questionable information or assessment. For example, many investors bought CDOs because of the Triple A credit rating. Moody’s could damage itself because reputation (which is awarded for honesty and objective analysis) is any firm’s most valuable asset.