“The implication is there that the economy will struggle with a higher debt burden with a diminished means to service that debt and hence, their downgrade actually reflects the heavier debt burden. One way they translate or anticipate this heavier debt burden to increase from about 40 percent of GDP to 45 percent. This is consistent with the ratings they have provided with Moody’s,” said Vishnu Varathan, the Asia head of economics and strategy at Mizuho Bank's Treasury department.
He further said that another key assumption for them (Moody’s) is that a lot of this debt has been taken on by the local government, and state-owned enterprises will turn out to be contingent liabilities for the government.
“At some point they suspect the government will service this debt and that is going to fall on them. That is Moody’s rationale to downgrade China by one notch, equally though Moody’s has been quick to point out that after this downgrade they think that the balance of risks doesn’t point to further downgrade, hence there is stable outlook,” the analyst said.
China is currently conducting some structural reforms in its economy; looking at why Moody’s expects that these reforms won’t be effective enough, the analyst said that China’s finance ministry and Moody’s differ in their point of view since Moody’s feels that these reforms won’t be sufficient to stop them from spiraling a little higher, whereas the finance ministry takes the diametrically opposite view.
He further said that Moody’s has also pointed out that the mounting debt burden is probably not fully accounted for, so they think that it will eventually be taken out as contingent liabilities at the governmental level as well.
Varathan also said that considering that China has quite a unique economic system, it is possible that Moody’s does not fully account for the fact that the government has the ability to absorb a lot of these losses by using methods such as direct capital injection.
Looking at whether Moody’s or the China’s ministry is correct, the analyst said, “Neither needs to be wrong but a lot of assumptions go into how much growth from fiscal stimulus can also help to actually pay back debt. So the multiplier effect of growth, be it driven by further credit or not, is essentially helping to pay down the debt. I think that’s where a lot of forecasts can get quite slippery,” Varathan said.
Talking about how the markets and investors reacted to the downgrade, the analyst said that initially it was a knee-jerk concern so it was seen that stock markets were selling off and a ripple effect went through Asia and even the Aussie dollar tumbled a little.
However, making his own prognosis about China’s economy, the analyst said, “China would still be tumbling a little to find the right balance between reigning in risks in the banking sector particularly, with shadow banking and the less regulated, riskier side of banking, while trying to boost more productive lending with an infrastructure boost and so on,” Varathan said.
"I don't see any imminent economic risks that China cannot manage,” the analyst said.
Earlier, Moody's Investor Service warned that the only way for China to achieve high growth is using government-led stimulus. Unsurprisingly, the country's finance ministry didn't agree with the move.
In a statement on its website, the ministry said the downgrade was based on an "inappropriate method." Chinese authorities added that Moody’s overestimates the difficulties China's economy faces and underestimates the government's efforts to tackle structural reforms.