Picture: Reuters
Beijing - Moody's Investors Service downgraded China’s credit ratings on Wednesday for the first time in nearly 30 years, saying that it expects the financial strength of the economy will erode in coming years as growth slows and debt continues to rise.

The one-notch downgrade in long-term local and foreign currency issuer ratings, to A1 from Aa3, comes as the Chinese government grapples with the challenges of rising financial risks stemming from years of credit-fuelled stimulus.

“The downgrade reflects Moody’s expectation that China’s financial strength will erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows,” the ratings agency said, changing its outlook for China to stable from negative.

China’s Finance Ministry said the downgrade, Moody’s first for the country since 1989, overestimated the risks to the economy and was based on “inappropriate methodology”.

“Moody’s views that China’s non-financial debt will rise rapidly and the government would continue to maintain growth via stimulus measures are exaggerating difficulties facing the Chinese economy, and underestimating the Chinese government’s ability to deepen supply-side structural reform and appropriately expand aggregate demand,” the ministry said.

China’s leaders have identified the containment of financial risks and asset bubbles as a top priority this year. All the same, authorities are moving cautiously to avoid knocking economic growth, gingerly raising short-term interest rates while tightening regulatory supervision.

At the same time, Beijing’s need to deliver on official growth targets is likely to make the economy increasingly reliant on stimulus, Moody’s said.

“While ongoing progress on reforms is likely to transform the economy and financial system over time, it is not likely to prevent a further material rise in economy-wide debt, and the consequent increase in contingent liabilities for the government,” it said.

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While the downgrade is likely to modestly increase the cost of borrowing for the Chinese government and its state-owned enterprises (SOEs), it remains comfortably within the investment grade rating range. World stocks inched lower after the move, though Shanghai’s main index recouped early losses to end marginally higher.

“After being very much at the front and centre of global risk sentiment at the beginning of last year, the Chinese slowdown story has been almost forgotten, with politics throughout Europe and the US taking the limelight,” said David Cheetham, chief market analyst at brokerage XTB.

The yuan currency briefly dipped against the US dollar in offshore trading, as did the Australian dollar, often seen as a proxy for China risk.

De-risk

“It’s going to be quite negative in terms of sentiment, particularly at a time when China is looking to de-risk the banking system (and) when there’s going to be some potential restructuring of SOEs,” said Vishnu Varathan, Asia head of economics and strategy at Mizuho Bank’s Treasury division.

In March 2016, Moody’s cut its outlook on China’s ratings to negative from stable, citing rising debt and uncertainty about authorities’ ability to carry out reforms.

Rival ratings agency Standard & Poor’s downgraded its outlook to negative in the same month. S&P’s AA- rating is one notch above both Moody’s and Fitch Ratings, leading to speculation among analysts that S&P could also downgrade soon.

“We understand the risk and the reason for downgrade, but due to China being a unique system - [with a] closed capital account and strong government control over all important sectors - it can tolerate a higher debt level,” said Edmund Goh, a Kuala Lumpur-based investment manager at Aberdeen Asset Management.

The slowing economy has become an increasingly sensitive topic in China.