Serious consequences of downgrading China's credit rating

Last week, the Chinese market was shaken when Moody’s downgraded the credit outlook of bonds issued by the world's second-largest economy.

Many Viet Hustler readers must be wondering whether this news has any negative impact on China's financial system? Especially when many readers don't hesitate to compare China with the US: the world's leading economic power was also downgraded in credit rating by Fitch in August, but to date there has been no clear impact on the US financial system.

So why does the market have such a pessimistic view on similar news about China? The answer lies in China's position in the financial market and economic regime that China chooses completely different from the US.

Following the events of last week, Viet Hustler sends to readers an in-depth analysis article related to the impact from Moody’s decision last week on China's financial system, in the Weekend Macroeconomics column.

1. Market negatively evaluates China's public debt issue

Moody's has just downgraded the credit outlook of China's government bonds from “stable” (stable) to “negative” (negative) last week.

• FYI: This decision by Moody's is suspected to have leaked online beforehand in private chat groups (according to Bloomberg) – causing Chinese stocks to plummet severely even a few hours before Moody’s official announcement.

  

• The deeper reasons for these negative assessments by Moody’s (besides slow economic growth) come from their warning about the possibility of “local government debt crisis” in China.

  

In reality, China's public debt, especially debt from local governments, is increasingly becoming a “cancer” in this country's financial system.

• Outstanding debt of Chinese local governments reached CNY 9140 billion (~USD 1,275.8 billion), equivalent to ~71% GDP of China in 2022.

  • … and possibly, local governments cannot repay 90% of this debt.

    

1.1. Causes of the surge in public debt of Chinese local governments

First, the answer still lies in the Real Estate (BĐS) sector crisis that has plagued this country for more than 2 years. 

Even though China denies the systemic risk of the BĐS crisis, this risk still spills over to all economic sectors: from consumption, banking to public debt. 

• However, the scope of this article only stops at the impact on the public debt issue.

  • Readers can refer to other issues of the Chinese economy here.

The market value of China's real estate (referenced to 100 in June 2006) has plummeted -81% during the 2021-2022 period.

• After the market tried to recover at the end of 2022, it continued to decline -64% in the first 7 months of 2023.

  

It was thought that the BĐS collapse only affected the wallets of people and businesses, but now local governments are also affected:

• Revenue of local governments from land sales has plummeted severely since early 2022 due to BĐS they hold depreciating.

  

  => Reduced revenue makes China's fiscal budget deficit more severe:

  • 2023 is the year when China exceeded the allowed limit (3%) for severe fiscal spending deficit: the budget deficit reached -3.8% GDP.

    

Secondly, China is facing the risk of deflation due to declining domestic demand from people:

• FYI: China's imports unexpectedly fell -0.6% y/y in November - a decline from the already weak baseline consumer demand last year.

  • previously forecasted imports to increase +3.9% y/y for this near-end-of-year month.

  => This raises concerns that the decline in consumer demand in China is more severe than economists' estimates.

Therefore, to fill the spending deficit and have enough money to stimulate consumption, China has issued a series of new bonds and debt certificates:

• 2/3 of Chinese local governments have debt levels exceeding the global public debt warning threshold. 

  

2. Why is the downgrade of China's credit outlook more severe than the US?

2.1. Reason 1: Original sin and currency crisis

Although the US was downgraded in government bond credit rating by Fitch in August, America has not yet faced overly serious problems in the debt market (at least until now).

However, China will not be as “lucky” as the US, because Moody’s downgrade of China’s credit outlook will have a more severe impact due to the factor called: Original Sin

FYI: As of 2020, the 5 main currencies used for borrowing on the international market are still: USD, EUR, GBP, JPY and CHF (Eren and Malamud, 2022).

• Up to 97% of debt on the international market is issued in these 5 currencies (Hausmann and Panizza, 2003).

=> of course, CNY is not a popular denomination currency for bonds!

Therefore, even as the world's 2nd largest economy, China still faces the dilemma of Original Sin:

• As of June 2023: the total outstanding debt of the Chinese government to foreign investors (issued in USD) is USD 2433.8 billion…

  (not including USD-denominated debt sold to domestic investors).

  

• Since 2019, China has also issued debt in EUR after 15 years, to reduce dependence on USD-denominated debt

  => as mentioned, China does not have much leverage to issue debt in CNY on the international market.

  

• But more importantly, USD-denominated debt issued by Chinese enterprises is even higher - especially the real estate sector.

  • USD debt of Chinese real estate companies is a major concern for creditors compared to other USD debts.

    

  • According to Barclays, most Chinese real estate enterprises have defaulted due to USD-denominated debt - the problem of Original Sin.

    

The impact of original sin is precisely the currency crisis: 

The main problem of Original Sin:

• The mismatch between foreign currency debt repayments and domestic currency revenues (often of lower value) will bring exchange rate risk….

• … especially when tightening interest rate and monetary policies from the West cause the CNY to depreciate against strong currencies like EUR and USD.

And Original Sin will ignite a currency crisis when the market loses confidence in China's credit (Moody’s downgrade of China's bonds)

• China's credit downgrade will further reduce the position of the CNY

  => making the debt burden even heavier as China must exchange CNY for USD to repay debt.

• Next, escalating public debt tensions make investors worry that China may artificially inflate the value of the CNY to resolve the debt problem 

  => Forex investors will attack by speculating on the CNY expecting it to appreciate => this leads to a currency crisis.

• Finally, China's credit downgrade will make the country difficult to borrow on the international financial market in the future…

  • - because investors themselves worry about exchange rate risk and the aforementioned currency crisis, making it even harder for China to repay debt.

2.2. Reason 2: Banking crisis due to government pressures to extend debt and real estate losses

Banks in China are the entities facing the greatest risk from the real estate crisis:

• Surveys up to 2018 show that real estate loans account for a large portion of loan products at Chinese banks:

  

• Naturally, when the real estate market collapses, non-performing loans (NPL) at banks related to real estate enterprises surge.

  

Before recovering the losses from real estate, in October 2023, cthe Chinese government again forces banks to extend debt for local government debts with longer maturities…

- due to the government's impasse as 90% of local government debt cannot be repaid.

Note:

• Operating income of Chinese banks listed on the stock exchange was only CNY 6087 billion in 2022 (according to EY):

  

  • Of which, only CNY 2136 billion is net profit (according to EY):

    

• Meanwhile, local government outstanding debt stands at CNY 9140 billion – of course, not all of it is held by banks. 

• But if banks are forced to extend a portion of this massive debt pile, it is still a heavy burden on the banking system. 

Therefore, it is no coincidence that less than 1 day after Moody’s downgraded China’s credit outlook, Moody’s continued to downgrade the credit ratings of 8 Chinese banks to negative. 

=> All because of the liquidity risks that the government is “piling onto” its own country's banking system.

CONCLUSION

By now, readers must have guessed the difference in economic measures and position on the financial map between the US and China that Viet Hustler mentioned at the beginning of the article. These two aspects are the key determinants of a country's financial system resilience against negative assessments from external credit rating agencies.

Regarding the position on the financial economic map: China's CNY is not in the “big 5” - the 5 main debt issuance and strategic reserve currencies. China itself also struggles to borrow from the international financial market in its own domestic currency (Original Sin). 

• Therefore, Moody’s downgrading of China’s credit outlook will make it even more difficult for the Chinese government to borrow in foreign currencies like USD or EUR (due to investors' concerns about exchange rate risks making it harder for China to repay debt).

• Additionally, on the forex market, arbitrage investors will also tend to speculate on CNY waiting for the Chinese government to inflate the value of this currency - then they will sell off en masse.

• As a result, if the US only has concerns with twin crisis (debt crisis + banking crisis), then China may face triple crisis (debt crisis + banking crisis + currency crisis).

Regarding economic controls, the US has a relatively free financial market where banks have their own space to manage their liquidity. But China has coercive economic controls:

• the central government “urging” the banking system to extend local government debts could bog the banking system down in liquidity risks.

  • A typical example is the liquidity squeeze in October that Chinese banks faced (details at Viet Hustler's old article - section 2).