Moody’s recently underscored China’s increasingly severe credit problems, announcing that it'll change the outlook on the country’s debt from “stable” to “negative.”
Readers of this column will hardly be surprised. Over the past few months, this space has itemized and analyzed the great burdens facing Chinese finance and economics. At the top of the list is the near collapse of Chinese property development and the legacy of questionable debt that it has left on the books of Chinese banks and other financial institutions. Local governments have also made clear the severe debt overhang left to them by their efforts to finance Beijing’s infrastructure projects, many of which have failed to pay an adequate return. Foreign borrowers under China’s Belt and Road Initiative (BRI) have left China’s state-owned banks with still more questionable debt on their books. At the same time, declines in China’s exports and a general economic slowdown have made it hard to cover for the losses.
Along with the turn in the overall China debt outlook, Moody’s also downgraded the outlook for eight state-owned Chinese banks, as well as 22 local governments. Downgrades were also issued for Hong Kong and Macau. Moody’s didn’t, however, downgrade China’s overall credit quality, which it kept at A1, investment grade, four notches below Moody’s top credit rating of Aaa, where it has been since 2017.
This seemingly dramatic gesture has done nothing more than recognize an already difficult reality and the likelihood that the problems will worsen before they improve. Predictably, Beijing has criticized the agency’s move, though in atypically muted language. The Ministry of Finance expressed “disappointment,” describing China’s economy as “resilient.” Its spokespeople have indicated that Beijing has already taken steps to address the debt problems of local governments and is taking additional steps to spur economic growth. On none of these points did the ministry offer many specifics.
Some commentary, although not from the Ministry of Finance, has tried to downplay the severity of China’s debt situation by pointing out that the debts of China’s central government are relatively lighter than those of the United States and Japan. China’s debt, so defined, amounts to 77 percent of the country’s gross domestic product, whereas the U.S. equivalent equals 123 percent and Japan’s is 264 percent.
While all of this is indisputable, it sidesteps the question before Moody’s and any honest analysis of China’s situation. Beijing has kept its debt levels low by forcing local governments to finance infrastructure spending. Besides, the weight on Chinese finance comes from all sorts of debt, of central and local governments, as well as of private borrowers. In this context, it matters not how the debt is classified.
Moody’s made its understanding of this fact clear in the language that it used to accompany the downgrade announcement. The analysts there made no distinctions between public and private debt or which level of government suffered the biggest overhang. They focused on the overall debt burden, much of it connected to projects that will never pay enough to discharge their associated financial obligations.
These analysts could see that the failure of even a portion of this questionable debt would severely limit the ability of Chinese financial institutions—state-owned or private—to support the ongoing investment needed for future economic growth. Especially since China’s exports are shrinking and the economy has slowed, these analysts concluded that matters presented “broad downside risks to China’s fiscal, economic, and institutional strength.”
Nor does Beijing’s retort to Moody’s action give any confidence that China can remedy its problems. The Ministry of Finance’s solution to local government debt problems, for instance, is to reclassify their infrastructure-related debts, the so-called local government financing vehicles. But a reclassification does nothing to relieve the obligation to pay. It just moves it.
The risk of default remains a burden on the financial system. The ministry also discussed efforts to stimulate faster economic growth with stepped-up infrastructure spending. Still, nothing the ministry said explained how that spending would be financed or how the planners would ensure that their projects could return enough to discharge any debt. Such concerns are more than a little reasonable because many recent infrastructure projects have failed to yield an adequate return.
It’s far from an encouraging situation for at least three reasons. First, Moody’s has accurately captured the severity of China’s present debt situation and the threat that it poses to the stability of Chinese finance and the economy’s growth prospects. Second, Beijing has offered a weak response to the reality that Moody’s has highlighted. Third, Beijing’s response leaves little confidence that it has the will to deal with the matter or even understands what it faces.
