Will China's Downgrade Cause Investors to Race for the Exits Yet Again?

 | May 24, 2017 | 9:00 AM EDT
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The markets are bipolar when it comes to China. Either everything is great in the Middle Kingdom and everyone wants to get into the still-closed economy -- or it's all going horribly wrong, and where are the emergency exits?!

Are we heading for the fire door now? Moody's has just downgraded China's debt, the first such move in three decades from the rating agency. 

Moody's dropped China from Aa3 to A1, its first cut in its rating since 1989. China has modernized at such an electric pace since then that it might as well have been a different nation. There was a bit of carrot with the stick: Moody's also upgraded its outlook on the nation from negative to stable.

There's one word to blame for the downgrade: debt. That is rising economy-wide, Moody's says, at the same time growth is slowing. It all means that "China's financial strength will erode somewhat over the coming years." And much-needed reforms aren't happening fast enough to prevent it.

The immediate fallout of the downgrade in practical terms should be limited. Less than 20% of China's debt is external, and total government debt amounts to only 40% of annual gross domestic product -- more than manageable by Western standards.

The benchmark CSI 300 index, tracked by the likes of the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR) , fell 1.2% right after the downgrade, but rallied to close flat. The Chinese yuan weakened negligibly after Moody's made its move, and is down 0.1% this week to C¥6.9 to the U.S. dollar. 

Watch, however, for higher costs of funding at the companies that borrow offshore extensively. They come in two principal industries: property development and banking.

There's no doubt that the move is a slap in the face for the boys in Beijing. It demonstrates a lack of confidence in the People's Bank of China's efforts to trim back debt. And longer term, it also demonstrates doubts about how committed or successful China's leadership will be in taking on the structural reform of its bloated state-owned sector that is so badly needed.

Moody's cited ongoing progress on reforms that are likely "to transform the economy and financial system over time," but they will likely stall, not prevent, higher leverage. The slow going "is not likely to prevent a further material rise in economy-wide debt," raising liability risk for the government, too.

Those heading for the exits are almost inevitably doing so too soon. The outlook is now stable, Moody's says, because "risks are balanced." The strengths of China's credit profile should allow it to stay resilient in face of nasty surprises, Moody's effectively says, with deepening reforms ultimately able to correct the deteriorating credit profile.

Still, there's growing skepticism among investors that there's true commitment to the structural reform cause. It will also likely require stimulus from the central government to keep growth on track given the structural problems holding back growth.

That much has become clear in meetings with investors this year, CLSA equity strategist Chris Wood said in his Greed & Fear newsletter, put out just after his Asia-focused brokerage's recent China forum in Tianjin. 

Are we about to see the friendly Dr. Jekyll face of China players turn into nasty Mr. Hyde again? Wood "cannot dismiss out of hand the risk of another dramatic mood swing in investor sentiment towards China."

At the start of 2016, the mood was overwhelmingly negative towards China and China plays. Now it's all sun and roses. That's precisely why Wood sees a risk, albeit not his base case, of the dark clouds suddenly coming in. There's a dual tightening under way that risks overkill in the government's efforts to cool the feverish property market and stamp down on "shadow banking."

There's little need for reforms in the vast state-owned segment when life is good. Despite overproduction in heavy industry that is depressing prices globally, "it is hard to push through capacity cuts when, say, steel mills are making money," Wood notes. And 80% of China's steel mills were making money in the first three months of the year, he reckons.

The pressure may now mount again. The ratio of profitable steel mills has fallen to 50% in the second quarter, Wood says, "which creates the required pressure to accelerate supply-side reform." The National Development and Reform Commission has targeted closing down 50 million tons of steel production in 2017, after cutting 65 million tons last year.

The central government is also sending out investigators to 15 Chinese provinces to check whether required anti-pollution measures have been properly put in place. Local government officials are on the line.

That's the only way in a nation that coined the phrase "The mountains are high, and the emperor is far away." Rules are often excellent in China -- it has some of the toughest labor laws and pollution controls in the world -- but enforcement is lax and expensive, and cheating rampant.

Coal is a sector that has already seen substantial consolidation. The four largest companies in northern China now control 70% of production, up from 50% as recently as 2015, CLSA figures. Fixed-asset investment in coal is down by half since 2012, and more than one-third for steel. Aluminum is likely the next industry to come under the cosh, which encourages some investors to look at companies such as Chalco, full name the Aluminum Corporation of China (ACH) , the largest producer in the country. 

But the industries with obvious overproduction are only part of the problem, and a small one at that. There's plenty of overinvestment in other industries that aren't necessarily churning out too much stuff. What's more, outside ownership of state-owned enterprise - so-called "mixed ownership"- is only in its infancy, introduced at only a few dozen SOEs.

Moody's thinks that the reform effort will not "have sufficient impact, sufficiently quickly," to contain worsening credit at Chinese companies. The "key measures introduced to date will have a limited impact on productivity and the efficiency with which capital is allocated over the foreseeable future."

Growth has fallen from a peak of 10.6% in 2010 to 6.7% last year. Moody's foresees the rate falling close to 5% over the next five years, with capital investment less and less important in an increasingly service-driven economy, the working age rising, and additional slowdown in productivity likely.

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