Moody’s China’s downgrade: A potential domino effect on credit?

HONG KONG – Almost 15 months after placing China on negative outlook, Moody’s Investors Service today downgraded China’s sovereign rating to A1 from Aa3. Moody’s says the outlook is stable. Despite China posting better than expected GDP growth in Q1, Moody’s decision to downgrade stems from their expectation that China’s debt will continue to rise while potential growth slows, eroding the country’s credit metrics. Moody’s does not see the Government’s reforms as fully offsetting the rise in economic and financial risk.

ANZ Bank says that, from a macro perspective, downgrade by rating agencies could potentially erode the financial soundness of China, creating the risk of a negative feedback loop.
“The downgrade will likely lift the cost of financing of Chinese issuers, especially in the offshore market. They will likely turn on onshore financing platforms, including banks, shadow banks and onshore bond markets as these channels do pay less attention to rating actions of international agencies, ANZ says.
“As the loan exposure of the domestic monetary system to local borrowers heightens, the central bank will be cautious in policy tightening in the future, extending the lingering debt concerns further.”
On the CNY bond market, ANZ says it sees only a marginal negative influence as the market is dominated by local investors who are not sensitive to international credit ratings. In addition, around 90% of the foreign holdings of China Government Bonds and Policy Bank Financial Bonds are held by central banks and sovereign wealth funds, which are long-term buy-and-hold investors.
“However, bonds issued outside China, especially those issued in foreign currencies, will see a negative impact from the downgrade. Demand for the upcoming bond connect scheme will be affected, as will efforts by the authorities to attract capital inflows,” ANZ says.
“On the FX front, the authorities have been setting the daily yuan fixings stronger in an attempt to ward off outflow pressures. But the onshore CNY spot rate has been consistently trading weaker than the fix, a sign that dollar demand onshore remains strong.
“Today’s much stronger than expected fixing (0.2% stronger than yesterday’s spot closing level even though the dollar was up 0.2% against the basket currencies) is likely an attempt to contain the FX impact from the downgrade. But while capital outflows have been well contained in Q1 this year, there has been a pick-up in April and we expect to see onshore dollar demand rise.
“The authorities will have to revert to FX intervention if they want to bridge the gap between the spot and fix, as merely setting stronger fixings by itself is unlikely to have much effect.”
ANZ says the impact of today’s downgrade will also dent sentiment in the region well. “We could see some unwinding of the strong inflows that have driven the rally in Asian currencies.
“KRW and TWD are the most susceptible to any equity outflow pressures. INR, which has benefitted from very strong foreign inflows since the March, is also at risk of a positioning unwind. While IDR will not be totally immune, last week’s S&P upgrade of Indonesia’s sovereign rating to investment grade status mean it should be more insulated than the rest.”
ANZ says today’s Moody’s downgrade puts its A1 rating for China equivalent to Fitch’s A+ rating. However, S&P has China one notch higher on AA- with a negative outlook since 31 March 2016. Another downgrade event is possible.

Natixis says China’s domestic markets have hardly reacted to the downgrade (at least after the necessary government intervention), “we think this is indeed a relevant event for China credit and it will be even more so if a second international rating agency follows Moody’s”.
 
“The impact on China’s domestic markets will be limited, except for further discouraging foreign investors into the market,” Natixis says.

“Still, the downgrade does not bode well for a surge in portfolio inflows through the recently announced Bond Connect with Hong Kong. Switching to the offshore market, the downgrade also may put some breaks on the rapid increase in offshore issuance by Chinese corporates this year

“We do expect higher funding costs in the offshore market, especially for higher-leveraged corporates. This is because Moody’s key reasoning for the sovereign downgrade is indeed the rapid accumulation of debt. We also expect more reaction for smaller banks exposed to the offshore market than the larger ones.”  www.live.anz.com www.natixis.com (ATI).