Moody’s Investors Service’s downgrade of China on 24 May, the country’s first sovereign rating downgrade from the rating agency since 1989, may force its political leadership to take corrective steps to rein in the huge accumulated debt that has bolstered its economy for some time, as the reformists at the People’s Bank of China (PBOC), the Ministry of Finance and the financial regulatory agencies will use the downgrade as an opportunity to push for their case.
“Following Moody’s downgrade, we expect Chinese policymakers will feel a sense of urgency to intensify financial regulation of the huge shadow banking system, maintain a hawkish monetary policy stance and somehow restore the fiscal discipline that has loosened in the past two years. This policy shift may become more pronounced after the power reshuffle expected at the 19th National Congress of the Communist Party this autumn.,” said Isaac Meng, a senior vice president and emerging markets portfolio manager in the Hong Kong office of PIMCO, in a blog.
Although these reforms have been awaited for long and if ushered in will bring about positive changes in China’s economy from a structural point of view, they will also put an extra strain on its growth rate, financial markets and commodity prices.
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Moody’s downgraded China to A1 from Aa3 but restored its outlook on Asia’s biggest economy to ‘stable’. China’s current rating is buoyed by high domestic savings, locally financed systems and high confidence of the public in the government-controlled financial system. A semi-closed capital account and very low external debt also reduce China’s vulnerability.
However, the market impact of this downgrade was limited and China’s financial markets took less than a day to recover from the rating downgrade.
“China has not issued sovereign external debt for more than a decade, and local currency bonds are not included in the widely tracked global indexes yet, so there was no index-related selling. Bonds from state-owned enterprises and local government financing vehicles (LGFVs) that rely on some form of government support may feel the impact, and those with low investment grade ratings could risk slipping below investment grade,” said Meng in his blog.