China has been issued another yellow card. In a report released last week, S&P Global Ratings warned that China is at risk of losing its AA-status if it doesn’t rein in its debt-fueled economic growth.
“Credit growth in China continues to outpace income growth, and much new lending appears to be financing public investment,” S&P analysts Kim Eng Tan and Xin Liu wrote. “Consequently, we see support for the Chinese sovereign ratings gradually diminishing.”
A downgrade would be the latest blow to the world’s second-largest economy, whose outlook was slashed to negative from stable by the ratings agency in March. At the time, S&P cited the country’s slower-than-expected economic rebalancing and the growing financial risks.
In the latest report, Tan and Liu found China’s “reliance on public investment to fuel economic growth to be unsustainable and a credit weakness” with little sign of the trend abating in the near future.
High volatility in the country’s stock markets and foreign exchange rates since last year, means that the Chinese government has kept the economy afloat by injecting borrowed money into public projects. This in turn resulted in a yawning gap between public and private investment this year.
“Without this boost, it’s unlikely that the economy would have been able to keep growth at above 6.5 percent in the first half of 2016,” added the analysts.
While low and stable funding costs have kept the problem somewhat contained, the pace of credit expansion is increasingly tying the hands of Beijing’s policy makers, they said.
The rapidly growing debt pile lowers savings rates in a country that boasts an extraordinarily high tendency to hoard money. When its aging population is taken into account, its debt-to-income ratio will rise even more rapidly, according to the analysts. This will further weaken the cushion provided by the large pool of domestic savings.
“If China continues to rely on credit-driven investments as a key source of economic growth, confidence in Chinese growth prospects may diminish” said Tan and Liu. “This could trigger another surge in outflows of domestic savings that would increase the risk to interest rate stability.”
In order to avoid a downgrade in its sovereign rating, the analysts suggest China rein in credit creation in line with income growth in a swift manner.
“The longer the government takes to bring lending growth in line with income growth, the greater the pressure on the sovereign ratings,” they concluded.