Chinese stocks tumbled to a seven-month low Wednesday, after a shock credit rating downgrade by Moody’s Investors Service. But the long-term outlook appears brighter, with analysts pointing to the world’s second-largest economy grabbing a greater share of global investment.
On May 24, U.S. credit-ratings agency Moody’s downgraded China’s long-term local currency and foreign currency issuer ratings to A1 from Aa3, similar to the rating for Japan, although it changed its outlook to stable from negative.
“The downgrade reflects Moody’s expectation that China’s financial strength will erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows,” Moody’s said.
“While ongoing progress on reforms is likely to transform the economy and financial system over time, it is not likely to prevent a further material rise in economy-wide debt, and the consequent increase in contingent liabilities for the government.”
Moody’s pointed to China’s growth slowdown, from a peak of 10.6 percent growth in gross domestic product (GDP) in 2010 to 6.7 percent last year. It said growth potential would decline to around 5 percent over the next five years, due to slowing capital stock formation, a declining working age population, and a continuing productivity slowdown.
As a consequence, Moody’s sees the government’s direct debt burden reaching 40 percent of GDP by 2018 and nearly 45 percent by 2020. Total debt of government, households, and non-financial corporates is expected to rise from the 256 percent of GDP reached at the end of 2016, which has climbed from 160 percent of GDP in 2008.
China’s Finance Ministry rejected Moody’s decision, saying it “underestimates the government’s capability to deepen reform and expand overall demand.”
Yet financial markets reacted negatively to Moody’s first Chinese downgrade since 1989, with Chinese stocks initially dropping by 1.3 percent. However, the benchmark Shanghai composite index rebounded in later trading, finishing Wednesday up 0.1 percent, with the Chinese yuan and bonds both holding steady.
“It seems that regulators do not want the Shanghai benchmark to fall below 3,000, so when the index is close to that level, they start buying for stability,” Castor Pang, strategist at Core-Pacific Yamaichi HK, told Bloomberg News.
The Shanghai bourse finished Friday at 3,110, showing only a marginal 0.2 percent gain for 2017. This compared to Hong Kong’s 16.5 percent rise, the 16.2 percent gain for South Korean equities, Singapore’s 11.8 percent increase, and the nearly 3 percent gain for Tokyo stocks.
Chinese stocks have also suffered the fallout of a crackdown by regulators on everything from excessive borrowing to equities speculation that has hit both equity and bond markets.
Yields on 10-year Chinese government debt have reached their highest level since August 2015 amid the crackdown, which has included tougher controls on capital outflows and measures to support the exchange rate and prevent “panic sentiment.”
According to a Bank of America Merrill Lynch survey, nearly a third of fund managers have described Beijing’s recent credit tightening as “the biggest tail risk for markets,” ranking above the threat of a Eurozone break-up.
“Given the pace and level of credit creation in China, it is only a question of time, perhaps no more than two to three years, before it will endure some form of deleveraging, which is likely to presage a protracted period of low growth and currency depreciation,” George Magnus, an associate at Oxford University’s China Center, told the Financial Times.
Magnus sees China’s shadow banking sector as a ticking time bomb, with a potential bust between six months and two years away.
According to a Reuters survey, China’s economy is seen slowing further, down from last year’s 6.7 percent GDP growth to 6.5 percent this year and 6.2 percent in 2018, continuing its weakest performance in 26 years amid tighter credit.
However, longer-term factors are more positive for Chinese stock investors. On June 20, the MSCI is expect to announce its key decision on the inclusion of mainland shares in its emerging market indices, which if positive could see a surge in global institutional investment.
While MSCI chief executive Henry Fernandez has said “there’s still a lot of issues to resolve” ahead of the decision, he also noted a commitment by the authorities to addressing them.
“We continue to be very committed to the process and we believe that the Chinese authorities, based on every discussion we have had, continue to be very committed to the pace of reform,” Fernandez told Bloomberg News. “It’s just that at times it’s faster and at times it’s slower.”
Inclusion in the MSCI indices is expected to raise the global profile of the $6.5 trillion mainland market, drawing in more of the around $2 trillion invested globally in emerging market equities.
Currently 169 mainland-listed Chinese companies are targeted for inclusion, with all comprising large-capitalization stocks accessible to foreign investors via the market connect links with Hong Kong.
“If it happens, when it happens, it sets the stage for future steps,” Fernandez said.
Robert Mann, senior portfolio manager at Nikko Asset Management, told Pacific Money that the Chinese authorities aim to “make it easier for foreigners to invest in Chinese bonds and equities” to balance outflows from China, such as through the MSCI push and the establishment of the Shanghai and Shenzhen connect linkages with the Hong Kong bourse.
“They want more foreign money in China, and when that happens they can let more Chinese money go overseas to balance it up. They recognize that the imbalance is caused by not enough foreign investment in China,” he said.
Mann said the Tokyo-based asset manager remained “overweight” toward China due to its confidence in the outlook.
“What’s interesting is a year ago, the Chinese were more confident in the Chinese market than the foreigners. That’s changed a bit at the moment, with the Chinese more aware of these regulatory approaches inside China than foreign investors, who are looking at published GDP data, which is backward-looking,” he said.
“But the companies we look at are the private sector companies… an interesting statistic is the three big U.S. internet companies Amazon, Facebook, and Google versus China’s big three of Baidu, Alibaba, and Tencent. China has four times the U.S. population, the Chinese market is closed to foreigners and the U.S. market is open, and yet the market capitalization of the big three Chinese stocks is only 40 percent of the big three U.S. companies,” he said.
“GDP per head in the U.S. is higher and U.S. GDP overall is higher, but China has more scope for growth and catching up, and the Chinese internet companies are pretty inventive.”
Mann also pointed to the continued rise of China’s middle class and its effects on consumption, with benefits expected for Chinese consumer, healthcare, and tourism companies.
“It’s middle-class consumption, whether it’s holidays in Australia and education for the kids, rather than old-fashioned [demand] for coal and iron ore… in the long term it’s all about services,” he said.
However, he also pointed to the emergence of Asia’s next big growth market and its importance for investors.
“In the long-term context you want to invest where the growth is. The story of the past 10 to 15 years has been China’s emergence… what’s positive for the next 15 years is India, which is remarkably like where China was 15 years ago,” he said.
“On a 10-year view we’re excited about the changes in India, and on a one-year view we’re very happy with China.”