03 Aug China’s Downgrade By Moody’s Reveals The Flaw In Its Rating Model
On July 28, the IMF’s 2017 External Sector Report reported China’s economy is on a steady course for the fourth year in a row. While the report pointed out China’s need for fiscal and credit tightening over the next few years, it declared China’s real exchange rate broadly in line with fundamentals and reported a current account surplus narrowing, which is a sign of improving structural balance.
To put this point in perspective, Germany and China have the highest current account surpluses in the world. In 2016, Germany’s surplus was $289 billion vs. China’s $196.4 billion — 0.4% and 0.3% of global GDP, respectively. But Germany’s surplus was 8.3% the value of its GDP. China’s surplus was only 1.7% of its GDP. Leaving aside the question of capital quality for the moment, these two trends would indicate that Germany is in bigger trouble than China.
Yet, on May 24, Moody’s Investors Service downgraded China’s long-term ratings by one notch, from Aa3 to A1, and changed its rating outlook from “negative” to “stable.” China’s first downgrade by Moody’s in three decades attracted a lot of initial attention. Meanwhile, Germany is still at Aaa.
Was the downgrade a meaningful economic signal, or noise?
The flaw in the ratings system
China has actively used its sovereign balance sheet to transform, scale and modernize its domestic economy to great purpose, with remarkable results. Moody’s main justification for its downgrade was that going forward China will require increasing levels of debt to extend its economic miracle, and reliance on government stimulus will grow, raising the its direct burden to 40% of GDP by next year.
But Moody’s ratings are not built to evaluate China fairly. They are the product of a static, backward looking mindset that comprehends size but not dynamics or policy objectives.
Two incidents loom large in Moody’s rating history where China, moving at breakneck speed, swerved and a downgrade followed. Not right away, but after a calculated delay to prevent association with the causes of market turbulence. Just a year after Moody’s assigned an A3 rating to China, it was downgraded to Baa1. With hindsight the A3 may have been overly liberal. Severe regional credit market strains and local labor unrest had surfaced in the Chinese language press, eventually morphing into the international headline-breaking unrest in the spring of 1989.
A shifting paradigm
May’s downgrade is a delayed response to elevated financial volatility that began in spring 2015. Moody’s forecast of eroded financial strength, a cooling economy, further credit expansion and more government debt, extrapolates from the recent past; but this is just one scenario.
A forward-looking view would consider not only risks but also dividends from One Belt, One Road, an expansion of ancient trading routes linking China to Europe, and from decades of investment and planning inside China’s borders. It would also factor in China’s seriousness about tightening credit and rolling back protectionism beginning this year.
To this point, William J. Norris, an expert on the role of economics in China’s statecraft, published a paper in June 2017 detailing how the Credit Crisis triggered an abrupt shift in China’s economic strategy away from export-oriented growth, towards greater economic self-sufficiency and isolation. Dr. Norris points to China’s herculean efforts to build “a new regional institutional economic architecture centered [on] itself over the next decade or two.” As a result, his economic forecasts are more agnostic than Moody’s, which ignore the shifting paradigm. But he warns that the failure to recognize this economic reorientation creates dangerous security blind spots in the West.
Note the severity of the downgrade
China is not the only large sovereign to have experienced a one-notch downgrade by Moody’s in recent memory. France was dropped from its 40-year Aaa pinnacle in just three years, to Aa1 in 2012 and Aa2 in 2015, where it remains today. Canada’s rating was lowered from Aaa twice in two decades, from 1975 to 1995; and then Moody’s reversed itself in two steps, in 2000 and again in 2002.
If anything, China’s rating history by Moody’s has been remarkably optimistic. Except for the interlude right after June 4, 1989, the rating was stable at A3 from 1988 until 2003. Between 2003 and 2010, it departed “medium grade” range and shot up three notches, from A3 to Aa3, where it stayed until this May.
So to me, what is newsworthy about the downgrade is not the frequency but the severity. China has been dropped just below the league of Aa-rated nations. Considering all that China has done since 2003 to reform its financial system, build up its economy and move from an export-oriented to a consumer economy, the downgrade at this juncture seems punitive.
-Ann Rutledge, CSC