Earlier in the week, rating agency Moody’s downgraded China’s sovereign rating by one notch from “AA3 to A1”. This is the first time that the sovereign rating of China has been downgraded in the last 3 decades. The last time the rating of China was downgraded was back in 1989 in the immediate aftermath of the Tiananmen Square massacre. The Chinese government back then had rolled heavy tanks over a student protest in Tiananmen Square in Beijing leading to the death of over 10,000 students. However, things changed drastically after that!
In the early 1990s, the Chinese economy embarked upon a massive program to emerge as the manufacturing capital of the world on the back of world class infrastructure, favourable government policies and cheap labour. That was largely achieved over the next 20 years with most of the large corporations relying on China to manufacture everything from pins to aircraft parts. The shift resulted in China consistently growing at over 9% for many years in succession. However, this growth came at a cost. There was a tremendous expansion in capacity and infrastructure and these had few takers after the financial crisis of 2008. Secondly, the spurt in incomes led to a consumption boom in China and easy credit also ensured that leverage of households went up sharply. It was this problem of rising debt levels and faltering growth that led to a downgrade by Moody’s
A curious case of rising debt and faltering GDP…
When the Chinese economy went for a massive expansion of capacity post the financial crisis of 2008, they did not bargain for a sharp slowdown in demand. The crisis in the US and the subsequent crisis in Europe in 2010 led to an all-round slowdown in most developed and emerging markets. World demand and world trade shrank and there was just not enough demand for the kind of capacity that China had created. The chart below captures the faltering GDP growth of China since 2010.
As the chart above indicates, there has been a consistent fall in growth over the last 6 years and at 6.9% in 2016, China’s GDP is nearly 70 basis points below that of India.
The second big worry for the rating agencies is the expansion in household debt in China. The problem with China is that it has a huge shadow banking industry which operates outside the ambit of banking regulation. That is an added risk for the Chinese economy as it is not properly regulated. These shadow banks have largely funded the spurt in consumption and that is not great news as the Chinese government has already started cracking down on these shadow banks and tightening the economic screws to keep a check on consumption.
Data Source: Trading Economics
As the chart above indicates, the household debt has gone up sharply in the last 3 years. To put things in perspective, the levels of household debt were at a low of 11% in 2006 and have gone up manifold from these levels. The problem becomes more complex when you consider that most of this increase in debt is financed by shadow banks.
Will the downgrade impact China and other Emerging Markets?
While the downgrade may not have any direct impact on India, there may be larger effects which may rub off on India too…
- Normally, the immediate impact of any ratings downgrade is seen in the debt markets. But in China’s case, global investors constitute just about 4% of the total debt market. The remaining 96% of the debt is held by domestic Chinese individuals and institutions. For them, the global ratings do not really matter. Hence Chinese debt markets are unlikely to be impacted by this rating downgrade.
- The Chinese Yuan is likely to be impacted by the downgrade. The immediate reaction has been muted partially because the Chinese Yuan is still on a managed float. The Chinese central bank (PBOC) manages the Yuan in a range on the strength of its vast forex reserves to the tune of $3.2 trillion. However, if the pressure gets a little too intense, the People’s Bank of China (PBOC) may be inclined to let the Yuan weaken.
- The immediate impact of the Yuan devaluation will be on those economies that depend on China to buy their commodities. Countries like Australia, Canada, Indonesia, central Africa and Latin America will all fall in this category. These countries could see their currencies getting weaker.
- The impact on India could be more muted but as we noticed in 2015, the INR has tended to depreciate in tandem with the Yuan, more because it makes the US dollar stronger. The INR may see weakness if the Yuan devalues from current levels.
- There could also be an impact for India on the capital flows front. The downgrade of China will lead to FPI flows turning risk-off with respect to emerging markets. The risk-off approach of FPIs coupled with weakness in the rupee may put pressure on the markets. However, the overall impact may be marginal for two reasons. Firstly, the Indian economy is not overly dependent on the Chinese economy. Secondly, domestic MF flows are robust enough to compensate for the FPI outflows.
In a nutshell, Chinese downgrade may result in a weaker Yuan and eventually have a rub-off impact on other emerging markets. The impact on India, however, may not really much to worry about.