Rating agency Moody's got a stiff rebuke from China’s finance ministry following its sovereign downgrade but the rationale is realistic and measured, writes Brian Caplen.

It is normal for a government to protest when an American rating agency comes out with a downgrade that threatens to unsettle markets. So when Moody’s took China’s sovereign rating down one notch to a still-high Aa3, it drew a swift response from the Chinese authorities.

“Moody’s has overestimated the difficulties faced by China’s economy and underestimated the government’s ability to deepen reforms,” said the finance ministry.

In fact, what the Moody’s report says about China is a moderate version of the general economic consensus – growth will slow to 5% over the next five years, reforms are in the right direction, but progress is slow, and they will not prevent rising debt levels.

Moody’s expects government debt to rise to 45% of GDP by the end of the decade and that total debt (government, households, companies) will continue rising from its current level of 256% of GDP.

“While such debt levels are not uncommon in highly rated countries, they tend to be seen in countries which have much higher per capita incomes, deeper financial markets and stronger institutions than China’s, features which enhance debt-servicing capacity and reduce the risk of contagion in the event of a negative shock,” says the Moody’s report.

The challenge for the Chinese government is that to maintain social stability it must keep the economy growing. At the same time it needs to rebalance growth away from investment and towards consumption and deal with a heap of problems such as overhauling state owned enterprises (SOEs), a fall in the size of the workforce and a rise in the elderly population, as well as a productivity slowdown.

Maintaining economic growth while waiting for the benefits of reform to materialise requires further stimulus. Moody’s argues that with monetary policy constrained by the risk of capital outflows, this stimulus will largely come from the spending efforts of SOEs and policy banks.

Economic history suggests that fiscal and monetary stimulus can be effective in solving short-term problems but often at the cost of building longer term difficulties. If China only suffers one downgrade during this tricky transition period, it will have achieved a miracle. 

Brian Caplen is the editor of The BankerFollow him on Twitter @BrianCaplen

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