Warning shot: China put on notice as it tries to fix its economic mess

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China’s authorities shouldn’t have been surprised by Moody’s Investor Services’ decision to downgrade the outlook for its sovereign bonds. They are acutely aware of the challenges within their financial system.

It was concern about the unintended consequences of a long property development and infrastructure boom – a boom ignited by Beijing’s response to the 2008 financial crisis – that caused Xi Jinping to crack down on leverage in the development sector in 2020 that, unwittingly, plunged the developers into a crisis that has also enveloped the local government and trust sectors.

Xi Jinping has been bringing China’s tech entrepreneurs into line.Credit: Getty

Despite escalating efforts to stabilise the developers and local governments, the property sector continues to shrink, most of the major developers are on life support, local governments and their financing vehicles are being bailed out by Beijing and its state-owned banks and, in an indication of the stresses within the $4.5 trillion trust sector, one of the largest of China’s shadow banks, Zhongzhi, recently declared itself “severely insolvent.”

Moody’s, in cutting the outlook for China’s sovereign debt from stable to negative, cited “rising evidence that financial support will be provided by the government and wider public sector to financially-stressed regional and local governments and state-owned enterprises, posing broad risks to China’s fiscal, economic and institutional strength.”

It didn’t, however, change the rating of the bonds, leaving it at A1, or at the upper end of its investment grades.

China’s central government debt is relatively modest by international standards – it’s the debt at regional and local government level and within the property and shadow banking sectors that pose risks to financial stability.

At the centre of the challenges facing the authorities is the property sector, where are vast numbers of homes financed by the pre-sales model Chinese developers used are either incomplete or where construction has yet to commence.

Local governments rely on property sales for much of their income, while the trusts and local governments’ off-balance-sheet financing vehicles have financed and invested in the developments.

China, naturally, expressed disappointment with Moody’s action, saying its concerns were unnecessary and that, despite a “complex and harsh” international environment, the economy had continued to recover and was advancing steadily.

China is on track to achieve its official target of GDP growth of around 5 per cent this year, albeit from a base depressed by last year’s “zero COVID” response to the pandemic, with its widespread, severe and protracted lockdowns.

China’s property wreckage is a puzzle that Beijing is struggling to solve.Credit: Bloomberg

It has also left in place its objective of doubling the size of the economy, relative to 2020, by 2035. That would require annual growth rates of around, or perhaps slightly above, five per cent every for the next 12 years.

Moody’s, however, referred to the increased risks of structurally and persistently lower medium-term economic growth and the continued downsizing of the property sector as factors in its downgrading decision.

Home sales continue to fall, activity within a manufacturing sector suffering from over-capacity continues to shrink (despite efforts to stimulate manufacturing), youth unemployment is at levels so disconcerting that the authorities have stopped publishing the unemployment rate and the hoped-for shift in the economy towards increased consumption is yet to develop any momentum.

Moody’s queried the effectiveness of some of Beijing’s policy responses to the challenges.

So far, the authorities have moved cautiously, anxious to avoid the unintended adverse consequences that might occur from a large-scale and broad stimulus program.

They are helping, directly and via the state-owned banks, local governments refinance their debts, extend the terms of loans, lower their interest costs and bring their off-balance-sheet liabilities onto their own balance sheets to create greater transparency and discipline.

Beijing is also thought to have drawn up a list of about 50 major developers that will receive unsecured finance – an injection of short-term liquidity – from state-owned banks in an attempt to keep the better-managed developers afloat and enable them to complete their projects and help stabilise the sector, albeit at much-diminished levels.

It has also earmarked spending on urban redevelopment – the renovation of “urban villages” in its big cities – as a mechanism for ensuring property-related activity that will generate some level of support for the stronger developers.

Youth unemployment in China is at levels so disconcerting that the authorities have stopped publishing the unemployment rate.Credit: Reuters

Fortuitously, China’s banks haven’t had significant exposures to the big developers, which have relied on pre-sales and the issuance of bonds to foreign investors for most of their funding. Foreign investors have seen the value of their bonds decimated.

Moody’s downgrading isn’t as much an alarm bell as it is a warning signal.

China’s economy faces some complex structural challenges, both internal and, given the increased tensions between China and the West, external.

The authorities, however, are very aware of them and have the benefit of low central government debt, the fact that the economy is still growing at a respectable rate and the authoritarian nature of the state to respond to them.

There is a sense that the messy, inter-connected, finances of the property, regional and local governments and trust sector are rapidly reaching the point where they could threaten the country’s financial stability and cause contagion and problems for the banking sector.

Nevertheless, there is a sense that the messy, interconnected, finances of the property, regional and local governments and trust sector are rapidly reaching the point where they could threaten the country’s financial stability and cause contagion and problems for the banking sector.

So far, Beijing’s responses have been piecemeal and incremental, more band-aids than solutions, although bringing the hidden debts of local governments into the open is a necessary prerequisite for any structural reforms even if that forces local government spending to shrink and weighs on economic activity.

Similarly, while its response was crude and ultimately destructive, it did need to do something about the speculation-driven property bubble, although it really needed it to deflate slowly rather than burst. Now it needs to contain the damage while salvaging some more sustainable from the wreckage.

China’s policymakers will meet before the end of the year at their annual Central Economic Work Conference, at which the national economic and financial agenda for next year (an agenda developed by the Politburo) will be discussed and set.

The outcome of that conference could provide an insight into how decisively the authorities will respond to the challenge of a now-discredited economic model that isn’t evolving as quickly as the authorities want and need it to, while trying to cope with the destabilising legacies of China’s past economic and financial strategies.

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