E Zhihuan and Ricky Choi: Moody's Rating Decisions Not Reflective of Economic Fundamentals of Mainland China and Hong Kong

2017-06-01 IMI

E Zhihuan, Chief Economist, Bank of China Hong Kong Ricky Choi, Senior Economist, Bank of China Hong Kong We believe that the downgrade on China and Hong Kong’s credit ratings does not fully reflect fundamentals and lacks foresightedness. Therefore, the impact of the downgrade should be fairly limited. A. Moody’s downgrade of China not indicative of fundamentals The rationale given by Moody’s differs from economic reality. Firstly, the main reason given by Moody’s is China’s economic slowdown and rising debt, but that is not an accurate reflection of the trend of China’s economy. In fact, since the second half of last year, China’s economic growth has bottomed. China’s 6.9% growth in the first quarter of this year is among the fastest in the world. The size of the Chinese economy is the second biggest worldwide, and China accounts for one third of global growth. In terms of economic structure, consumption and services are becoming increasingly important. Services now account for 51.6% of China’s economy and have become the main engine and stabilizer of growth. Meanwhile, the contribution of consumption to growth exceeds 60%. Pessimism on China is not justified by stable economic fundamentals. Meanwhile, supply-side reforms are bearing fruit. As the issue of overcapacity is being addressed, producer price index ended 54 months of persistent deflation in September of last year and rose 6.4% in April, 2017. Firming producer prices will help improve corporate earnings and lower indebtedness. Deleveraging and de-stocking will continue to improve the health of the economy. Looking ahead, critical reforms on state-owned enterprises, taxation, finance, and pricing will be deepened, while the belt and road initiative will unleash new momentum and create synergies. These developments are all conducive to stable and robust growth. Secondly, Moody’s debt forecasts are not entirely accurate. According to Moody’s, China’s direct debt burden will rise to about 40% in 2018 and approach 45% in 2020. Yet according to the BIS, China’s overall leverage ratio stands at 255.6%, considerably lower than the 279.2% average of developed economies. In 2016, China’s government debt to GDP ratio was at 36.7%, lower than the 60% requirement of the EU as well as those of most advanced and emerging economies. Moreover, most of the debts are denominated in local currency. While foreign debt amounts to 1.4 trillion dollars, it was lower than half of China’s foreign reserves. Furthermore, as only 34% of China’s foreign debt was denominated in foreign currencies, risks are manageable. As for fiscal conditions, even as China continues to implement proactive fiscal policies by increasing investment and lowering taxes, its fiscal deficit to GDP ratio was only 3%, substantially less than the height of 10% reached by the U.S. in the aftermath of the financial crisis. Meanwhile, government income is rising at a similar pace with economic activity and gained 11.8% in the first four months of this year compared to the same period of last year for a year-over-year acceleration of 3.2 percentage points, the strongest growth in the same period since 2013. Healthy fiscal conditions are instrumental to economic stabilization and restructuring. Moreover, China’s high savings rate and massive foreign reserves provide an important defense against debt risks. As China’s economy stabilizes, concerns about an economic slowdown and RMB depreciation have notably eased, mitigating capital outflows. As of April, 2017, China’s foreign reserves had been rising for three consecutive months and reached $3.03 trillion, far larger than second-placed Japan’s $1.2 trillion. Given China’s stable economic fundamentals, prudent monetary policy, and the RMB SDR status, foreign reserves will remain at adequate levels, which, along with sizable current account surpluses, will offset the impact of capital outflows. Therefore, we agree with the judgment of Ministry of Finance that Moody’s overestimated China’s economic challenges and underestimated the effectiveness of supply-side reforms. Major debt indicators are unlikely to change materially in 2018—2020, supporting China’s sovereign creditworthiness. B. Lack of foresight in downgrading Hong Kong’s credit rating Moody’s action in downgrading Hong Kong’s credit rating does not reflect the actual condition of Hong Kong, while it exposed some weaknesses of its rating methodology. Firstly, the Hong Kong economy is now on a cyclical upturn. Over the past few years, Hong Kong economic growth remained modest, largely because of the subdued economic growth and elevated political uncertainties globally. However, Hong Kong economy has been recovering since 2H 2016, with its Q1 2017 GDP growth accelerated to 4.3% over the previous year, the highest level in 6 years. Meanwhile, the labor market also reaches full employment level, with unemployment rate hovered between 3.1% and 3.5% since mid-2011. Even though there were comments that the household debt to GDP ratio is increasing in Hong Kong, the debt servicing ratio of mortgage loans are under control after eight rounds of prudential measures for mortgage loans. The debt servicing ratio of new mortgages approved was just 34% in March 2017, indicating the financial condition of Hong Kong households remains healthy. Secondly, the fiscal condition of Hong Kong government remains solid, holding one of the largest fiscal reserves in the world. Hong Kong government has long maintained the principle of keeping its expenditure within the limits of revenues in drawing up its budget. Over the past two decades, Hong Kong government recorded 14 years of fiscal surpluses, and 6 years of deficits. The fiscal reserve of Hong Kong then increased from HK$ 370 billion in mid-1997 to over HK$ 950 billion in March 2017, equivalent to 38% of GDP and up 8 percentage points since 1997. Thirdly, the institutional strength of Hong Kong is widely recognized globally. Hong Kong’s steadfast commitment in safeguarding the free market principles, favorable business environment, free trade, simple and low tax regime, the rule of law and independent judiciary, is widely affirmed globally. For example, the Heritage Foundation ranked Hong Kong as the world's freest economy for the 23^rdconsecutive year. The International Institute for Management Development World Competitiveness Yearbook 2016 also ranked Hong Kong as the world's most competitive economy, moving up from second place in 2015. The institutional strength forms the foundation of Hong Kong’s long-term economic prosperity. Fourthly, Hong Kong benefits from the rising economic and trade interconnection with the Mainland. Based on the International Monetary Fund’s statistics, Hong Kong’s nominal GDP recorded US$320.7 billion in 2016, ranking 33^rd in the world. Its GDP per capita even hit US$43,700, ranking 15^th in the world, similar to or even better than many advanced economies. High GDP per capita is the result of decades of successful economic development. This also shows the economy has a strong ability to withstand shock and provides stronger fiscal support to the government when it becomes necessary. Indeed, the financial sector and economy of Hong Kong also increasingly benefits from the opening and reform of the Mainland economy. For example, Mainland-based companies raised HK$181.3 billion IPO funding in Hong Kong last year, making Hong Kong the largest IPO centre in the world. Also, the number of Mainland-based companies listed in Hong Kong increased from 101 in 1997 to 1,002 in 2016, boosting the capitalization of Hong Kong stock markets to HK$24.8 trillion. Meanwhile, Hong Kong also develops into the largest offshore RMB centre in the world. Against this background, the financial sector of Hong Kong recorded remarkable growth, with its economic value-added and employment increased to HK$409.9 billion and 246,000 in 2015 respectively, up 150% and 45% since 2000. Going forward, the Hong Kong economy will continue to benefit from the belt and road initiative, Guangdong-Hong Kong-Macau Bay Area development, as well as the increasing interconnection between the capital markets of the Mainland and Hong Kong. C. Market reaction didn’t support the Moody’s views After the Moody’s downgrade, the Mainland and Hong Kong’s equity markets both increased slightly on that day and rose further in the day after. The 10-year yield of the Mainland government bonds even decreased around 2 bps after the downgrade to 3.63%, while the 10-year Hong Kong government bond yield remained largely steady at around 1.24%, indicating that the market did not take the rating agency’s views seriously. All in all, the Mainland economy is now stabilizing and also making some progress on economic restructuring. The economic upgrading can help offset some negative impacts from economic slowdown. On the other hand, Hong Kong is already one of the highly developed economies in the world. With its strong ability to withstand shock, it deserves a higher credit rating.

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E Zhihuan and Ricky Choi: Moody's Rating Decisions Not Reflective of Economic Fundamentals of Mainland China and Hong Kong

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