Credit Moody's for sounding alarm on China's serious debt problem
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One must applaud the Moody’s rating agency for having had the courage to take on the Chinese government and to downgrade its debt rating. However, had Moody’s failed to do so, it would have run the risk of seriously eroding that agency’s credibility. This is particularly the case considering the mounting problems in the troubled Chinese economy.

The rating agencies can serve a useful function when they act in a proactive rather than reactive manner to a country’s changing economic circumstances. A downgrading of a country’s credit rating can serve as a useful warning to creditors as to the rising risks associated with lending to a country. By discouraging lending to a country, it can also act as a useful warning to a country’s government to take remedial action to put its finances on a more sustainable path.

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Sadly, as a result of the rating agencies’ being paid by the issuers rather than by the borrowers, they all too often are far too slow in adjusting their ratings to keep up with a country’s deteriorating economic and political situation. For this reason, Moody’s recent Chinese downgrading rating decision is to be all the more applauded.

 

Despite the predictable protests by the Chinese government about the alleged unfairness of Moody’s rating decision, there are many reasons to think that Moody’s was right to downgrade Chinese government debt to at least the same level as that of the Japanese government. Among the more compelling of those reasons is the fact that over the past eight years, China has gone on a credit binge of a size that has few parallels in recent memory.

According to IMF estimates, since 2008, Chinese credit to its nongovernment sector has increased by almost 100 percent of GDP as the Chinese authorities aggressively pursued policies to pump up its economy. Particularly worrying is the fact that the size of the resulting credit bubble well exceeds those which preceded the U.S. housing bust in 2007 and Japan’s lost decade in the 1990s.

It also has to be of concern that this credit bubble has financed the building of ghost cities and see-through office spaces around the country and it has also spawned gross excess capacity in many key Chinese industries.

The historical experience with the bursting of credit bubbles, even those very much smaller than that in China, has not been a happy one. Based on that experience, one must expect that for many years to come, Chinese banks will be clogged with non-performing loans while the country will be littered with zombie companies.

As was the case with Japan before it, one must also expect that the bursting of the Chinese credit bubble will place it on a lower economic growth than before. That, in turn, will make it all the more difficult for the country to grow its way out of its debt problem.

Another reason for thinking that Moody’s was right to downgrade its assessment of China’s economic outlook is the serious erosion that has taken place in that country’s external position. In the past, one of the principal factors that had supported the favorable Chinese credit rating was its very strong international reserve position, which at its peak exceeded $4 trillion.

That position has now dramatically weakened as a result of the country having experienced a capital outflow problem that is estimated to have amounted to around $1 trillion over the past 18 months. As a result, Chinese international reserves are now down to around $3 trillion.

It also has to be of concern that the country now has to make the very difficult transition away from the investment and export-led model on which it had relied so heavily over the past 30 years. This would seem to be particularly the case with the recent changing of the guard in Washington and with the adoption of the "America First" policy by the Trump administration.

The more protectionist line being pursued in Washington will be very much less tolerant of China running large trade surpluses or of China using its exchange rate to gain a competitive advantage.

Hopefully, the Moody’s decision will be a useful wake-up call for the Chinese government to start addressing the serious problems associated with its credit market overhang. It might also serve as a wake-up call to the Trump administration to ready itself for a very much less favorable international economic environment in the period ahead than has been the case to date.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.


The views expressed by contributors are their own and not the views of The Hill.