Moody’s Cuts China Down To Size

Moody’s has downgraded China’s sovereign debt rating for the first time since 1989, as the Long March toward a Chinese meltdown continues. The Wall Street Journal has more:

In a Wednesday statement, Moody’s said it downgraded China’s rating to A1 from Aa3, while changing its outlook to stable from negative. In March of last year, it cut China’s outlook to negative from stable. […]

The news triggered an early selloff in Chinese stocks, with shares in Shanghai falling more than 1% before recovering, in addition to modest losses for the Chinese currency in the freely traded offshore market. […]

“The downgrade reflects Moody’s expectation that China’s financial strength will erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows,” Moody’s said in the statement.

“While ongoing progress on reforms is likely to transform the economy and financial system over time, it is not likely to prevent a further material rise in economy-wide debt, and the consequent increase in contingent liabilities for the government,” it added.

The Chinese Finance Ministry, sure enough, is disputing the Moody’s verdict, and China’s tightly insulated domestic markets have shrugged off the demotion. But the rating is just another confirmation of what foreign investors have slowly been realizing: China’s debt-fueled growth model is unsustainable in the long run, and Beijing is seeing diminishing returns from its credit binge.

The WSJ analysis picks up on all the usual signs of stress: not just China’s rapidly rising debt load and expanding asset bubbles, but the increasingly heavy-handed measures that Beijing has been taking to crack down on systemic risk in the economy. From sudden interest rate hikes to heightened regulatory scrutiny over shadow banking, the central bank has been leading an aggressive campaign of fiscal tightening in recent months. But none of these short-term measures have altered analysts’ expectations that serious economic reform has stalled, and that all of China’s underlying problems—from the excess capacity in its industrial sector to its current bout of capital flight—are here to stay.

As always, it is a fool’s errand to predict an imminent collapse of the Chinese economy; Beijing’s economic engineers have repeatedly managed to stave off catastrophe in the past. But it looks increasingly likely that China could repeat the Japanese scenario, with excess debt leading to a “Lost Decade” of sluggish stagnation—and foreign investors are pricing in the risk accordingly.