Moody's and China: So what?

People have gotten used to reading at least one negative headline about China every day. The economy is growing at its slowest pace in a quarter of a century, stocks are tanking and foreign currency reserves are evaporating. Today's headline read: “Moody's lowers China government bonds outlook”.

But that could easily be misunderstood. What the American ratings agency did was knock its outlook for China from “stable” to “negative”, which is effectively the precursor for a downgrade. But it left the country's credit rating at Aa3, the fourth-highest investment grade, meaning the risk that China will default on any of its debt is next to zero.

Moody's arguments

So what prompted Moody's to make this adjustment? The ratings agency cited important reforms that have yet to materialize and rising debt levels, but that's not entirely true.

China has long begun pushing through reforms to make its economy more sustainable in the long term. The service sector now makes up just under half of China's gross domestic product (GDP). Production levels from the industrial sector have been decreasing for years.

This economic restructuring was part of the reason why growth in the world's second-largest economy dipped below 7 percent last year. That's a very modest performance by Chinese standards, although worldwide it's still one of the best rates of growth.

The rising debt Moody's addressed is largely held by Chinese companies. Those levels have grown much faster than the economy on the whole, which is indeed cause for concern. Many firms racked up debt in the shadow banking sector. Beijing intends to more stringently regulate such lending as well.

Killing 'zombies'

According to insiders close to the central government, a number of so-called “zombie enterprises,” or companies that have ceased operations but still keep employees on their payroll fearing social and economic repercussions, are slated for closure.

Millions of jobs will disappear, but that's not an unusual side effect of economic restructuring. Just think of Germany in recent decades as jobs in the coal and textile industries were eliminated en masse. The Chinese government must, however, ensure that this process unfolds in a socially acceptable way, meaning jobs are created in other areas in exchange.

If push comes to shove, Beijing will surely be able to rely on state-owned enterprises to help it avoid social unrest. This, in turn, will inflate the national debt. But with debt-to-GDP ratio of 41 percent, China's debt levels are a source of much envy from most countries.

Fitch's criticism

Moody's likely only lowered its outlook because Fitch had already fired warning shots across China's bow. The source of the latter's disapproval was the Chinese central bank's decision to lower the reserve requirement for the country's largest domestic banks to 17 percent. Last year, that threshold was revised downwards four times to encourage banks to lend more.

The criticism of the People's Bank of China's loose monetary policy seemed like a bad joke. With a benchmark interest rate of more than 4 percent, the Chinese are well within the spectrum of normal monetary policy. The European Central Bank, with long-standing policy of keeping its key rate near zero, is more deserving of scolding than China.

One more thing

It should be noted that the ratings agencies did a terrible job in the lead-up to Europe's sovereign debt crisis. It doesn't take a cynic to recognize that they may now be trying to save face and prevent history from repeating itself. During the euro crisis, they took a lot of heat for their lack of prescience.

The fact is that China's economy currently finds itself in a difficult phase. The central government doesn't always make a good impression when it comes to reforming state-owned enterprises or the financial markets.

But even after the People's Bank of China spent $760 billion (701.7 billion euros) propping up the yuan, it's still sitting on more than $3 trillion in foreign currency reserves - a solid cushion should any turbulence materialize. It also has plenty of wiggle room for adjusting interest rates.

The most important thing to remember, however, is that China still exports more than it imports. In other words, the Chinese don't live beyond their means. This distinguishes them from the Americans and many Europeans.

China's leadership can take note of the ratings agencies' warnings, but it needs not do more. Investors, for their part, certainly weren't perturbed by the latest statements from Moody's and Fitch. On Wednesday, the markets in China rose sharply.

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