S&P Cuts China Just Ahead Of Party Congress

Well, the timing leaves something to be desired.

Showing not much in the way of decorum ahead of the Party Congress, S&P downgraded China this morning to A+ From AA- (stable) citing economic and financial risks from explosive credit growth. “Although this credit growth had contributed to strong real GDP growth and higher asset prices, we believe it has also diminished financial stability to some extent,” the ratings agency said.

This of course comes on the heels of the Moody’s downgrade in May.

Needless to say, folks are becoming increasingly skeptical about whether Beijing will ultimately be successful in reining in the labyrinthine shadow banking complex (“defusing a ticking time bomb” would be one less charitable way to describe the effort) without either i) triggering a crisis, or ii) choking off growth to the real economy.

Here are the bullets:

• Since 2009, claims by depository institutions on the resident non-government sector have increased rapidly, often above the rate of income growth
• Although this has contributed to strong real GDP growth, we believe it has also diminished financial stability to some extent
• Recent intensification of government efforts to rein-in corporate leverage could stabilize trend of financial risk in medium-term
• Expect credit growth over next 2-3 years to remain at levels that will increase financial risks gradually
• May raise ratings on China if credit growth slows significantly and is sustained well below current rates while maintaining real GDP growth at healthy levels
• Says Chinese government continues to make significant reforms to its budgetary framework and financial sector
• Changes could yield long-term benefits for China’s economic development
• Outlook reflects view China will maintain robust economic performance and improved fiscal performance over next 3-4 years

And see that bolded bit is key. That’s the tightrope. How do you target tightening efforts to affect only non-productive, shadow credit while ensuring you spare credit growth to the real economy? So far, so good in that regard, but the S&P downgrade effectively represents another bet that the effort will prove too difficult even for the PBoC.

China CDS widened 1bps. There was a fleeting reaction in the offshore yuan, but it snapped back. That said, it’s riding a five-day loss of 0.7%, falling after the Fed meeting, while the onshore yuan weakened beyond 6.60 versus the dollar intraday for the first time this month.

As for the impact of the downgrade (I mean beyond irritating the Politburo), “it will have a relatively big impact on Chinese enterprises since corporate ratings can’t be higher than the sovereign rating,” Xia Le, an economist at Banco Bilbao Vizcaya Argentaria said. “It will affect corporate financing.”

Of course it will also tempt Beijing to simply double down on efforts to “smooth” things over which is the ultimate irony. The more people warn about instability, the less likely it is that things will become unstable – at least in the near-term. The long-run is another story entirely.