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China's deleveraging efforts are likely to be more gradual than thought, S&P says.

By Reuters
September 22, 2017

China’s attempts to reduce risks from its rapid buildup in debt are not working as quickly as expected and credit growth is still too fast, S&P Global Ratings said on Friday, a day after it downgraded the country’s sovereign credit rating.

While S&P warned months ago that a cut may be on the cards, it said it decided to make the call after concluding that China’s “de-risking” drive that started early this year was having less of an impact on credit growth than initially expected.

“Despite the fact that the government has shown greater resolve to implement the deleveraging policy, we continue to see overall credit in the corporate sector to stay at a 9% point”, Kim Eng Tan, an S&P senior director of sovereign ratings, said in a conference call to discuss the one-notch downgrade to A+ from AA-.

“We’ve now come to the conclusion that while we do expect some deleveraging in the next few years, this deleveraging is likely to be much more gradual than we thought could have been the case early this year.”

Tan said broader lending by all financial institutions, excluding equity fund-raising, has started to rise after growing by a relatively steady 12-13% in the last few years.

“That was the key metric that we look at…and we believe while this growth of aggregate debt financing could come down somewhat over the next few years, it’s not likely to come down very sharply.”

Indeed, China’s new bank lending and total social financing (TSF), a broad measure of credit and liquidity in the economy, look set to hit record highs again this year.

China’s banks extended a record $1.84 trillion of loans in 2016, roughly the size of Italy’s economy. TSF was a record $2.70 trillion.

“One of the things that we do look for is more than just stabilization of financial risks, but actual decline or moderation in financial risks,” Tan said.

If China’s credit-to-income growth falls sharply in coming years and the economy remains healthy, S&P would consider a ratings upgrade, he added.

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Hong Kong stocks were on track for their worst day in a month and China shares hit three-week lows early on Friday, as investors reacted to S&P’s downgrade and North Korea’s threat of another nuclear test.

The yuan was little changed, with some big state banks seen trying to stabilise it in early trade. China’s debt market are not expected to be impacted much as it is dominated by domestic investors, though foreign interest has been on the rise.

Pointed message or bad timing?

S&P’s move put its rating in line with those of Moody’s and Fitch, though the timing raised eyebrows as it came just weeks ahead of one of the country’s most politically sensitive events, the twice-a-decade Communist Party Congress (CPC).

China’s finance ministry said on Friday the downgrade was “a wrong decision” that ignored the economic fundamentals and development potential of the world’s second-largest economy.

“China is able to maintain the stability of its financial systems through cautious lending, improved government supervision and credit risk controls,” the Ministry of Finance said in a statement on its website.

“(S&P’s) view neglects the characteristics of China’s financial market fundraising structure and the accumulated wealth and material support from Chinese government’s spending.”

To be sure, China’s economic growth has unexpectedly accelerated this year, racing ahead at 6.9% in the first half, but much of the impetus has come from record bank lending in 2016, a property boom and sharply higher government stimulus in the form of infrastructure spending.

While the crackdown on riskier lending has pushed up borrowing costs from corporate loans to mortgages, it has not yet dampened growth as many China watchers predicted.

The International Monetary Fund warned this year that China’s credit growth was on a “dangerous trajectory” and called for “decisive action”, while the Bank for International Settlements said last September that excessive credit growth was signaling a banking crisis in the next three years.

The IMF said in August it expected China’s total non-financial sector debt to rise to almost 300% of its gross domestic product (GDP) by 2022, up from 242% last year.

Debt battle has mixed success so far

Analysts say China’s campaign to cut financial risks this year has had mixed success, and opinions differ widely on whether Beijing is moving fast enough, or decisively enough, to avert the dangers of a debt crisis down the road.

Regulators are making significant inroads in reducing interbank borrowing – perhaps the most pressing risk – and have curbed some riskier types of shadow banking.

But analysts agree more comprehensive structural reforms are needed. Though the pace of credit growth may be easing by some measures, it continues to outpace economic growth.

And, while stronger economic activity and sales should be giving companies more cash flow to start paying down their debt, there is little evidence of that yet. A recent Reuters analysis showed few listed companies including state-controlled firms are using a profit windfall this year to reduce their debt burden.

“There has actually been some progress recently in tackling credit risks, particularly in reining in the activities of the ‘shadow’ banking sector (and) broad credit growth has slowed,” Capital Economics said in a research note.

“But it continues to rise relative to GDP so the overall trend remains deeply unhealthy.”

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