Overview:

• While this change generated a lot of headlines, the significance for China’s economy is likely to be minimal, as relatively little of China’s debt is held offshore. That said, the downgrade may inspire a renewed focus on debt management and regulation that would be a long term positive for the economy.
• A sovereign downgrade is typically a major concern for any economy. Investors generally demand a larger return to compensate them for higher perceived risk – leading to higher funding costs that then flow through the economy (with corporates often facing their own downgrades relative to the sovereign). However in China’s case, the impact is reduced by the low level of foreign ownership of government debt. In May, foreign holdings of Chinese government bonds were around 3.9% of the total. China’s domestic bond investors typically pay little attention to international ratings – yields on 10 year government bonds have fallen slightly since the Moody’s downgrade
• One of the key concerns surrounding China’s financial sector has been the rapid growth of shadow banking. Moody’s estimates suggest that the sector was equivalent to 89% of China’s GDP at the end of 2016. Our broad estimate is larger – above 105% of GDP – with this estimate excluding the rapidly growing peer to peer (p2p) sector.
• China’s p2p sector is by far the world’s largest, but is relatively small compared with other components of shadow banking (around 1.1% of GDP). That said, it has been growing rapidly – up 86% yoy in Q4 2016 – despite a number of high profile scandals. Tighter regulation is likely to slow growth in the sector.
• Moody’s downgrade of China’s sovereign credit rating in part reflected the rapid growth of shadow banking over the past decade. While tighter regulation and closer oversight of the sector should assist in managing its risk, further financial reforms (perhaps inspired by the downgrade) that widen conventional financial access of non-state owned enterprises and individuals would be encouraging – filling the gaps that have allowed shadow banking to flourish.

For further details, please see the attached document:

• China Economic Update:  June 2017 (PDF, 72kb)