The ratings agency said its decision was based on its expectation that “China’s financial strength will erode somewhat over the coming years” as debt continues to widen and potential growth shrinks.
However, Moody’s added that reforms implemented by the Chinese government would likely curb some of the negative effects from rising debt.
Most investors were not taken aback by China’s downgrade from an Aa3 credit rating to an A1 on Wednesday, arguing that markets were similarly prepared for such a move.
“The market reaction to this should generally be mild,” predicted Aberdeen Asset Management fixed income manager Edmund Goh.
“Onshore Chinese investors will largely ignore the downgrade. Foreign participation in the onshore market is too small to move the market there,” he continued.
“The exception would be some Tier 1 US dollar bonds issued by state owned enterprises which derive most of their credit strength from the sovereign rating.”
Schroders emerging market economist Craig Botham agreed that markets had already taken stock of China’s leverage to growth ratio, mitigating some of the immediate negative reactions from the ratings announcement.
“The direct implications of the downgrade are limited. External debt in China is just 13% of GDP, so reliance on foreign lenders is limited,” said Botham.
“We would also argue that markets had already priced in the risks arising from higher leverage and slower growth.”
However, he suspects the move could be worse for sentiment in the short-term and “reawaken markets to China risk.”
“Our own expectation is that the policy tightening already under way will weigh on parts of the economy later in the year.
“But will not be sufficient to bring growth below target – or to begin a deleveraging process. Property, and as a consequence commodities, are likely to feel the impact first.”
Aviva Investors’ head of Emerging Markets and Asia Pacific equities Will Ballard suspects the prognosis is not good for Chinese financials or stocks in general.
“The first stage impact is that once the sovereign rating is downgraded, it is likely that most Chinese banks will have to be downgraded as well,” said Ballard.
“A rising cost of funding for the banks, unless it can be passed on, results in falling net interest margins. That in turn to the average equity investor, means lower earnings for banks stocks.
“Considering international investors are already having misgivings about investing in Chinese banks, with ICBC’s H shares trading on only 6x earnings, any fall in earnings is going to do nothing to help confidence.”
The credit downgrade, he argues, could reflect the fact that China is on an even slower path to growth for GDP than previously considered:
“Should that be the case, then again, future earnings of Chinese companies could be lower than investors expect. Lower growth and lower earnings normally mean lower valuations.”
However, Chinese valuations remain much lower than other emerging market counterparts, he pointed out.
