China stocks fell and the yuan weakened Tuesday after Moody's Investors Service lowered the credit rating for the world's second-largest economy amid concerns for rising debt levels and slowing growth.
Moody's clipped China's rating by one notch, taking it to A1 from a previous grade of Aa3, marking the country's first downgrade in nearly 30 years. Moody's said the new rating outlook is stable, however, and said the country remains resilient to negative shocks and that growth is likely to remain comparably strong in the near-term.
However, Moody's said the downgrade "reflects the expectation that China's financial strength will erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows."
"While ongoing progress on reforms is likely to transform the economy and financial system over time, it is not likely to prevent a further material rise in economy-wide debt, and the consequent increase in contingent liabilities for the government," Moody's said.
China's benchmark Shanghai Composite Index fell as much as 1.3.% immediately following the downgrade, but pared the decline to end the session little changed at 3,064.08 points, putting the benchmark down just under 1.3% for the year-to-date. China's benchmark 10-year government bond yields rose to a near two-year high of 3.68% while China's currency, the yuan, slipped around 0.1% against the U.S. dollar.
Moody's said that China's central bank has limits to its policy stance, given the risk of igniting capital outflows if it eases interest rates, and thus the burden of priming growth will fall to the government's fiscal strategy of infrastructure spending.
"Looking ahead, we expect China's growth potential to decline to close to 5% over the next five years, for three reasons. First, capital stock formation will slow as investment accounts for a diminishing share of total expenditure," Moody's said. "Second, the fall in the working age population that started in 2014 will accelerate. Third, we do not expect a reversal in the productivity slowdown that has taken place in the last few years, despite additional investment and higher skills."
The will likely mean China's direct debt burden will rise to 40% of GDP by next year and 45% of GDP by the end of the decade, Moody's said, and that its current level of "economy-wide debt", which includes government, households and non-financial corporation obligations, will continue to rise from its current level of 256% of GDP.
China has a AA- sovereign debt rating at Standard & Poor's, one notch higher than the new assessment from Moody's, but it cautioned in January that "gradually increasing economic and financial risks to the government's creditworthiness ... could result in a downgrade this year or next."