Well, I guess it had to happen sooner or later and overnight it did.
Moody’s finally plucked up the courage and downgraded China’s sovereign debt rating to A1 from Aa3 and in doing so formalised a fact of life that we all knew to be true but which nobody dared to articulate. Hundreds of articles over the past few years – and a goodly number of these columns too – have pointed to what has become the largest elephant in the room, the huge amount of debt that the Middle Kingdom has been racking up at various levels and in various forms.
Not surprisingly the Ministry of Finance has come out fighting by claiming that Moody’s analysts don’t understand the many layers of public sector finance and the government’s ability to reform. We should never forget that underneath all the glitz and glamour of the rise of the Chinese economy there lies the base model of a command economy. It has been rest of the world’s belief, and if only for at best practical and at worst self-delusionary purposes, that Beijing can turn the taps on and off at will and that if the flow of growth were ever to decline to a trickle, there would be plenty of new pipelines that could be brought into play to make up for the softness elsewhere.
Unfortunately it’s all a little more complicated than that and Moody’s appears to have decided that constantly rearranging the deckchairs on the Titanic is no longer enough to satisfy its ratings requirements, That said, does anybody really care?
My mind is drawn back to a parliamentary exchange between the then Chancellor of the Exchequer George Osborne and shadow chancellor Ed Balls, in the middle of the financial crisis. It went something along the lines of the chancellor being accused of mismanagement on the basis that interest rates were falling, which indicated the prevalence of a low growth economy. Osborne retorted that if high interest rates were the sign of success and growth why was Italy paying X-percent more for its money than Britain?
I suppose the point is that commentators will be popping up left, right and centre today boldly declaring that the downgrade will increase the cost of borrowing for the government and for its agencies. That’s a load of claptrap. If it were to have any validity, why would Single A rated Japan be paying 0.45% yield on its 10-year bonds when the Triple A rated US pays 2.27% and equally Triple A Switzerland’s 10-year bonds are trafficked at a yield of minus 14bp? The level of interest paid is therefore obviously not linked to the sovereign rating but to monetary policy and, in the brave new world, the degree of central bank intervention in the bond markets by way of quantitative easing or whatever sobriquet is applied to government-sponsored market manipulation.
But in the case of China that only tells half the story. In the Fortune Global 500 list of the world’s largest companies by revenue, nine of the top 50 are Chinese and every single one of them is government owned. The top end of the Chinese economy is not only interlocked but welded together and should any part fall, it would risk taking down the rest of the edifice. The chances of this happening are pretty remote but again that only tells part of the story. At the end of the day, the real risks are embedded in the borrower’s exposure to international investors. Both Japan and Italy can afford their eye-watering debt/GDP levels thanks to their ability to fund deficits through the domestic investor base and their concomitantly low dependency on foreign investors.
Recent TIC data, on the other hand, reveals that of the US$10.6trn of outstanding US Treasury bond issuance, just over US$6trn is held by foreign investors.
MOODY BLUES
The risks on China and on the US might be very different but they are both significant. Why then is the US Triple A and China Single A? Back in the middle of the last decade Moody’s also put a bunch of synthetic CDO-squared through its models and they came out as Triple A. Lending is ultimately an art, not a science, and the greatest risks to the global financial system are entered into when regulators and boards alike deceive themselves into exclusively believing in the latter. When we were taught as cub bankers not only to look at potential borrowers’ figures and projections but at finger nails and shoes too our mentors were not joking. Medicis, Rothschilds and Morgans did not rise to prominence on the back of quant models and box ticking.
Take a look at the at the new PRA handbook for credit exposure. I think it is section 4 that relates to credit ratings. It allows for differential ratings on a national basis, which means that there is likely to be a developing ratings war between Brussels and the UK once Brexit has been expedited. Boxing risk exposure into cohorts with differentiated capital reserve requirement makes sense but at the end of the day these can, at best, give only a very rough approximation of default probability.
I remember the morning 20 years ago when Moody’s jumped ahead and stripped Japan of its Triple A rating – the head of sovereign rating was attending a conference that we at BNP were giving in Paris at the time and he appeared on stage very bleary-eyed to fess up to his overnight activity – and look where we are now. China downgrade…so what?
Meanwhile, US equities again traded higher yesterday and the Dow is now within 50 points of the pre-wobble level. The subject of the day was the publication of the first Trump budget, which has of course been dismissed out of hand. No surprise there, given some of the suggestions it makes with respect to Medicaid and so on. However, it is not the content of the budget that is relevant, but the debate it will generate with respect to what role a government with 100% debt/GDP and a 3% deficit can and should be playing. This is where we get to see Trump the businessman at work. What the career politicians will make of it is a different matter. Irresistible force and immovable object? Interesting times ahead but of no immediate market relevance.
WTI at US$51.65 per barrel this morning and looking to go higher. Methinks US$60/bbl not a bad call with the driving season ahead.