China Economic Crossroads: Moody’s Warning Rings Echoes of Japan’s Past”

China Economic Crossroads: When Moody’s Investors Service raised the possibility of downgrading China, it invoked the specter of Japan’s deflationary woes, sending a subtle but impactful message. Similar parallels are evident in Tokyo, where, more than two decades after pioneering quantitative easing, policymakers are contemplating removing the economic training wheels, with talks of BOJ “tapering” causing the yen to surge.

However, the recent economic headline-stealer in Asia was Moody’s downgrade of Beijing’s credit outlook, a move that followed a similar reduction for Washington a few weeks prior. This warning to Beijing appears strategically timed, urging Chinese leader Xi Jinping’s government to address debt-related issues, particularly in the default-prone property sector, reminiscent of Japan’s 1990s bad-loan crisis.

A key concern for Moody’s is the hidden debt, concealed from analysts, investors, and government ministries, potentially lurking on the balance sheets of Chinese government-backed entities involved in infrastructure development. This debt is generated by local government financing vehicles (LGFVs) and various financing schemes supported by the People’s Bank of China, often lacking transparency.

Compounding the problem is the apparent shift in Xi’s government prioritizing fiscal and monetary stimulus over structural reform, signaling a potential reluctance to confront the underlying debt issues. PBOC Governor Pan Gongsheng’s recent acknowledgment of economically distressed regions facing difficulties servicing local government debts adds to the unease.

Beijing’s attempts to lean on state-owned banks to support defaulting property developers, ensuring completion of construction projects, raise concerns about national service risk and credit risk in the medium term, caution economists at JPMorgan Chase & Co. This risky move is viewed through the lens of historical precedents, with China’s debt-to-GDP ratio surpassing the peaks seen during Japan and South Korea’s respective debt bubbles.

Diana Choyleva at Enodo Economics underscores China’s uncharted territory, pointing out that the credit-to-GDP ratio for the non-government non-financial sector has exceeded the peaks observed in Japan and South Korea during their debt bubbles. Notably, China is in deflation, with the GDP deflator falling in the second and third quarters, mirroring patterns seen during past crises.

Choyleva also notes China’s limited fiscal room for maneuver compared to the U.S. and the U.K. during the global financial crisis, aligning it more with the Euro area and less constrained than Japan. While China has prioritized leveraging in recent years, the post-Covid-19 recovery challenges collided with Xi’s pandemic lockdowns and Big Tech crackdown, tipping the property sector into turmoil.

China’s pushback against Moody’s reflects a sense of invulnerability, reminiscent of Japan’s past. However, recognizing global dynamics is crucial for Beijing, akin to the lessons Tokyo learned too late. If China successfully navigates this economic challenge, it would break the cycle that no industrializing nation has managed to avoid. Failure, however, could spell an unprecedented shock for the global financial system.

Also read: China Economic Quandary: Deflation Looms as Consumer Prices Take a Dive