China's rating drop seen as less serious than other issues

Foreign investors are concerned less with Standard & Poor's downgrade of China's sovereign rating than a set of other factors, which are influencing their engagement with its debt market.
China's rating drop seen as less serious than other issues

China's sovereign rating downgrade by Standard & Poor's (S&P) is unlikely to dampen the sentiment of foreign investors towards the country's bond market, but they are grappling with several other issues about whether to invest more there, say market experts.

S&P cut China's long-term sovereign credit rating from AA- to A+ on Thursday (Friday 22) and reduced the rating of Hong Kong from AAA to AA+, citing the former's mounting debt pile and the latter's strong connections to the mainland.

Researchers said investors were unlikely to greatly change their attitudes towards Chinese bonds following the cuts.  

“Ratings for many other sovereign countries are not particularly high; I don’t think a change to A+ from AA- makes a big difference,” Stephen Chang, Hong Kong-based managing director, head of Asian fixed income at JP Morgan Asset Management, told AsianInvestor.

This view was echoed by Luke Spajic, head of portfolio management for Emerging Asia at Pimco. He told AsianInvestor that previous rating downgrades had not dramatically impacted the demand curve for Chinese bonds, and he did not expect this one to either.

Even S&P doubted the move would cause major changes in bond flows.

“The flows into Chinese debt market, or the bond market, are more likely to be determined by the [government’s] policy stance towards such flows,” added Kim Eng Tan, senior director, sovereign ratings S&P Global Ratings in a media webcast.

Many global investors are under exposed to Chinese financial instruments because of past capital restrictions, which began to loosen with Bond Connect. As Beijing continues to ease these limitations, more investors will increase their allocations into an asset class that is underrepresented in their portfolios, Kim added.

“Definitely we are seeking keen interest on the part of sovereign wealth funds who have often approached the government directly to try to get bigger quotas for their investments in this market, and I expect now the private sector will still be quite enthusiastic about going into this market,” he said.

Bigger issues

A mixture of international macroeconomic issues and domestic Chinese signals are also likely to affect the appeal with which Chinese bond investments are held by foreign investors.

Global investors are particularly focused upon a potential interest rate hike by the Federal Reserve and the European Central Bank’s likely tapering of quantitative easing, said Chang.

Europe’s ultra-low interest rates could begin to reverse course when the ECB starts tapering, possibly in early 2018, and indeed Germany’s finance minister Wolfgang Schaeuble reportedly believes the EU’s central bank should already have begun doing so.

In the US, the 10-year Treasury bond yield rose from 2.1% to 2.27% over the last two weeks over concerns about another potential interest rate hike this year, Chang said. Compared to these two markets, China’s 10-year government bond had a yield of 3.64% on Friday.

In China, foreign investors are most focused upon the exchange rate of the renminbi to other countries. This is particularly imporatant at times when China bond yields are relatively less attractive. The more volatile it is, the less eager they are to enter the market, Chang said.

More clients have asked how they should invest in the China bond market after seeing the renminbi’s appreciation from $0.145 to the renminbi in May to $0.152 on Friday (September 22) and the launch of the Bond Connect in July, but for now most investors are taking a wait-and-see attitude, he added.

Morever, international investors have to consider how difficult it is to buy China bond futures, a key hedging tool. To limit their risk foreign asset managers typically focus on bonds that have the most liquidity. 

And while China’s sovereign rating shifts may not hugely factor into global investor thinking, they do worry that the global rating agencies don’t cover Chinese local corporate bonds sufficiently closely, said Freeman Tsang, head of China and Hong Kong at Legg Mason Global Asset Management. Speaking at a media luncheon, he said his company has been slightly underweight on Chinese corporate bonds since last year.

That defensive attitude is not likely to be helped by this rating drop. Some corporates with ratings at the sovereign ceiling level will see their ratings drop a notch too, Spajic said.

Further cuts possible

S&P annnounced that it had dropped China’s credit rating because of the country’s increasing financial instability, caused by a prolonged period of strong credit growth.

Credit growth in the next two to three years will remain at levels that gradally will increase financial risks, despite government efforts to rein in corporate leverage, according to S&P’s statement.

The agency cautioned that further downgrades could ensue if it looks more likely that China will reduce its efforts to stem growing financial risk and allow loan growth to accelerate to support economic growth, according to the statement.

Moody’s said in May that it downgraded China from Aa3 to A1 amid fears that China’s financial position would “erode somewhat over the coming years”. 

The downgrade by S&P was widely expected by the market.  The rationales of the downgrade are also things that investors are familiar with, including rapid credit growth, build-up of leverage, and reform progress, so the market reaction was muted, said JP Morgan AM’s Chang.

However, the rating cut was criticised in China itself. The country’s finance ministry claimed the decision was “perplexing”, according to Bloomberg, arguing the economy was on a solid foundation.

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