PIMCO Expects Moody’s Downgrade to Spur Chinese Financial Reform

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The recent downgrading of China’s sovereign credit rating by Moody’s for the first time in three decades is expected by PIMCO analyst  to lend succour to the efforts of reformers improve regulation of the Chinese financial sector.

Isaac Meng writes that Moody’s downgrade served as “warning shot” for Chinese leaders with respect to the economy’s current trajectory, as well as the need for rigorous reform of the financial sector.

Towards the end of last year Chinese authorities already took steps to tighten the financial system in order to contain systemic risk as well as curb the formation of asset bubbles, with a shift in emphasis from the preservation of high GDP growth to “maintaining financial stability.”

Regulators led by the China Banking Regulatory Commission also launched a crackdown on the financial sector this year, as part of efforts to effectively deleverage the economy and expedite more effective channeling of capital to the real economy.

While the Moody’s downgrade prompted an emphatic, strongly worded response from Chinese policymakers, Meng expects it to give ammunition to reformers for much needed reforms of the financial system, abetting a shift away from the country’s debt-intensive growth model.

“Following Moody’s downgrade, we expect Chinese policymakers to feel a sense of urgency to intensify financial regulation of the huge shadow banking system, maintain a hawkish monetary policy stance and somehow restore the fiscal discipline that has loosened in the past two years,” writes Meng.

“This policy shift may become more pronounced after the power reshuffle expected at the 19th National Congress of the Communist Party this autumn.”

While reform impetus may be a positive for the Chinese economy from a long-term structural perspective, Meng also expects it to put pressure on growth and financial markets in China, as well as commodities prices over the next year.

Meng further notes that despite official protests from China the Moody’s downgrade was warranted, given the long-term risks associated with the debt-intensive economic model it’s adopted since the GFC to deal with secular impediments to growth.

“The wave of excess credit stimulus over the past several years – designed to counter ageing demographics, stalled structural reforms, slowing productivity and various global headwinds, have clearly raised systemic risks.

“The financial sector is increasingly vulnerable, with worsening asset quality, surging reliance on wholesale funding and poorly regulated shadow banking system.”

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