Moody's: China's sustained capital outflows to challenge policy effectiveness and exchange rate stability, although companies largely resilient

Moody's Investors Service says that the likely persistence of capital outflows from China (Aa3 negative) over the rest of this year could constrain monetary policy and may lead to a more activist fiscal policy, if the government's growth target is to be achieved.

"Moreover, if capital outflows persist, domestic liquidity conditions are likely to tighten further, with small- and mid-sized banks -- which are most reliant on wholesale funding -- feeling the greatest impact," says Michael Taylor, a Moody's Managing Director.

"However, we expect most rated banks and non-financial companies to remain resilient both to the intensified application of capital controls and to a hypothetical further modest depreciation of the RMB," adds Taylor.

Moody's conclusions are contained in its just-released report on China credit, "Sustained Capital Outflows Constrain Policy and Pressure the Currency, but Companies Largely Resilient".

In his report on government work delivered on 5 March, Premier Li Keqiang stated that China will strive to maintain a stable currency within the global monetary system during year.

"Consequently, Moody's expects the authorities to continue the intensified application of capital controls and to use the country's official reserves to stabilize the currency throughout 2017," says Lillian Li, a Moody's Vice President and Senior Analyst.

"Nonetheless, capital outflow pressures will persist against the backdrop of a strengthening dollar, rising US treasury yields, expectations of slower Chinese GDP growth, and lower returns in China relative to some assets offshore," says Li.

By February 2017, China's foreign exchange reserves were $988.1 billion below their peak of nearly $4 trillion in June 2014, but are still ample relative to the country's external payment obligations.

At the same time, Moody's notes that the extent to which currency reserves cover broad money (M2) has rapidly and steadily deteriorated, falling to 13.0% as of February 2017, a low ratio compared to other emerging markets. Capital controls are therefore likely to remain an important buffer against the materialization of risks in the financial system.

In the near term, persistent capital outflows are likely to result in a more constrained monetary policy and tighter domestic liquidity conditions, testing the ability of the government to maintain robust growth, a feature that has supported China's sovereign credit profile.

With monetary policy more constrained going forward, the government may adopt a more activist fiscal policy if it is to meet its growth targets.

China's general government debt, at 36.7% of GDP in 2016, is higher than the Aa3 median of 29.7%, and Moody's expects an increase to around 39% by 2018.

The debt burden could further rise if state-owned enterprise-related (SOE) contingent liabilities start to crystallize, either directly through government support, or indirectly through the provision of aid to the financial sector, including by the commercial banks and policy banks that finance SOEs.

China's banking sector as a whole does not face immediate liquidity pressures, although banks that rely on wholesale funding are encountering higher borrowing costs.

Furthermore, their foreign currency exposure is limited, indicating that they source most of their funds domestically and that liquidity is sufficient.

But if capital outflows persist, the banking sector could experience more elevated levels of liquidity pressure with small- and mid-sized banks -- which are most reliant on wholesale funding -- experiencing the greatest impact, as indicated.

While Moody's expects the Chinese authorities to strive to maintain currency stability over the rest of this year, it also considers the potential impact of a hypothetical further modest devaluation in the RMB.

The modest size of the rated banks' foreign currency assets and liabilities does not expose them to significant risk in such scenario. Some could actually record gains from foreign exchange movements in an environment of RMB depreciation as they hold net foreign asset positions, rather than net liabilities.

Most non-financial rated companies would also be resilient to in a hypothetical scenario in which the RMB gradually depreciated by 10% from the level at the beginning of 2017 to USD/CNY7.7 over 2017.

Moody's conclusion is based on their manageable levels of foreign currency exposure and the presence of financial mitigants, such as expected strong parental support, long-dated maturity profiles, good liquidity and/or a stable operating performance.

Moody's also does not expect various restrictions -- including those on capital account transactions and overseas investments -- to materially impact most rated Chinese non-financial companies because they generally have good access to offshore capital markets.

But if the authorities were to continue such measures over a prolonged period, the effects could delay reforms that would foster a more market-based pricing of risks, a credit negative for the sovereign.