What happened?
The downgrade is the second for China this year after Moody's move in May. In a press release, S&P said that while the ongoing deleveraging campaign can stabilise financial risks, China’s pace of credit growth seen through 2017 suggests the authorities will not be able to tackle the debt problem as quickly as expected.
"The recent intensification of government efforts to rein in corporate leverage could stabilise the trend of financial risk in the medium term,” S&P said. “However, we foresee that credit growth in the next two to three years will remain at levels that will increase financial risks gradually."
The agency said the outlook for the Chinese economy was stable, citing robust growth rates. S&P also expects to reverse its rating decision should China’s credit growth slow significantly while high GDP growth rates remain.
What does this mean for China's reform agendas?
China's external profile remains strong, said S&P. Exchange reserves had fallen on the back of the renminbi’s depreciation expectations but the current account surplus and the stricter controls on capital outflows have stabilised the situation in recent months. The agency also underlined that the RMB's increasingly global role bolsters China's external financial resilience.
"We expect the share of renminbi-denominated official reserves to rise over time. If the renminbi achieves reserve currency status (which we define as more than 3% of aggregated allocated international foreign exchange reserves), it could strengthen external and monetary support for the sovereign ratings."
The Bank for International Settlements noted in a 2016 survey that the RMB made up 4% of FX transactions globally.
S&P does not expect the People's Bank of China to fully float the currency but said markets are likely to continue to see efforts to gradually liberalise the capital account.
"We have seen liberalisations but they have been relatively modest and we see reversals and tightening when the situation calls for that," said Kim Eng Tan, senior director, sovereign ratings, during a media briefing on Friday.
In terms of inflows, some initiatives had made it easier to access onshore capital markets.
"The government has been cautious about foreign investment in the bond market because they are afraid capital flows can bring the seeds of financial instability," said Tan. "Recently the government has become more comfortable with allowing investments, as we have seen with the Stock Connect and Bond Connect launches. These schemes will bring more inflows, but past restrictions mean investors are underexposed to Chinese instruments."
How did markets react?
The downgrade of China's rating triggered a series of other actions, beginning with Hong Kong’s rating also falling from AAA to AA+. Three foreign financial institutions' China entities have already seen their ratings cut from AA- to A+ — namely DBS (China), Hang Seng Bank (China) and HSBC (China).
But the reaction in the domestic markets was relatively muted on Friday, with the RMB trading flat against the dollar at 6.5917 at 2:30pm and the Shanghai Composite Index down 0.34%.
In the fixed income market, China's 10 year benchmark government bond yield was marginally higher by 1bp at 3.63% compared to the previous close.
What are analysts saying about the downgrade?
Rob Carnell, head of Asia research at ING, said he expects some negative knock-on effect on foreign interest in domestic bonds.
"We have seen that the PBoC is trying to reform the CNY to be more market-oriented by removing reserves from forward contracts," he wrote on Thursday. "That should attract more foreign investors in the onshore CNY sovereign bond market (as they can hedge at lower costs). But S&P’s rating cut is a big blow for China’s sovereign bond market as foreign investors will be more hesitant to invest in Chinese bonds (whether in CNY or in other currencies)."
Yang Zhao, economist at Nomura, said the broader impact on credit markets would be rather limited given the government's efforts to keep systemic risks under control and the ongoing deleveraging.
Helena Huang, China economist at ICBC Standard Bank, meanwhile, underlined that despite the downgrade, China still had the same investment grade rating as Japan and Ireland.
“As a result of S&P’s downgrade Chinese corporates, primarily the SOEs, need to be prepared for renewed pressures on their corporate ratings," Huang wrote. "This, in turn, will affect their corporate financing capability in the offshore market.”
Suan Teck Kin, an economist at UOB, drew attention to the timing of S&P's announcement.
"The rating downgrade just ahead of the upcoming Communist Party of China’s 19th National Congress (from 18 Oct) to elect leaders for the next five years will likely bring greater attention to China’s reforms and deleveraging process, which we think will continue to be driven by domestic conditions," he wrote. "As the rating cut is within expectation, we do not anticipate significant impact on the RMB."
Raymond Yeung, chief China economist at ANZ, pointed out the regulators would continue with their agenda regardless.
"We expect Chinese policymakers to continue to push forward with structural reforms," Yeung wrote. "Capacity reduction will be of paramount importance to mitigate the risk of deflation and maintain sustainable nominal GDP growth."
How did China take it?
As one would expect, the Chinese authorities were none too pleased. In a Friday statement, the Chinese Ministry of Finance slammed what it called the inertial thinking of international rating agencies, accusing them of misreading the Chinese economy based on their experience in developed countries.
MoF laid out a few counterarguments.
"It is a well-known fact that China is a country with high saving rates,” an unnamed official said in the statement. "High saving rates have supported China’s indirect financing-led financial system, with bank loans taking a major part in the society’s financing [activities]."
MoF sounded confident about the authorities’ ability to cope with the many challenges facing the economy.
"As long as we are careful with lending, strengthen our supervision, prevent and control credit risk, we can totally maintain the stability of the Chinese financial system.”