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China Faces Rising Risks as Future Credit Downgrade Threatens Currency and Capital Outflows

Recently, Reuters reported similar rumors that many may remember: the Chinese government was supposedly planning a ¥2 trillion special bond issuance. Half of this was intended to stimulate consumer spending, while the other half was for supporting local governments with debt relief, including an 800-yuan monthly subsidy per child for families with two or more children. As it turned out, these claims were exaggerated, leaving domestic expectations for fiscal policy quite high.

Prominent figures, like the public official Liu Shijin, even proposed a ¥10 trillion stimulus plan, widely discussed among citizens. This proposal was far more aggressive than the recent Reuters version, as Liu’s plan called for the issuance of ¥10 trillion in bonds over one to two years. However, looking purely at the current economic model, even ¥10 trillion annually might be insufficient given the scale of local government debt and the ongoing pressures in the real estate market. President Xi’s determination to boost GDP adds further strain, but the issue lies deeper; China’s economy faces structural rather than cyclical challenges. Yet, official policy never acknowledges structural issues, focusing instead on "counter-cyclical adjustments." This likely reflects the government’s inability to implement profound structural reforms, which could be politically risky for President Xi.

Structural reforms—like income distribution changes, curtailing the dominance of state-owned enterprises, or expanding welfare—are not on the table. As long as President Xi remains in power, we will likely continue to see stimulus measures without meaningful reform, aiming to sustain rather than transform the economy. Consequently, whether it’s ¥10 trillion or ¥2 trillion, without proper structural changes, these measures are only temporary fixes.

Now, let’s analyze the specifics of the reported ¥10 trillion extra budget. The first ¥6 trillion, to be issued over three years at ¥2 trillion per year, aims to help local governments address hidden debts, primarily by refinancing shorter-term debt with longer-term bonds. This move reduces local governments' cash flow burden and interest payments, but it only alleviates short-term pressures rather than solving the root issues. Some analysts estimate that ¥4.5-5.5 trillion is required yearly to truly address the scale of local government debt, so the ¥2 trillion falls short of expectations.

The remaining ¥4 trillion would be allocated over five years, adding about ¥800 billion annually to local government funds specifically for land and property purchases. This increase equates to a 20% rise in the 2023 special bond quota of ¥3.9 trillion, likely welcomed by local governments needing funds. But can this additional ¥800 billion prevent property sales from declining further? It's doubtful, given that real estate sales dropped from ¥13 trillion in 2022 to ¥11 trillion in 2023, a significant loss. Relying solely on government purchases to stabilize property prices is unrealistic due to the vast market scale.

Beyond this ¥10 trillion, Reuters also hinted at an additional ¥1 trillion to stimulate consumption, including trade-in schemes for consumer goods, and another ¥1 trillion injection into state-owned banks.

Comparing Reuters’ recent reports reveals some notable shifts. One key change: there’s no mention anymore of subsidies for families with more than two children. While the latest report still discusses consumer stimulus and local government debt relief, any reference to birth subsidies has disappeared. This omission underscores my point: fiscal policy is only focused on economic stimulation, not structural reform.

The State Council did release a document encouraging higher birth rates yesterday, but it was mostly just rhetoric. Concrete subsidies remain up to local governments, with no central funding so far. For instance, Jiangxi is the only province where a county provides substantial birth subsidies—¥7,000 for a second child, ¥13,000 for a third, and monthly childcare subsidies of ¥300 and ¥500 for the second and third children, respectively. However, whether these funds actually reach the public remains uncertain, especially in less economically developed areas where government reliability tends to be lower.

An interesting aspect of Reuters’ report this time is the mention of Trump. If he’s re-elected, China may need to increase its stimulus efforts, as his policies would likely place added economic pressure on China, potentially requiring a boost to the already-planned ¥10 trillion stimulus. Trump’s tough stance on trade could push China to allow the yuan to devalue further to counteract tariffs, while increasing domestic debt issuance would further strain the currency. Biden, meanwhile, has imposed new restrictions on U.S. investments in Chinese high-tech industries, such as semiconductors. With fewer dollars flowing into China and Beijing needing more stimulus, a managed yuan depreciation seems more likely. How much it devalues may ultimately depend on how much pressure Trump’s policies place on China.

Market reactions to the latest Reuters report were tepid, suggesting the stimulus is still seen as underwhelming. After the news, the A50 Index rose by 1.5% but quickly retraced, and the A-shares market opened with declines. It’s possible that fiscal authorities, having learned from previous announcements, are deliberately testing market reactions with modest news first, only to unveil more significant plans next month to bolster the stock market.

Regardless, there’s consensus: without real structural reforms to improve people’s income and welfare, fiscal stimulus alone is a temporary solution. Heavy reliance on bond issuance could lead to sharp yuan depreciation and risks to national credit ratings. The People’s Bank of China is accumulating low-quality assets, deteriorating its balance sheet. If this trend continues, China’s credit rating could face downgrades, prompting further capital outflows.

A credit rating downgrade for China would raise borrowing costs, accelerate capital outflows, and put downward pressure on the yuan, increasing inflation risks. Foreign investors might reduce holdings in Chinese assets, impacting both government and corporate bond markets.

The People’s Bank of China may face pressure to stabilize the currency and economy, potentially through interventions that could create further financial strain.

Holding yuan assets, therefore, might not be the wisest choice right now. Preparing for these shifts is essential.

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