Moody's latest edition of Inside China looks at the country's deleveraging reforms

Moody's Investors Service's November 2016 issue of Inside China examines the Chinese authorities' response to, as well as the possible medium-term economic and financial implications of, elevated leverage among state-owned enterprises (SOEs). Moody's says that the SOEs' high and rising leverage poses contingent liability risks for the Chinese government (Aa3 negative).

"The authorities are employing a wide range of tools to ensure that China's growth rate is stable and close to the official target," says Marie Diron, a Moody's Associate Managing Director.

"Meanwhile, implementation of the deleveraging guidelines is likely to be gradual, as policymakers balance the objective of deleveraging, against managing the negative short-term economic impact of lower leverage levels," adds Diron.

Policy support is also reflected in a widening of the budget deficit to more than 3% of GDP. As a result, government debt will rise gradually. SOE liabilities — and, with them, contingent liabilities for the government — also continue to increase faster than nominal GDP, registering a 9.9% year-on-year growth as of September 2016.

Moody's Inside China newsletter points out that the People's Bank of China (PBoC) has maintained accommodative monetary conditions. These conditions are visible in the continued rise of Total Social Financing (TSF) at a faster rate than nominal GDP. Growth in mortgages has been particularly strong, fostered by measures to ease access in 2014 and 2015.

Moody's says that while monetary policy accommodation will likely continue, the PBoC will likely move cautiously on further cuts in interest rates or required reserves.

Moody's further points out that the stabilization of GDP growth has helped strengthen the financial metrics of a number of Moody's-rated issuers, and increased demand for and output prices of overcapacity industries, such as mining and steel.

In Moody's view, the effective implementation of deleveraging guidelines would be credit positive. But there are challenges related to the negative short-term economic impact of deleveraging, and incomplete legal and regulatory structures.

Moody's says that while official statements point to marked progress in the removal of capacity in steel and coal. However, steel production in particular has not been reduced. This uneven and uncertain path towards reducing excess capacity illustrates the difficulties for the authorities of implementing reforms that have negative short-term consequences for local economies.

Moody's also says that the efficiency with which capital and credit are deployed is on a clear declining trend. Without significant reforms to enhance productivity over the next few years, the ability of policy makers to maintain high rates of growth through fiscal and monetary stimulus will likely diminish over time.