On 24 May, Moody’s downgraded China’s long-term local currency and foreign currency issuer ratings to A1 from Aa3 and changed the outlook from stable to negative. This comes on the back of efforts by Chinese authorities to reduce a build-up of debt, after becoming concerned about financial sector stability and asset price bubbles. With short-term uncertainty around China on the rise, what can ETF investors expect in the years ahead?

Despite sluggish performance in 2017, China A-shares ETFs are up 73% in the three years to 23 May.

The credit rating downgrade, the first for China since 1989, reflects the rating agency’s expectation that China’s financial strength will erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows.

James Butterfill, head of research and strategy at ETF Securities, said: “Since 2008, China has had the biggest increase in this ratio of debt to gross domestic product of any country. The Bank of International Settlement estimates that ratio jumped from 141 percent at the start of 2009 to 260 percent by the end of 2016.”

China has been taking steps since the start of the year to tighten financial conditions including raising short-term interest rates across the interest rate corridor, slowing the growth of total social finance and tightening bank regulation to reign in off-balance sheet lending and the shadow banking sector. Both bond yields and money market rates have risen sharply since the start of the year and, according to ETF Securities’ Butterfill, it is now 20% more costly for companies to borrow than at the start of the year.

Tighter funding conditions are likely to dampen domestic growth in the short to medium-term. According to Buterfill, “A-shares are tightly correlated to domestic liquidity as up to 80% of turnover is generated by retail investors. A-Shares have been among the worst-performing emerging markets year-to-date, down -1% in local currency versus +11% for H-shares and +12% for the MSCI EM.”

ETF Securities’ offering in this space, the ETFS-E Fund MSCI China A GO UCITS ETF (LON: CASE), is down -4.5% in 2017, although it has risen an impressive 73% in the last three years. The fund has £19 million in AUM and a total expense ratio of 0.88%. Other ETFs offering China A-share exposure, such as funds from iShares, Source and Deutsche’s Xtrackers have fared similarly.

However, against the backdrop of financial reforms leading to tighter credit, Moody’s believe that the Chinese authorities will be unwilling to see GDP growth drop too far and, as a result, will continue with fiscal stimulus that will, in fact, end up increasing the debt burden.

According to Moody’s: “While China’s GDP will remain very large, and growth will remain high compared to other sovereigns, potential growth is likely to fall in the coming years. The importance the Chinese authorities attach to growth suggests that the corresponding fall in official growth targets is likely to be more gradual, rendering the economy increasingly reliant on policy stimulus. At least over the near term, with monetary policy limited by the risk of fuelling renewed capital outflows, the burden of supporting growth will fall largely on fiscal policy, with spending by government and government-related entities – including policy banks and state-owned enterprises (SOEs) – rising.”

So, on the one hand, China is taking much-needed steps to reign in the excessive credit growth seen since the financial crisis, which is likely to have a negative effect on domestic growth and equities. On the other hand, Moody’s believes that this might prompt authorities to boost fiscal stimulus which would keep growth elevated but worsen the debt problem. China appears to be walking a tightrope as it attempts to transform its economy without hitting the brakes too hard. Any mistakes could prove very costly, not just for China, but for the global economy as well.

But there are reasons to be cheerful. Undertaking necessary reforms is certainly a positive thing for long-term prospects even if they prove painful in the short-term. Moody’s verdict is that the erosion of China’s credit profile will be gradual and eventually contained as reforms deepen, with the strength of the credit profile allowing the sovereign to remain resilient to negative shocks and GDP growth likely to stay strong relative to other countries.

Despite the short-term headwinds, Butterfill expects A-share multiples to revalue to a higher sustained P/E ratio in the medium term. “First, we are starting to see signs that state-owned enterprises are becoming more shareholder friendly, increasing transparency and improving corporate governance. Secondly, we think the potential inclusion of A-shares in the global equity benchmarks is another medium-term driver.”

Discussion over whether to include onshore domestic Renminbi-denominated equities in mainstream EM benchmarks has been growing recently and there could be a decision by MSCI in June 2017, resulting in a possible inclusion beginning in June 2018.

Another way to play the country might be through currency ETCs. ETF Securities offers a range of long and short exposure Renminbi ETCs. The ETFS Long CNY Short USD gives investors long exposure to the Renminbi, which is restricted from being traded on foreign exchange markets, relative to the US dollar. The product has AUM of $1m and a management expense ratio of 0.59%.