Why China Sought Help With Credit Ratings for Bonds

(Bloomberg) -- One reason foreign investors think twice about dabbling in China’s $15 trillion bond market is the quality of domestic credit ratings -- and a pickup in defaults in late 2020 has cast fresh doubt on their reliability. The authorities sought to address such concerns last year by allowing S&P Global Inc. to become the first foreign ratings firm to operate independently in the country. The move proved to be a milestone but hardly a watershed. Even with Fitch Ratings Inc. also in China now, there’s a long way to go in a market where the vast majority of bonds receive stellar ratings and defaults can come out of nowhere.

1. Are overseas companies shaking things up?

Not just yet. The world’s top credit risk raters face a long journey to establish a substantial presence. While S&P received approval to grade all domestic bonds, Fitch is permitted only to rate financial institutions, their securities and structured finance bonds. Moody’s Corp., which has a joint venture with a local rating firm, is still waiting for its license to rate onshore bonds to be approved. Since it started early in 2019, S&P has issued just 19 ratings, including six issuer credit ratings. Fitch has assigned three ratings thus far. That’s a drop in the ocean compared with an overall 3,978 onshore ratings of debt products from 2,388 issuers in the second quarter of this year alone, according to the National Association of Financial Market Institutional Investors.

2. What’s holding them back?

To some degree, their higher standards. The majority of Chinese borrowers are rated investment grade by domestic firms. Given the multiple reasons to want high ratings -- regulatory approval for bond sales, lower borrowing costs, debt qualifying as collateral for certain loans -- there’s limited incentive for local issuers to risk getting a lower rating from an overseas firm. Other challenges include cut-throat pricing by domestic raters and, in Fitch’s case, those restrictions on the scope of its business.

3. What’s the issue with domestic raters?

They’re criticized for being overly generous and failing to differentiate between different credit qualities. About 96% of onshore ratings now are AA or above, according to Peter Eastham, managing director and head of analytics for S&P’s China business. In comparison, 72% of U.S. corporate debt was investment grade at the start of 2019, according to an S&P report. Local rating firms have also been slow to spot companies in trouble, such as:

• Yongcheng Coal & Electricity Holding Group Co., whose surprise payment failure in November triggered a slump in bonds of some other state-owned enterprises, held a AAA rating when it failed to repay a bond maturity by the deadline. It was cut to BB the following day.
• Brilliance Auto Group Holdings Co., a state-owned carmaker linked to BMW AG, also held the top rating from two local credit companies just a month before it failed to honor its debt.
• In both cases, the agencies involved -- Dagong Global Credit Rating, China Chengxin International Credit Rating and Golden Credit Rating International -- didn’t respond to requests for comment.

Other big corporate bond defaults since China’s first in 2014 include Wintime Energy Co. and Kangmei Pharmaceutical Co. There’s been wayward behavior, too. Dagong Global was banned from grading bonds for a year in 2018 for charging borrowers high fees for consulting services and giving regulators fake information.

4. How differently do overseas raters see things?

A look at the offshore market -- Chinese bonds sold outside the country -- illustrates the gulf. Among 15 property developers with top AAA ratings in the domestic market and that also carry offshore ratings, eight had a low rating from at least one of the international firms.

5. Are overseas funds buying more Chinese bonds?

International investors have been steadily increasing their bets in the world’s second-largest bond market in recent years, but predominantly on safer debt issued by China’s government and policy banks. Foreign holdings accounted for 0.75% of onshore corporate debt at the end of May, according to data compiled by Bloomberg. That’s up 0.22 percentage point from the same period last year. The rise in defaults by state-linked firms has prompted some investors to reassess the credit risks of such borrowers, which were once considered to carry an implicit guarantee. Other concerns for overseas funds include liquidity, hedging options, the convertibility of China’s currency and capital controls.

6. What is in it for China?

Having more robust credit ratings is a pillar of its efforts to turn the bond market into a more effective fund-raising venue where risk is better priced, so as to take pressure off an overstretched banking system. Chinese officials have sought to encourage steady inflows of global funds into the domestic market, in part to help balance pressures on the yuan after an exodus of capital in 2015. The push for foreign investors is also part of the government’s drive to modernize its financial markets and increase the yuan’s global usage.

7. So overseas raters need patience?

Correct. The dominance of local firms and a financial culture that is less risk-averse, at least for now, means acceptance of more rigorous standards will need time. A big challenge is to change the mindset of investors and issuers who are used to dealing with local raters that tend to have sub-par practices. While competition may lead to consolidation in the industry, major domestic firms are expected to maintain their dominance for the foreseeable future

8. Are the authorities doing anything else?

Beyond welcoming overseas ratings agencies, there are signs of a more concerted effort to raise industry standards. In December, the People’s Bank of China pledged to improve its oversight of the ratings industry in the wake of a pickup in defaults by state-linked firms, with the central bank’s deputy governor Pan Gongsheng citing inflated credit ratings. Also, two former general managers at Golden Credit Rating International Co. are being prosecuted for allegedly inflating the ratings of some companies that offered bribes.

The Reference Shelf

• QuickTakes on China’s bond market include the push to to lure foreign investors, the use of keepwell clauses and why recent defaults are more alarming this time.
• Bloomberg Opinion’s Anjani Trivedi asks if banks can absorb all these losses, and Shuli Ren on state-owned defaulters shifting assets.
• Bloomberg Markets reports that China’s bond market opening is set to reshape the world of finance.

©2020 Bloomberg L.P.

With assistance from Bloomberg