The completion of 10 Chinese local government bonds in October has transformed the industry in more ways than one.
China’s local governments were allowed for the first time to tap the bond markets for funds directly, issuing Rmb109.2 billion ($17.9 billion), which was a big enough step.
But the move was also significant for the development of the local ratings industry, whose agencies are allowed, also for the first time, to evaluate the risks associated with Chinese public sector borrowing.
Previously, debt issued by local governments tended to be done in the name of the Ministry of Finance, was unrated and came with an implicit guarantee from central government.
“Local government bonds will provide more business to local rating agencies and test the credibility of the first such ratings,” Huo Zhihui, chief analyst with China Rating Corporation, one of the three companies that have rated local government bonds, told FinanceAsia.
More local governments are set to issue bonds and will bring a total volume of Rmb400 billion to the bond rating agencies over a two-year period, according to the central government.
However, some bond investors have criticised the ratings assigned so far, which are all AAA and do not reflect any difference in pricing risks between the 10 issuers.
Chen Long, chief analyst with Bank of Dongguan, cited the bonds issued in August by the western province of Ningxia as an example. In spite of having a per capita GDP ranked 15th out of China’s 31 provincial-level administrative regions at end-2013, its bonds were rated AAA by Dagong Global Rating, much like the bonds of Guangdong, considered China’s wealthiest province.
Credit analysts are concerned this practice will lead to ratings inflation for upcoming government borrowings, a phenomenon that has been embedded in China’s bond market for long.
Because of intense competition between rival agencies for business, local rating agencies tend to give higher ratings, according to credit analysts.
Potentially exacerbating the situation are regulatory rules aimed at curbing low-rated bond issuance. For example, insurers can’t invest in longer-term enterprise or corporate bonds rated lower than AA, or short-term financings lower than A-1, according to China Insurance Regulatory Commission.
According to research by Haitong Securities, about 50% of issuers on average are rated AA by the five biggest Chinese rating agencies. That compares with 1% in the case of their global peers, the so-called Big Three of Moody’s, S&P and Fitch.
Haitong Securities’ research on 56 Chinese companies with credit ratings from both domestic and global agencies also show local ratings tended to be on average 6.5 notches higher than those assigned by the Big Three.
Both onshore and offshore bond investors have occasionally seen ratings downgrades on Chinese domestic bonds they have invested in.
Far East Rating, once China’s largest rating agency by market share, was fined by regulators after its rating of Shanghai’s Fuxi Investment was slashed over the course of a few weeks in 2006 from A-1 to CCC, shattering its credibility. Far East has since exited the market and has not issued a single rating since.
To be sure, in this round of government bonds, ratings were only given to the bonds rather than the local governments and the bonds account for only 2% of the governments’ revenue. The government has a low default risk.
The fact only three agencies out of the nine in China received a mandate for the 10 transactions also raised doubts about the fairness of the selection process (see table). The three – Dagong Global Credit Rating, China Rating Corporation and Shanghai Brilliance Credit Rating and Investor Service – have got all the business to date, covering $17.9 billion of issuance.
Ratings industry insiders believe that lowering fees may be one of the reasons why the three got mandates. “A rating agency bid with fees much lower than the industry standard price of Rmb250,000 per project, which triggered a price war,” a person familiar with the situation said.
Among the three rating companies, Dagong Global and Shanghai Brilliance are privately owned, China Rating was set up and is controlled by the National Association of Financial Market Institutional Investors, or NAFMII, which is overseen by People’s Bank of China.
Still, the local government bond issuance is a significant step forward in the evolution of China’s ratings system in the sense that, from now on, local governments have to disclose their financials and their borrowing levels can be monitored by the whole market.