How China’s "distorted" ratings hold back foreign investors

With corporate defaults likely to rise further, developing a reliable credit rating system could be key to drawing more participation from global investors.

The lack of reliable credit ratings is holding back overseas investment in Chinese onshore corporate bonds and all the more so at a time when defaults in China are rising, an industry conference in Hong Kong heard on Tuesday.

Because local rating methods are not sufficiently rigorous and don’t fully reflect the underlying credit risks, global investors still own just 2% of the world’s third-largest bond market, delegates were told.

“Among China’s outstanding corporate bonds, 40% are not rated and the remaining 60% are rated BBB or above,” Ying Wang, Fitch’s head of China Research Initiative, said at the RMB Fixed Income & Currency Conference organised by Hong Kong Exchanges and Clearing (HKEx).

“Effectively 99% of China’s domestic corporate bonds are investment-grade rated and the high-yield market accounts for less than 1%,” Shanghai-based Wang said, dubbing the system “distorted”. 

More than half of China's outstanding corporate bonds were rated AAA as of last year, according to data provider Wind. 

Why the ratings should be inflated, Wang said, is in part due to the country’s guidelines for insurance companies and pension funds. Chinese insurance companies can only buy a bond with an AA rating or above, essentially pushing bond issuers to chase after higher ratings. 

There are also differences in the way Chinese credit rating companies evaluate risk, with some evaluated according to the size of their assets rather than their ability to repay creditors, confusing many outsiders.

“Global investors don’t understand yet how China’s domestic rating system works,” said Philipp Sterner, head of sales for Asia at MarketAxess, a US-based electronic trading platform for the global bond market, explaining this key concern among foreign investors.

And coming at a time when defaults in China are rising, there is even less of a desire on the part of global investors to forge ahead unguided into unfamiliar territory.

At least 11 other Chinese companies have defaulted on their onshore bonds so far this year as domestic credit conditions have tightened, including China CEF, a finance-to-energy conglomerate and Fuguiniao, a Hong Kong-listed clothing company, according to Wind.

DEFAULT ADJUSTMENTS

Among the latest Chinese companies to default is the port operator called Yingkougang, which is rated AA+ by domestic rating company Dagong. In an announcement cited by a report in Economic Observer, the company said it was unable to repay a Rmb530 million bond.

Secondary bond pricing has started to reflect the rising credit risks in China, according to analysts. 

“The credit differentials in market pricing have improved over the last couple of years, given the increasing credit defaults in the onshore market,” Wang, a former credit researcher with JP Morgan in New York, said.

Even so, global investors have to be more vigorous in doing their credit research, not least because a lot of China's debt issuers are not listed, so their information disclosure can be limited, he added.

What's more, going to court in the event of a default to get your money back is uncommon in China as it can drag in different interested parties, including local governments, which may put their local economic or social interests above creditors'.

“It may take years before a resolution is achieved because there is [a] ... battle of interests among local governments and creditors and issuers,” Wang said.

Speaking on the sidelines of the conference, Wang told FinanceAsia foreign investors were still only really keen to buy China’s sovereign bonds or bonds issued by the country's policy banks rather than true credit products. But with market pricing beginning to reflect the credit risks more effectively, there is the promise that that could yet change over time. 

“In terms of pricing, it hasn’t going to the perfect level yet but it is going to the right direction,” said Wang.

Whether the country's credit rating system adapts to the changing environment remains to be seen. 

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