Investors outpace rating agencies in downgrading China’s FIG debt

Deteriorating credit metrics in China’s financial sector expose the weaknesses of its domestic rating agencies.
The default potential within the corporate sector grabs all the headlines, but it is the financial sector where the real downgrades are taking place according to Wind data.
The financial data provider has become one of investors’ main sources of credit analysis in a market, where the official rating agencies do not offer deep enough differentiation between issuers. For what Wind data shows is that 1,129 financial bonds had “implied ratings downgrades” between January 31 ,2018 and January 13 2019.
In Wind’s terminology, this means that a bond should have been downgraded based on its trading performance. By contrast, actual downgrades from the ratings agencies themselves numbered just 18 over the same period.
Shandong Zouping Rural Commercial Bank's 10-year 6% notes, due 2027, are a case in point.
In January last year, the bond's yield-to-maturity was around 5.95%. The figure rose as high as 6.46% in August and the bond was downgraded to A+ from AA- by Golden Credit Rating International, a local credit rating agency, in July 2018.
The bond returned to strength since then and its yield has tightened to 4.63% as of February 18 this year, but its credit rating was not lifted accordingly. This was just one of the many examples where domestic credit ratings do not reflect secondary trading levels in the onshore bond market.
Another example is Jilin Jiaohe Rural Commercial Bank. The zero volatility spread, or Z-spread, of this bank's 10-year 5.7% notes over a four-year Chinese government bond rose from 183 bps on February 28, 2018 to 348 bps on August 7, 2018, then fell to 164 bps on February 18 this year. 
This bond was downgraded to BBB+ from A- on July 31, 2018 by Shanghai Brilliance Credit Rating & Investors Service, but the rating has not changed since then, despite the significant drop in spread over that period.  
The data also shows that the financial sector’s credit metrics have deteriorated much faster than the manufacturing sector. Here Wind data shows that 560 manufacturing-related bonds were either downgraded, under observation for downgrade or suffered implied downgrades over the same one-year period. 
By individual issuer, manufacturing was the riskiest sector overall with 124 companies suffering rating warnings compared to 72 financial institutions. 
Investors hope that the entrance of international rating agencies, which have finally been allowed to set up a wholly owned Chinese subsidiary, will bring global best practices to a market where investors continue to fall back on implied government support as their main measure of creditworthiness. 
As James Dilley, a Hong Kong-based associate director of deals at PwC, told FinanceAsia: “If you look at the universe of onshore Chinese bonds rated by the domestic credit rating agencies, the breadth of yields can vary widely within the same credit notch.”
Dilley added that this differential is far greater than it is in the international bond markets. It is one of the chief reasons why foreign investors still do not trust domestic ratings and remain hesitant to move further down the yield curve beyond government bonds (CGBs).
One of the few standouts has been China Cheng Xin International Credit Rating (CCXI) in which Moody’s has a minority stake. A recent CLSA report flagged that it had downgraded 10 Chinese banks, a financial leasing firm and an insurance company over the past year. 
Over the past year, the financial sector has come under intense pressure because of the clampdown on shadow banking. Capital adequacy ratios have plummeted as banks move off-balance sheet assets back onto their books.
It is one of the main reasons why the China Banking and Insurance Regulatory Commission  announced that it would allow insurers to invest in perpetual and tier-2 capital bonds issued by qualified Chinese banks on January 24. Moody’s concluded that it is credit negative for insurers, because it elevates their correlation risk to the nation’s broader financial system. 
But there is no doubt that it should help some of the country’s weaker financial institutions to replenish their capital. 
The financial sector has also come under pressure because of China’s softening growth. 
In a recent ratings report, Moody’s commented that any dip in GDP growth below 6.0% will the asset quality of banks, asset management companies and leasing companies. It added that more volatile market conditions would negatively affect insurers and securities firms.
Similarly, Standard & Poor’s has warned that non-performing loans (NPLs) will rise if the Sino-US trade dispute does not ease. At the end of 2018, the ratio stood at 1.89% in the commercial banking sector. 
CICC agrees. “We expect the NPL formation rate and NPL ratio to further increase in 2019,” it said. “Banks’ asset quality may be weaker than some investors expect.”
However, while default risks are rising across the country, many investors remain fairly sanguine. Andrew Collier, managing director of Hong Kong-based Orient Capital Research told FinanceAsia that unless corporate defaults “are widespread, they won’t create a financial crisis".
He added that state-owned banks, including the large central state-owned banks, are safe from default. 
“The chances of a default among the smaller banks is low but it does exist,” he added. “However, the likely scenario would be a default disguised as a merger. That way, the local party officials won’t have a bank failure to account for.”
PwC’s Dilley comes to the same conclusion. 
“In the event of a problem, we can't see a scenario where the city, provincial or state level authorities doesn't step in with a managed solution,” he commented. “A local bank going under would cause huge financial disruption in its particular geography.”  
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