The China Securities Regulatory Commission finally signalled on Friday that it understood what bond market participants have long known: that the country’s local credit rating agencies aren’t very good.
The securities watchdog announced it had been investigating seven domestic agencies since September and had sent warning letters to six of them, asking representatives to attend “supervisory interviews”.
The CSRC’s indictment was damning. It highlighted nine major flaws in the companies, including a lack of standardised criteria for ratings, different rating methodologies from those disclosed, and a lack of adequate due diligence on the ratings.
The candour of its critique was long overdue but welcome nonetheless. Offshore bond market participants have long questioned China’s local rating companies and their rating standards.
As Christopher Lee, managing director for corporate ratings across Asia Pacific at Standard & Poor’s, put it at FinanceAsia’s 7th Annual North Asia Borrowers & Investors Forum on March 2: “[Domestic Chinese] ratings are very narrow, typically from AA to AAA. That doesn’t seem to correspond with the ratings we have [on the same borrowers].”
By way of example he offered up property developer Evergrande. S&P cut the company’s credit rating from BB- to B+ in May 2015, citing a drop in its interest coverage ratio to 1.45 times in the 2014 financial year from 2.5 times in the 2013 financial year. S&P also noted that Evergrande’s net debt-to-equity ratio would be more like 251% if its interest-bearing perpetual bonds were classed as debt instead of equity.
But local rating agencies are rather more sanguine about the credit risks, rating Evergrande a tip-top AAA – on a par with Chinese government debt no less.
That's not an isolated event either. China's top three rating agencies – CCXR, Lianhe and Dagong – rate at least 30% of China's entire onshore corporate bond market at AAA too.
The entire point of credit rating companies is to accurately assess the riskiness of a company’s debt, relative to its peers and other companies. If the agencies can assign the Chinese government the same rating as a company barely able to cover its own interest payments, their assessments are essentially meaningless.
The absurd lack of discrimination is nothing new. China's rating agencies have been offering uniformly glowing ratings to local companies for years. And for all this time China’s authorities seemed perfectly happy for them to do so, along with the resulting lack of divergence in bond pricing.
The willingness to overlook questionable ratings seems to have been based upon the belief that local debt defaults simply would not happen and therefore all corporate borrowers were effectively top tier. In short, Communist China's version of moral hazard.
But that’s changing. Chinese companies are borrowing a lot more than they used to and look likely to do so for the foreseeable future. The People’s Bank of China said corporate bond financing in December reached Rmb1.8 trillion ($277.3 billion), the highest level in six months.
China's borrowing binge has led corporate debt to rise to 160% of GDP, according to the Organisation for Economic Cooperation and Development. Mounting government debts, slipping foreign exchange reserves, and uncertainty over reform efforts in turn led Moody’s to downgrade its outlook on China’s Aa3 rating on March 2.
It’s not just outside observers that are becoming more fretful. On Sunday PBoC governor Zhou Xiaochuan stated at the China Development Forum that lending,“especially corporate lending as a share of GDP, is too high”, with high leverage raising economic risks.
Some corporates have already started defaulting. S&P states that six Chinese companies with offshore bonds defaulted in 2015. The most notorious was real estate developer Kaisa Group Holdings, which missed a payment on its bonds on January 5, 2015.
S&P predicts that more corporate defaults will follow as the slowing of China’s economy takes its toll on some heavily leveraged borrowers. So all the more reason to have credible credit ratings.
Local rating agencies that fail to adjust to the changing circumstances will damage their reputations, perhaps fatally, if a string of companies they assigned lofty ratings to start defaulting.
Investors could lose faith in the local ratings system entirely, which would limit support for new bonds, and demand higher yields in compensation.
Awkward questions would also be raised about exactly how and why all of these supposed credit rating experts assigned impeccable credentials to dud borrowers.
That sort of uncertainty is the last thing the Chinese government wants when the country needs reliable sources of funding.
By announcing a biting critique of the agencies, the CSRC can get ahead of such fears. If it is sensible, the regulator will heavily censure the companies, demand large management changes and wholesale reforms to their rating methodologies, to better reflect the full spectrum of borrowers that exist within China.
In an ideal world the Chinese authorities would also let the likes of S&P, Moody’s, and Fitch Ratings establish wholly-owned local companies, instead of the limited joint ventures they operate with now-censured local rating agencies.
While the capabilities of the global rating agencies have been found wanting in the past (their poor record with sub-prime mortgage ratings in the US continues to haunt them) they are at least in a better position to assess just how risky Chinese borrowers are in comparison to similar corporates from across the world.
China’s bond market is growing fast but it’s set to face growing pains as it does so. It’s a positive for the CSRC to have finally identified the inadequate job done to date by local rating agencies. It now needs to get them to fix their ways rigorously and quickly.