Before even getting started, it is worth pointing out that China’s financial system is heavily bank-oriented, with there being a clear need for a proper bond market framework. And while one is indeed in the works, let’s just say the growing pains are more than obvious and a textbook example to that effect is represented by credit rating agencies, with domestic rating agencies oftentimes far more lenient than their global counterparts.
A popular example is represented by the domestic sale of bonds by a CEFC China Energy unit back in 2014, with domestic rating agencies granting it a solid “AA” rating, one robust enough to make investors feel confident that purchasing the bonds in question represented a very low-risk endeavor. As time passed, the unit in question managed to hang on to its rating and even exceed it, with that only changing… a few weeks prior to it defaulting. In May of 2018, it missed its first payment and 10 more defaults followed, bringing the grand total to $4.2 billion in defaults.
Needless to say, the credibility of any rating agency takes a major hit whenever a blatant example of excessive optimism such as this one manifests itself. And unfortunately, this issue by no means represents an isolated incident, with recent data indicating that in China, roughly 8 of 10 issuers receive a rating of “AA” or above.
How does this compare to global rating agencies, for example Fitch, Moody’s as well as Standard & Poor’s?
According to research published in 2017 by the BIS (Bank of International Settlements), Chinese bonds which were issued offshore and therefore rated by global players ended up receiving a rating 6-9 notches lower compared to what domestic rating agencies awarded. This lack of clarity is more than troublesome, especially in light of the fact that even in these beginning stages, China represents the world’s #3 bond market.
Why are domestic rating agencies proving to be more optimistic?
We could speculate about potential reasons quite a bit, for example:
- Regulators being excessively stringent, with a minimum rating of “AA” being required for a bond to be sold to the general public and as such, domestic rating agencies oftentimes feel compelled to be more generous because otherwise, the entity in question would not be able to secure financing via issuing bonds at all
- Domestic players not having enough experience
- There not being that much of a track record with respect to Chinese bond ratings
- Issuers not providing accurate information to rating agencies, with the latter having to frequently work with numbers that are overly-optimistic and inevitably lead to an overly-optimistic rating which isn’t exactly backed by… well, reality
The list of examples could continue but the bottom line is this: domestic rating agencies have been suffering a relatively serious credibility hit and this state of affairs inevitably ends up hindering growth as far as China’s vital bond market is concerned.
What solutions are there?
Quite a few, including solutions which revolve around letting more experienced global rating agencies take over. And, indeed, China has been gradually allowing just that, with S&P Global representing the very first global rating agency which was granted a license with respect to issuing scores for Chinese bonds.
However, even so, suspicions persist with respect to whether or not global standards will be maintained, with there being a very high likelihood that scoring methodology will be “adapted” to Chinese realities. This aspect, correlated with other issues such as potential pressures from the authorities makes observers once again raise an eyebrow when it comes to the effectiveness of the entire endeavor.
There are of course other solutions as well, for example “punishing” domestic rating agencies, with China occasionally doing just that. For example, one of China’s top agencies (Dagong Global Credit Rating) ended up with suspended licenses and other rating agencies had to deal with investigations involving potential conflicts of interest, methodology problems, quality control issues, update track records and so on.
Of course, not all observers are as eager to point the proverbial finger toward domestic rating agencies and considering their global counterparts angelic entities. On the contrary, the observers in question oftentimes consider the entire endeavor deeply hypocritical in light of the fact that global rating agencies have sins of their own to atone for, with the most (in)famous of them revolving around the Great Recession, when rating agencies were ridiculously optimistic and ended up even granting sky-high ratings to Mortgage-Backed Security bundles which included various combinations between quality loans and subprime loans.
As such, a more than compelling case could be made that information provided by rating agencies in general (whether Chinese or global) should be taken with a grain of salt when making decisions pertaining to bond-related opportunities.
While the ChinaFund.com team does consider that rating agencies provide more than useful information, it does tend to agree that in light of case studies such as the previously mentioned Great Recession, it would be wise to double down on the “do your own due diligence” perspective. In other words, rather than blindly trusting rating agencies (again, both domestic and global), we would strongly recommend simply considering the information provided by them (including ratings) a data point just like any other and nothing more.
By all means, include rating agency-provided data in your overall strategy but do not make investment decisions exclusively based on it, a mistake made by investors in a wide range of jurisdictions, from China to the US. Should you be in need of “hands-on” assistance when it comes to precisely critical research, the ChinaFund.com team is at your disposal and would be more than happy to work alongside you and/or your team (to send us a message, simply use the Contact section of ChinaFund.com).