China’s Domestic Credit Rating Problem Persists

We have analysed the issue of domestic credit rating provision within China on a number of occasions here in Financial Regulation Matters. Today one of my articles was published in The Journal of Business Law (available here, and here in a pre-published version) that analyses the trajectory of rating provision within the country. We have also looked at the situation from the view of the political and geo-political ambitions of China here, and from the viewpoint of the leading US-based rating agencies here. In today’s post, we will look at evidence that demonstrates the problem at hand, and why China has now become so open to having the US-based rating agencies operating within its territory, on their own, for the first time.

 

It has been reported this morning that domestic Chinese rating agencies are providing for massive upgrades in their ratings for ‘local government financing vehicles’ (LGFV), despite the impacts of the Covid-10 pandemic still playing out. The article in the Financial Times utilises research from Wind, a financial data provider, who have identified that more than 100 LGFVs have had their ratings raised since January of this year. The fear is that these ratings are artificially inflated, and that the result will be that a wave of downgrades must be the natural result of such a move by the domestic agencies. The agencies themselves have focused on the strong performance of the LGFVs at the turn of the year and are discounting the pandemic because ‘we chose to ignore the disease because its short-term impact on growth is limited. We can downgrade these bonds later if the economic recovery fails to live up to our expectation’. However, there are question marks over whether the impetus for such rating actions are political in nature, rather than financial. One analyst argues that the ratings are in response to the role played by the LGFVs in boosting the economy, rather than the actual creditworthiness of the bonds they are issuing. The article makes another assertion, in that the main buyers of LGFV bonds – leading Chinese banking entities – are restricted to investing in highly-rated bonds and for the national economy to recover, the LGFVs must have their bonds placed on the market at palatable rates; local provinces have been clear that they need to reduce the amount of interest they are paying on their bonds and, it seems, that the domestic rating agencies are concentrating on the needs of the issuers, rather than the investors.

 

The reasons for why China has now allowed the large American credit rating agencies – first S&P, then Fitch, and soon to be Moody’s according to the first phase of the recent trade deal struck between the two countries – is clear, but multifaceted. We looked at the geopolitical element of the new approach, but there are a number of other reasons. In reality, the Chinese credit rating agencies are in an incredibly difficult position, because their operating environment is very different to the global rating agencies. Let us very crudely suggest it could be called the “puppet theory”, the Chinese rating agencies have a role to play in the effective running of the financial system which, like every other country, is central to the country’s wellbeing. However, the state, ostensibly, has a much more direct and interventionist role in the functioning of the economy than most other countries. So, with LGFVs needing to issue bonds but reduce their interest rates to stay buoyant, and with the largest consumer of such bonds being restricted to only investing in highly rated bonds, what is the domestic rating industry to do? Technically they should rate the creditworthiness of the bond irrespective of who owns it and what the economic effect may be of a low rating, but in reality the agency that does that in China will be committing suicide. However, if they inflate their ratings – which has been identified to be the case on a number of occasions – then their legitimacy is destroyed. This has been represented in a different story recently, whereby the Chinese State has tried, whether directly or indirectly, to assist with the domestic rating industry’s rating-inflation issue by ‘removing a requirement for bond issuers on the nation’s stock exchange markets to seek credit rating’, with the article continuing by suggesting that ‘the removal of the previously mandated requirement may also in the long rub help prevent domestic credit rating firms from issuing often-inflated grades under pressure from borrowers’. Although the China Securities Regulatory Commission (CSRC) is currently consulting on the move, it falls in line with the ever-so-slightly growing sentiment for regulators to move away from credit rating entirely (akin the European Union and the US Federal Reserve allowing for “fallen angels” to be included in collateral agreements); though not the same issue, the sentiment is similar. Yet, it is another example of regulators taking action without considering the marketplace and how it functions. There are a number of other methods that an investor can take to determine the creditworthiness of a bond, but how do they signal this to the entities (investor base, regulators) they need to signal to? How does this data become comparable if there are different standards of creditworthiness being used? How will regulators attempt to control, in even a cursory way, the risk that large institutions expose themselves to? The focus on the short-term recovery is blinding the vision of the larger picture. The likelihood is that by removing the need for credit ratings because, essentially, the domestic rating agencies cannot be relied upon to provide impartial ratings – largely because of their environment – a whole host of issues will arise so much so that there will be a clamour for ratings to be reintroduced. The domestic agencies will not have the track record to meet those needs, so there exists an extraordinary potential for the US-based rating agencies to fill that void. However, on the day that China imposes retaliatory sanctions on US officials in Hong Kong and arrests, under the new laws being administered in the territory, media tycoon Jimmy Lai, the future for US-based interests within China is certainly not certain. If you scale this up and think about the extraordinary effect that a US-based rating agency could have upon the Chinese economy and marketplace, then that future relationship becomes even more uncertain.

 

Keywords – credit rating, china, business, US, @finregmatters