China’s Continued Reform Posturing Against Domestic CRAs Continues to Miss the Point (or Does It?)

China’s response to the issues within its domestic marketplace recently has been well covered here in Financial Regulation Matters (like here and here) so I will not go into the background too much in this short post. However, the most recent posturing from the collected regulatory framework in the country reveals, in perhaps its most obvious form, why a regulatory framework (and not just China’s) is only even a robust façade on top of underlying and societally fundamental truths.

 

What do I mean by this last sentence? Well, let us start by considering the recent statements made by five of the country’s top financial regulatory bodies. The five bodies – the central bank, the finance ministry, the national economic planner, the securities regulator, and the banking and insurance regulator – have all teamed up to declare that the new regulatory approach will be to shift the burden onto the domestic agencies with the aim being to ‘guide them to see reputation as the basis of their very existence’. The draft rules push the agencies to develop new rules and standards relating to boosting consistency, accuracy, and the timeliness of their credit ratings, together with a new focus on quality assurance. One of the measures that has been put forward is for the domestic agencies to install independent directors. Against this backdrop, there will also be structural developments relating to lessening the reliance on credit ratings as a concept; one example will be loosening the standards required for systematically important entities with regards to their investment choices, and also encouraging different forms of creditworthiness assessments. The central bank followed this up with the declaration that ‘rating agencies must gradually lower the proportion of high ratings to a reasonable level, and help form a system with clear differentiation’.

 

This tactic of blaming anybody else but the system that surrounds the financial arena is a commonly used and, regrettably, commonly accepted tactic. It was done in the US after the Financial Crisis, in the EU after the Sovereign Debt crisis, and will be continued to be used moving forward. The reality is that the Chinese credit rating agencies, operating in an arena where the international rating agencies were not allowed to operate, were the only vehicles for signalling creditworthiness in a country that has one political party, a stringent economic system designed in the best interests of the State, and a wide variety of economic entities that, cumulatively, form part of one of the fastest growing and largest economies ever seen. It is not their internal processes that led to inflated ratings, but the overarching conflict of interest that exists within the country. Even the international rating agencies who are now allowed in the country’s domestic space without being tied to a domestic partner have begun developing ‘unique’ methodologies for the Chinese space. It is not a stretch to suggest that if a domestic rating agency, before the collapses we have recently witnessed, were to accurately rate some of the commercial entities we have seen crumble, then their registration would be immediately revoked, with potentially many more consequences than that. Some of the commercial entities are incredibly important to strategic zones within the country; allowing them to be blocked from investment and suffer the consequences was not, in reality, an option.

 

Of course, the domestic rating agencies understand this position and cannot claim sympathy for how they are being treated now. This is why the suggestion that the Big Three rating agencies should be exposed to more competition is complete nonsense, and the many regulators who have mentioned this have long since given up on the idea; simply put, the market believes in their products (perhaps not for their content but their ability to signal, as I constantly argue) more than anybody else. Chinese domestic rating agencies are clearly under immense pressure from the State which has a particular set of objectives, so why trust their output. Other agencies have suffered the same fate (think of ACRA in Russia). But, the Big Three operate for money only, and this can be predicted and factored in (enough). That the Chinese State has turned on the rating agencies they essentially forced to inflate the market is very much predictable, and will no doubt continue. However, the key takeaway is that they must do this, rather than admit publicly that this is how the game is played. The investment flows must continue at all costs in the Chinese space, as evidenced by the State allowing US-based CRAs into its domestic market for the first time ever. One wonders whether the State has decided to bet on the pressure that can be applied to the internationals in the form of lucrative rewards for obedience; only time will tell.

 

Keywords – credit rating agencies, China, financial regulation, @finregmatters