Loose Bonds

The suspension, the second instance in the country since 2018, comes as China’s domestic credit rating industry is plagued with credibility issues in the wake of a series of defaults involving State-owned enterprises (SOEs). 　

Starting in October, State-owned automaker Brilliance Auto, mining company Yongcheng Coal and Electricity Holding Group, and the Tsinghua University-backed chipmaker Tsinghua Unigroup all defaulted their debts either on bonds or commercial papers - unsecured notes issued by companies to meet short-term financial obligations. 　

China’s bond market is the second-largest in the world, worth over US$15 trillion. As well as dealing a heavy blow to the market, the defaults depressed confidence in domestic credit ratings, as the companies in question are all AAA-rated which should indicate a strong ability to repay debts. This again draws attention to entrenched and sustained problems with the domestic credit rating system, including inflated ratings and an inability to give early warnings of defaults. 　

The same company can be rated quite differently at home and abroad. A new media platform operated by Security Times revealed in 2016 that bonds issued by real estate company Evergrande Group were rated AAA at home but bonds issued abroad were rated as junk - high-risk but with the potential for high returns. 　

On November 30, the Securities Association of China (SAC) released a notice on the status of 10 rating agencies in the third quarter of 2020. The SAC said that 136 issuers had changed agencies in that period. Subsequently, 17 were rated higher. The SAC noted that the number of issuers for which certain agencies have raised ratings is above the average level in the industry, an indication of inflated ratings. 　

In China, AA and above is the basic threshold regulators require before companies can issue credit bonds. High ratings make it easier to issue bonds at lower cost and use debt as collateral for certain loans, according to Wang Dalin (pseudonym), who works at one of the top five rating agencies in China.　

In most cases, issuers pay an agency to get rated (i.e. the issuer-pay model), making it hard to maintain complete independence and opening the door to potential corruption, Wang said. 

　

The corruption case involving Golden Credit Rating exposed problems like paying for higher ratings, the CCDI said. In a video on the CCDI’s website, the two former executives from Golden Credit Rating confessed how they catered to the needs of issuers by helping them inflate their ratings and received bribes in exchange.　

In August 2018, Dagong Global Credit Rating was suspended from conducting new ratings assessments for a year, the first case in the industry. The agency had provided counseling services to rated companies and charged high fees, which violates the rule of independence. 　

The high threshold for issuing bonds means a large number of companies are already filtered out by rating agencies before they have a chance to get rated, Wang said. But as the companies that issue bonds, which are of different qualities, are all rated above AA, it is a challenge for investors to distinguish the good from the bad. Inflated ratings make things worse. 　

Local ratings agencies have been criticized for a long time for being too slow to spot troubles with issuers and tardy in giving early warnings, which are supposed to be their core function. The SOEs that defaulted in October and November all kept their AAA-ratings and were only downgraded after the defaults. 　

China Chengxin, another top ratings agency in China, is also under investigation following the Yongcheng Coal and Electricity Holding Group default, which the agency had rated AAA. The day after the default, the company’s rating was downgraded to BB, meaning weak credibility and uncertainty it can repay debts in the future. Shortly after, the ratings of several other issuers were downgraded by nervous agencies out of an abundance of caution. 　

In total, 44 companies defaulted in 2018, among which only four were downgraded six months ahead of their defaults. In 2019, only 12 out of the 40 companies that defaulted were downgraded six months in advance, according to data from the National Association of Financial Market Institutional Investors (NAFMI). 　

Spotting the lag in ratings adjustments in the third quarter, NAFMI has had conversations with agencies including China Chengxin and Dagong Global Credit Rating, the SAC notice said. “NAFMI stressed that agencies should keep an eye on factors that will affect issuers’ credibility and track the ratings from time to time to ensure they reflect the credit level effectively,” the notice said. 　

With more than a decade’s experience in the industry, Wang, the anonymous credit agency employee, said that a benign ecology has never managed to form under the current system. He cited the fierce competition among agencies as the main reason behind the inflated ratings and associated problems. 　

There are 13 agencies listed on the SAC’s website. “Compared to foreign markets like the US, where three agencies dominate the market, there are too many participants to share the limited domestic market,” Wang said. 　

He revealed that to grab a bite of the market where issuers pay for ratings, some agencies, particularly latecomers, have no choice but to give high ratings to win clients. 　

“Besides, the rating fee is rather low here,” Wang added. Domestic agencies charge according to a self-discipline pact initiated by five leading agencies in 2007 which requires them charge no less than 250,000 yuan (US$38,675) for rating one bond, with the fee for tracking the rating included, regardless of the bond scale. International agencies like Moody’s charge a lot more and the fee increases according to the scale of the bonds.　

“What’s worse, there is a price war. Agencies usually package several products at a low price to keep quality clients,” Wang said, adding that some ratings agencies only earn around 300 million yuan (US$46.4m) a year and barely make ends meet.　

Under these conditions, the field is plagued by severe brain drain, which Wang attributes to low salaries. “Many analysts enter the field and stay for two or three years just as a springboard to better-paid jobs, like in financial institutions. The constant lack of experienced analysts with a sense of judgment certainly affects the quality of ratings reports and also causes inadequacy in giving timely warnings.”　

Zhou Yuanfan, vice president of Pengyuan Credit Rating, said that the most important thing for the industry is not high technology or education, but the stability of a rating team and the accumulation of experience and data. It takes [the industry] several decades’ experience to do the job well, he was quoted as saying by news outlet China Economic Net.　

At the same time, under pressure to keep their heads above water, many agencies put most of their energy into gaining new clients and producing rating reports, but pay little attention to tracking the rated companies dynamically thereafter. “Dynamic tracking isn’t possible most of the time. Some tracking is just pro forma,” Wang said. 　

It is not all the rating agencies’ fault though, he added. “Rating agencies have limitations. They produce ratings based on a company’s financial statements. Sometimes it is hard to tell if the statements are false,” Wang said. 　

Besides, in an investment environment where there is an implicit government guarantee and investors believe they can always count on principal redemption and interest payments, particularly for bonds issued by SOEs or government-backed companies, the credit rating system is not given due attention for its ability to measure risks, Wang said.　

Wang revealed that many investors only pay attention to the institutional background of a company when buying bonds. When it comes to rating local government-backed municipal investment companies for city construction, some agencies mainly look at the financial situation and the economic development level of the local government, regarding its financial statements as of limited value as references. “But the situation is likely to change in the future. The wave of defaults between 2018 and 2019 broke investors’ trust in private companies first. Now SOEs are proving they are not a haven either. In a few years, all companies may be at the same starting line in the bond market,” Wang said. 　

For the time being, the ratings market is supervised by several regulatory bodies including the NAFMI, the People’s Bank of China (PBoC), the CSRC and more, and their responsibilities are not clearly defined. This causes overlapping regulations or regulatory gaps, experts pointed out, stressing the necessity to unify supervision to improve efficiency. 　

Aside from strengthening self-discipline, it is important to reinforce supervision and increase punishment for agencies that violate the rules, Wang said. “Suspending business will probably become a common means of punishment for regulators in the future.” 　

In a December meeting, Pan Gongsheng, vice governor of China’s central bank, said that the PBoC and other departments will tighten regulations on the ratings market to improve the quality of ratings and make sure that agencies live up to their role as the gatekeepers for investors. In late December, the PBoC, the CSRC and the National Development and Reform Commission issued a regulation aiming to reinforce information disclosure in the credit bond market to better protect investors’ rights to be informed. 　

More changes are expected. In August 2020, the CSRC released the revised version of a regulation on bond issuing to solicit opinions, which removes the demand for companies to get rated first before issuing bonds. This will reduce the issuers’ reliance on ratings and make rating more of a need for investors rather than for supervision purposes, which will help gradually cultivate the market for investors to pay for ratings services, or the investor-pay model, experts said. 　

As the rules tighten, the industry is likely to undergo mergers and restructuring that will squeeze out smaller players, leaving only a few big ones, Wang said. “That may help reduce competition and cultivate a healthier environment. After all, there are too many [agencies],” he said.