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The rating chaos behind the wave of bond defaults

Rating results of entities and bonds are cluttered in high ratings, therefore under such an economic environment, often a rating upgrade happens more than a downgrade. Regulators don’t want to see defaults in their administrative area, and ‘the competition among regulators results in rating issues being deliberately overlooked’.  These all lead to the bubbles in the rating industry.


After restrictions being placed by regulators to control rating bubbles, it has seen the growth of bubbles is slowing down.


‘A while ago, a VP from an issuer company paid a visit to a rating agency, and was initially told that they could have their rating increased, but the main undertaker approached us recently saying that they were told by the rating agency that they wouldn't be able to carry it through, and he asked if we could do it for them,’ said an anonymous staff from a rating agency in Beijing to the journalist from 21st Century Economic Report.  Since the recent emphasis on rating agencies ‘not competing for clients and markets’ made by the regulators, rating agencies are more cautious about increasing ratings of issuer companies.


‘The ratings of new clients are not necessarily restricted; upgrading for existing clients needs to be more cautious.  Other rating agencies compete on ratings offered, but now internal restriction is most important,’ a member of staff from this rating agency said.


The journalist from 21st Century Economic Report made inquiries to employees from multiple rating agencies, and they all commented on the more cautious attitude towards upgrading in ratings.


Moreover, due to the separation of domestic bond markets, the separated licences of rating agencies is likely to be resolved and unified.


‘China Cheng Xin Credit Rating Co. Ltd. and United Credit Rating Co., Ltd. have separate licences for inter-bank and for exchanges, which leads to variance in credit rating for one single issuer,’ a high-level executive from a rating agency based in Shanghai revealed to the journalist of 21st Century Economic Report, suggesting that China Cheng Xin would likely have a unified licence. ‘We haven’t heard the news of a unified licence, but this event is not directly the result of regulators’ effort in restricting the rating bubbles.  It is likely to speed up the process though.


‘The equity of China Cheng Xin Security Rating will be transferred from China Cheng Xin Credit Rating to China Cheng Xin International,’ an informed source told the journalist, ‘although they are still two rating companies, but the company relationship has changed from one parent two children to one grandparent, one parent and one child.’


The journalist of 21st Century Economic Report contacted China Cheng Xin regarding this matter, but they refused to comment yet.


‘United Credit Rating has not changed yet.  It is inevitable for them to combine the licences too, and they are considering this.  But due to factors including price, control and supervision etc., they are only waiting to choose the best option and timing,’ said Zhang Zhijun, CEO of United Credit Rating Co., Ltd. (hereinafter referred to as ‘United Credit’) during the interview with the journalist from 21st Century Economic Report.


Unifying licences will help to reduce some bubbles


When we mentioned the Chinese rating agencies, the employees in bond rating work would raise names including China Cheng Xin, United Ratings, Shanghai Brilliance, Dagong Global, Golden Credit, Pengyuan etc. Among these players, China Cheng Xin and United Ratings are the top and second in terms of market shares, while Brilliance and Dagong usually take turns to be in the third place.


The Chinese bond markets have two major forms, inter-bank and exchange bond markets. Both have with different regulating bodies, including central bank, SFC and DRC (bonds regulated under DRC can be issued in both markets).  There are differences in authorised credit rating agencies by different regulating bodies. 


Due to historic reasons, SFC does not allow foreign capital in rating agencies, but China Cheng Xin International Credit Rating Co., Ltd. (hereinafter referred to as ‘China Cheng Xin International’) and United Credit Rating Co., Ltd. (hereinafter referred to as ‘United Credit’) both have 49% of foreign investment, Moody's and Fitch respectively, therefore not eligible for related credit rating authorisation from SFC.


This led to the two companies resorting to setting up solely owned Chinese subsidiaries to enter the exchange market regulated by SFC. China Cheng Xin Credit Management Co., Ltd, the parent company of China Cheng Xin International, set up a solely owned subsidiary China Cheng Xin Security Rating Co., Ltd. (hereinafter referred to as ‘China Cheng Xin Security Rating’).  And United Credit Management Co., Ltd, the parent company of United Credit, set up United Credit Rating Co., Ltd.


Dagong Global, Shanghai Brilliance, Golden Credit etc. are holders of ‘double licences’ recognised by Dealers’ Association and SFC.  China Cheng Xin and United undertake credit rating business for inter-bank market including short-term financing, medium-term notes etc. through respective JVs, and corporate bond credit rating through their solely own Chinese subsidiaries.


‘Issuers can issue bonds in different markets, but the separate licence can cause sequence disruption of the same issuer. For example, a company is rated AA for inter-bank market, but might be AAA in exchange market. A rating agent from Shanghai said the unification of licences might help to reduce some rating bubbles.


‘After unification, the ratings from two rating agencies for the same client must be unified.  In general, based on cautiousness, the lower rating prevails.’ said this agent, ‘the exchange market corporate bond rating will face more pressure overall.’


However, Zhang Zhijun told the journalist from 21st Century Economic Report that the China Cheng Xin system and the United system are ‘generally aligned between their respective two companies.  It is not likely to be entirely identical as they are independent entities’, but ‘the current differences are not significant.’


Where is the ailing rating industry going to?


‘The entire rating industry has almost turned into a laughing stock with no sign of improvement.’ An experienced insider with over 10 years in rating industry did not shy away from the problem, ‘the ratings of entities and bonds are very much cluttered at the top grades. Under the current economic situation, upgrading is still more frequent than downgrading.’ 


Data from Wind shows that by 26th May, among all 4647 bond issuing entities, as many as 670 companies received AAA rating, and 912 and 2289 for AA+ and AA respectively.  The number of companies in top 3 rating grades account for more than 83% of the total.


Data provided by the senior researcher Ying Jian from BOC HK showed that credit bonds issued by the U.S. companies are rated in four investment rating grades, AAA, AA, A and BBB, and three speculation rating grades, BB, B and CCC.  BBB is the most concentrated grade with 34% share for investment rating. And B is the highest for speculation rating with 16%.  The highest grade AAA only accounts for 0.8%, next AA 4%, totally around 5%.


On the other hand, the Chinese credit bonds see AAA accounting for 15%, AA 82%, A 2%, with B and below less than 1%.


‘Fundamentally, I think the divided bond markets with regulators letting loose has caused this embarrassing situation.’ An anonymous brokerage and fixed income analyst told the journalist from 21st Century Economic Report that regulators don’t want to have defaults on their administrative area, and ‘the competition among regulators results in rating issues deliberately overlooked’.  These all contribute to the bubbles that occurred.



‘The regulators have mixed feelings about this.  They are worried not only about rating agencies failing to give risk warnings but also them downgrading too quickly as a result.’ said the brokerage fixed income analyst.


‘The rating industry in China is different from the U.S. The major rating agencies in the U.S. have gone through years of selection by the market.  For example Moody’s used to be a publisher.  They had a lot of data and later they started to expand into rating business with other publishing businesses supporting to remain its independence.’ The above said rating agent analysed that the rating industry in China on the other hand came to existence because of the needs to develop bond markets.  As single business operations, inevitably they would get into rating competition. ‘When Pengyuan made its way into the corporate bond rating market, it acquired over 50% market share in less than a year, forcing others to join in the competition too.’


How can we break out when we face this kind of dysfunction?


Ying Jian believes that if we would like the credit bond market to grow, we cannot only have AA and above in the market.  When it's necessary, we should leverage external forces, for example to allow more speculation bonds in the market through compulsory requirements. Meanwhile, investors can play important roles in the secondary market too.  Even when pricing is unreasonable, it can be corrected through bond trading, providing evidence for the pricing of reissuing.


Even so, the said rating agent expressed his pessimism, ‘it may be too late to fix the problem now.  Probably to overturn everything and start again is the only way to turn things around.’