China Opens its Doors to International Ratings Agencies

We’ve written extensively about Asia in recent weeks, and I wanted to return to the region in this week’s blog post in order to talk ratings.

A Bold Step into the Unknown

Standard & Poor’s recently became the first international ratings agency to be granted a license to operate in China, the world’s (soon to be) second largest bond market. The company has already hired at least 30 analysts for its Beijing office, so this is a serious commitment and it’s worth pausing to explore its causes and implications.

Demand for credit analysis is high in China, due to an unprecedented wave of defaults, often with little impact on domestic credit ratings. 45 Chinese corporates defaulted on 117 bonds with a principal amount of Rmb110.5bn ($16.3bn) in 2018, according to Fitch.

By granting S&P a license to set up a wholly owned unit to grade domestic bonds, the Chinese authorities are signaling to the world they’re serious about bringing international investor capital into the country. Issuers and dealers across international capital markets will be licking their lips at the prospect, but challenges remain.

The Curious Case of CMIG

Bloomberg cites the example of China Minsheng Investment Group (CMIG), one of the country’s largest private borrowers, which defaulted in February and is now in talks with creditors to maintain solvency. It was previously rated AAA by Shanghai Brilliance Credit Rating & Investor Service and this has not changed, despite the default.

The fact remains that the rules of engagement are very different in China versus traditional capital markets jurisdictions. S&P and other foreign ratings agencies must navigate a complex, politically fraught market whilst competing with established domestic companies. There are several local ratings agencies, but they have grown up in an era of tight state control in which China has prevented defaults. In China, more than anywhere else, the bond market is highly politicised.

Anyone for Some Political Risk?

China still falls within the somewhat antiquated purview of ‘Emerging Markets’, which feels a little crazy to anyone who’s visited Beijing’s gleaming financial district and seen the wealth that washes around the streets of Shanghai. But when it comes to corporate transparency, China is still playing catch up with developed markets. Challengers like S&P will have to be content with a fundamental lack of information and data and abnormal practices whereby the majority of ratings are AAA despite suspect credit fundamentals.

40% of domestic corporate bonds are rated AAA by the four leading local agencies, compared with just 2% in the US. This so-called “ratings inflation” has lead to a recalibration of investor expectations, with Chinese credits rated lower than AA considered as junk.

Into this strange new world steps S&P. What might seem like a no-brainer is actually a high-risk move. A number of questions remain unanswered. How will it manage and interpret the Chinese government’s hands-on approach to preventing private sector defaults? Can it retain impartiality in this new market, or will standards applied to its Chinese operations diverge from those in other, more developed financial markets? Can a tailored approach to credit analysis across different markets really work? I don’t have answers to these questions, and neither, I suspect, do S&P at this point.

No Pain, No Gain

Despite the formidable challenges ahead, I see this move as a hugely positive development and I commend S&P for stepping into the unknown and being the first international ratings agency to commit to China. The PBOC has been making the right noises about credit ratings for some time, understanding that they hold the key to widespread financial reform in the country by attracting foreign capital and independent scrutiny. Downgrades and defaults can be a good thing, as they demonstrate that the market is functioning properly. Global funds are pouring record amounts into China’s fixed-income market, and we can expect this to accelerate with the right reforms.

It will be interesting to see to what extent the international ratings agencies bring about a wholesale re-rating of credits and whether there is any impact to the Chinese bond market’s credibility. But in the long run, the opening up of the ratings system will transform international perceptions of Chinese capital markets, bringing more transparency, better price discovery and ultimately, a larger and more diversified investor base.