Artificially inflated credit ratings pose systemic risk to China’s economy

As a result of China’s credit ratings industry assigning favorable ratings to the bonds of local issuers while downplays their credit risks, the market is full of issuers who have AA ratings which are reserved only for the safest and strongest of investment-grade debt. This risks starting a new financial crisis.

In a rare rebuke to China’s own rating agency, Beijing’s securities regulator have punished the country’s biggest debt rating agencies underscoring growing concern of credit risks at a time of cooling economic growth.

International watchdogs have warned that risks from China’s debt levels could result in a financial crisis. China’s credit ratings industry typically assigns favorable ratings for local issuers and downplays their credit risks.

On Friday, the China Securities Regulatory Commission (CSRC) stated it would ban Dagong Global Credit Rating Co Ltd, one of the country’s four big bond rating companies, from taking on new securities rating business for a year, and forbade it from replacing senior management during that period.

The development comes in the wake of the National Association of Financial Market Institutional Investors (NAFMII), an official industry group under the arm of China’s central bank, stating it would suspend Dagong’s business around debt-financing instruments for non-financial firms, for a year.

Both, NAFMII and CSRC stated Dagong had provided consultation services to firms that it also issued credit ratings for.

Additionally, the CSRC came down heavily on Dagong for its unqualified management, poor internal management, assessment committee members, and missing modeling data. NAFMII said Dagong had provided false statements and information when NAFMII was investigating Dagong’s business practices.

Significantly, neither NAFMII nor the CSRC stated said which companies seeking ratings were involved in the violations.

“Credit ratings agencies providing consulting services to companies seeking ratings seriously deviates from the principle of independence, and is prohibited by the relevant regulations of the interbank market,” said NAFMII in the statement.

Dagong “violated industry norms, business rules and basic compliance requirements and caused serious adverse effects on the market,” said NAFMII.

Market watchers have attributed the punishments to Dagong as amounting to a slap on the wrist.

Dagong could not be immediately reached for comment.

HOLLOW RATINGS

According to Samuel Chien, managing director of Shanghai BoomTrend Investment Management, companies looking for ratings for their financial instruments typically shop among domestic agencies and give business to the agency which grants them better ratings. As a result, the market is full of issuers who have AA ratings.

In other countries, such high ratings are provided only for the safest and strongest of investment-grade debt.

“Risk differentiation is increasingly difficult in China, which could hamper investors’ confidence,” said Gary Ng, an economist with Natixis in Hong Kong. “This is not desirable as China needs the bond market more than ever to fund the upcoming fiscal stimulus. Any credit event created by underestimation of risk could worsen risk appetite of investors, and (lead to) a higher yield and funding cost for both local governments and corporates”.

2018 saw a whole lot of defaults in corporate bonds, including ones which were rated very high by domestic firms.

Case in point: Xinjiang Production and Construction Corps (XPCC) Sixth Division State-Owned Asset Management Co Ltd, which had been awarded an AA rating by Shanghai Brilliance Credit Rating & Investors Service Co, missed principal and interest payments on a short-term commercial paper issue, in a rare default by a local government financing vehicle.

Significantly, although China has tried to maintain and ease credit conditions while encouraging investments in corporate bonds to support struggling private firms midst signs of a slowdown in economic growth, corporate issuers have not been the main beneficiaries of these policies.

Dagong is one of China’s most prominent ratings firms, and has achieved some recognition outside China for its controversial sovereign issuer ratings.

Earlier this year, in January 2018, Dagong cut the sovereign ratings of the United States to BBB+ from A-, equivalent to those for Peru, Colombia and Turkmenistan, citing concerns that tax cuts could weaken Washington’s ability to repay debt.

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