China Moves to Deflate Ratings Bubble as Downgrade Fears Grip Bond Market

Regulators launch sweeping overhaul of credit ratings

Fear of downgrades spreads across China’s bond market

Chinese regulators are moving to rein in inflated corporate credit ratings. Authorities concluded that top-tier ratings have been handed out too freely in China’s bond market, often regardless of issuers’ underlying finances. As the crackdown intensifies, downgrades and rating withdrawals are piling up.

Caixin reported on July 8 that regulators have begun broad financial reviews of companies carrying AAA ratings, the highest grade. The focus is on screening out issuers that lack sufficient justification for those ratings.

Authorities are also closely examining companies whose bond yields trade more than 200 basis points above government bonds of the same maturity. The group reportedly includes many property developers and local government financing vehicles. The move is intended to push Chinese rating firms to adopt stricter standards.

Ratings inflation in China’s bond market is a structural problem that has built up over years. As of the end of the first quarter, 27% of the country’s roughly 6,000 bond issuers carried AAA ratings, while 32% were rated AA+. That means well over half of all issuers were clustered in the top rating bands.

In the first half of last year, 90% of rated corporate bonds issued in China received AAA ratings. A decade earlier, AAA bonds accounted for less than half of the total. Yet even as the property slump deepened and corporate profitability weakened, the share of top-tier ratings kept rising.

That inflation reflects the aligned interests of companies seeking to raise funds through bond sales and the credit-rating firms that assess them.

Higher ratings allow companies to issue bonds at lower interest rates and tap a broader investor base. Some institutional investors and wealth-management products are permitted to hold only bonds that meet minimum internal rating thresholds.

Because companies pay for their own ratings, credit-rating firms are in a weak position. Issuers have a strong incentive to take their business to agencies willing to assign higher grades. That ratings shopping ultimately fueled the inflation.

Regulators moved in because the ratings system was no longer serving as an effective warning signal for risk in the bond market.

Defaults by AAA-rated issuers including Yongcheng Coal & Electricity Holding Group, a state-owned coal producer in Henan province, and Tsinghua Unigroup shook confidence in the bond market. Those defaults also triggered selling in related sectors and companies and widened credit spreads.

The crackdown is already showing results. As of the end of June, China’s bond market had recorded 28 rating downgrades this year, far exceeding the nine for all of last year.

More than 220 companies also withdrew rating requests as the risk of downgrades mounted. CSC Financial projected that as much as 494.6 billion yuan ($68.9 billion) of corporate bonds could face downgrade risk in the second half.

"AAA ratings in China’s bond market will probably be awarded more selectively going forward, mainly to large financial institutions and high-quality companies," an industry official said. "In the short term, downgrades are likely to continue, and some bonds may come under selling pressure."

Kim Eun-jung, Beijing correspondent, Korea Economic Daily, kej@hankyung.com