The announcement that China's corporate bond market was getting a new policeman was cause for cheer among the foreign credit ratings agencies. Now run by the progressive securities regulator as opposed to the conservative state planner, this anemic area of the capital markets could expect to get a shot in the arm.
The more firms issuing debt, the greater the demand for those who assess whether this debt is worth buying. Could it mean that the likes of Moody's, Standard & Poor's (S&P) and Fitch Ratings were finally going to get permission to rate domestic corporate bonds?
Unfortunately, it did not or at least, not yet. When the China Securities Regulatory Commission issued permits to assess these new bonds during the summer, it opted for local operators exclusively. Domestic stalwarts China Cheng Xin, Dagong, China Lianhe and Shanghai Brilliance were chosen; the local joint ventures through which some foreign agencies operate were overlooked.
Out of the running
"It is not uncommon for regulators in emerging market to let domestic agencies come to the market first," said Dr Chen Chung-Hsing, head of Xinhua Finance Ratings, which has a joint venture with local agency Shanghai Far East. "In fact, not being able to get approval may be a blessing, as the environment is not good for ratings agencies right now."
To find out why, it is necessary to browse the small print of the CSRC's new regulations. In most markets, the auditor, legal counsel or the company executives are held responsible for information they disclose which is then used in a credit rating. But the CSRC places the burden of responsibility on the ratings agencies.
"It's a big deterrent," said Joseph Hu, China country head for S&P. "How can we have our analysts held responsible for things like that? We would have to be ratings analysts and auditors."
According to sources, the local ratings agencies permitted to assess corporate bonds get around the rules by printing a disclaimer on their reports although it is unclear whether this would stand up in court. It is not something foreign ratings agencies, with their heavyweight reputations to consider, could get involved in.
"The domestic agencies are very courageous," said Xinhua Finance's Chen. "They see the licenses as a blessing to enter a new market. Our experience is that the survivors are the ones who get to the end of the marathon and this isn't determined by who gets a license first."
The implication is that domestic ratings agencies have yet to establish themselves as reliable arbiters of risk. Given the ease with which they hand out AAA ratings to Chinese bond issuers in 2004, for example, the Big Four state bank were all top-rated domestically despite foreign analysts saying they were technically insolvent and hopelessly inefficient this may be a fair judgement.
"Right now the ratings agencies rush to be the first to give a high rating because they want to generate business [among the issuers]," said Charlie Ye, head of fixed income at UBS Securities in Beijing. "I believe some credit default events will happen and the accountablity of local ratings agencies will be on the spot. Some of them will be banned or punished if it turns out they misled investors."
Awarding a corporate credit rating is an intricate process. First, a team of analysts trawls through a stack of information provided by the company being assessed: financial statements, profiles, market share information and product and pricing strategies.
Then there are meetings between analysts and company executives after which a report and initial rating recommendation are produced. Ratings range from AAA (top investment grade, indicating a strong ability to repay the debt issued) to C (highly speculative junk bonds).
Once senior analysts have approved the rating, it is passed on to the company along with details of the thinking behind it. The company can appeal against the ruling, keep the rating confidential or make it public. Going forward, the agency keeps the company under surveillance to ensure the rating stays accurate.
"If you speak to the local ratings agencies, they will say they have 15 years of experience," said S&P's Hu. "But have they accumulated enough data? Are they using the right procedures? Have they done enough surveillance to test their own rating criteria? Can they say their ratings have been stable?"
It is not only in their methodology that the local players underperform. In many ways they are also victims of the market. Amassing accurate data on Chinese companies remains challenging as the corporate culture doesn't lend itself to disclosure. Furthermore, many firms rely on a strong rating AA or above to attract institutional investors, and this has called into question the ratings agencies' independence and objectivity.
Yet as they strive to play a greater role in the corporate bond market, reputation is likely to be the agencies' prime asset. In more mature, market-driven conditions, investors will look for ratings provided by agencies with strong track records.
"What makes a ratings agency good is speaking the truth and being independent," said Ivan Chung, a Beijing-based analyst at Moody's. "The priority is getting the rating correct as this brings value to your business. Not all ratings agencies comply with this principle but, ultimately, it is the market that will decide."
If they are to operate at a higher level, the local players must also stop competing so ruthlessly on price as there is always the risk that analysts will capitulate to the demands of the issuer and compromise their standards. Stephen Green, senior China economist at Standard Chartered Bank, advocates introducing a minimum price system for credit ratings, which would cut out the bargain basement behavior but still allow agencies to compete on price after a certain point.
Either way, he believes it is in the industry's best interests to allow greater overseas involvement so that domestic agencies have something against which they can benchmark their progress.
"Allowing foreign competition would be a great move as it would raise standards across the board and push local agencies to give credible ratings," Green said.