U.S. Subprime Echoes Seen in China Debt Ratings for Dagong

Competition among China’s credit-rating companies is intensifying, leading to a slide in standards reminiscent of what happened in the U.S. before the financial crisis, according to Dagong Global Credit Rating Co.

China’s onshore bond market had its first default today, with Shanghai Chaori Solar Energy Science & Technology Co. saying it’s unable to make an 89.8 million yuan ($14.7 million) interest payment. The solar cell maker sold 1 billion yuan of five-year debt in March 2012 and the notes were rated AA, the fourth-highest investment grade, by Pengyuan Credit Rating Co. when they were issued. The debt was subsequently downgraded twice, most recently to BBB+ in April 2013, according to the rating company's website.

“China’s rating system has problems similar to those in the U.S. in 2008,” Guan Jianzhong, the Beijing-based chairman of Dagong, said in a phone interview yesterday. “There’s cut-throat competition and it’s not about who accurately evaluates the risks, but comes down to prices and ratings.”

The U.S. Financial Crisis Inquiry Commission said in 2011 that inflated credit grades were partly to blame for the worst downturn since the Great Depression, as rating companies lowered standards to win business amid a housing boom that fueled issuance of mortgage-backed bonds. China ended in 2012 a four-year ban on sales of asset-backed securities and credit assessments are of growing importance as market forces play a greater role in pricing risk in its $4.2 trillion bond market.

Chaori Solar is trying to sell some overseas solar power plants to raise money to repay the debt and is in talks with banks on assistance with liquidity, Chaori Solar’s Vice President Liu Tielong said in an interview today.

Rising Yields

A default by Chaori Solar may become China’s “Bear Stearns moment” and prompt investors to reassess credit risks as they did after the U.S. securities firm was rescued in 2008, Bank of America Corp. said this week in a report.

The average yield on five-year AA- notes in China climbed 17 basis points in the last four days to 7.82 percent, headed for the biggest weekly increase this year, ChinaBond data show. Ratings of AA- or below are equivalent to non-investment grades globally, according to Haitong Securities Co., the nation’s second-biggest brokerage.

The average yield on junk corporate dollar debt surged to a record 22.66 percent in December 2008, more than double the 9.68 percent at the start of that year, according to the BofA Merrill Lynch High Yield Index. JPMorgan Chase & Co. bought Bear Stearns in March 2008, when the latter was on the brink of failure, and six months later Lehman Brothers Holdings Inc. collapsed in the biggest bankruptcy in U.S. history.

Reform Time

A missed payment by Chaori Solar “won’t pose systemic risks to China’s bond market, but it’s time to think about reforms in improving the rating system,” Guan said. Credit-rating agencies should be made responsible for the grades they award companies and provide more details on how they come up with their assessments, he said. Pengyuan Credit Rating wasn’t available to provide immediate comment for this article in three phone calls made to its Shenzhen headquarters.

Dagong, which cut its U.S. sovereign rating to A- from A on Oct. 17, was set up in 1994 and is one of China’s three biggest rating agencies. The other two are China Lianhe Credit Rating Co. and China Chengxin International Credit Rating Co., which is partly owned by Moody’s Investors Service.

Chaori Solar’s failure to make today’s interest payment would be a “wake-up call” for China’s bond market and signal regulators’ higher tolerance for corporate bond defaults amid financial reforms, Moody’s said in a report today.

Worsening Problem

“A default would also highlight the importance of more sophisticated credit analysis and would likely galvanize investors and regulators to pursue reforms such as the introduction of covenants, and better disclosures and governance,” Moody’s analysts Ivan Chung and Gary Lau said.

Issuers in China must obtain a rating of AA- or above in order to secure authorities’ approval to sell debt, Guan said. He warned in 2010 that grades assigned to bonds issued on behalf of local governments were misleading and failed to reflect the risks faced by investors.

“The problem is getting worse,” Guan said. “Ratings on companies have been upgraded rapidly not because their repayment abilities have improved, but for the sake of getting bonds sold at lower rates, for getting the business done.”

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