China Cracks Down on Credit-Ratings Inflation, Stoking Downgrade Fears

Credit Ratings Face Overhaul as Regulators Launch Broad Crackdown

Fear of Downgrades Sweeps China’s Bond Market

Chinese regulators are intensifying a crackdown on inflated corporate credit ratings after concluding that top-tier grades have been handed out too freely in the country’s bond market, regardless of issuers’ actual financial health. As the campaign gathers pace, downgrades and rating withdrawals are increasing.

Caixin reported on July 8 that regulators have recently begun broad financial reviews of companies awarded AAA ratings, the highest grade. The effort is focused on screening out issuers that lack sufficient grounds for such ratings.

Authorities are also closely examining companies whose bond yields are more than 200 basis points above those on government bonds of the same maturity. The group reportedly includes many property developers and local government financing vehicles. Through the reviews, regulators are pressing China’s credit-rating firms to adopt stricter standards.

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

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

The inflation reflects overlapping interests between companies seeking to raise funds through bond sales and the agencies that rate them.

Companies with higher ratings can issue bonds at lower borrowing costs and reach a broader investor base. Some institutional investors and wealth-management products are permitted to hold only bonds above certain internal rating thresholds.

Because issuers pay for their own ratings, credit-rating firms are at a disadvantage. Companies have a strong incentive to take their business to agencies willing to assign higher grades. That kind of ratings shopping ultimately fueled the inflation.

Regulators stepped in because the ratings system is no longer functioning as a reliable warning signal for risk in the bond market.

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

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

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

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

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