On April 1st, 2019, 364 Chinese government and policy bank bonds began to be included in the Bloomberg Barclays Global Aggregate Bond Index. Full inclusion is expected by end 2020.
When it’s all done and dusted, China’s bond market, that has just eclipsed Japan to become the world’s second largest after the US – and according to Bank of International Settlements data, is now worth US$12.8 trillion – will have attracted some $180 billion in foreign funds.
And that doesn’t count the potential international inflows into the domestic Chinese corporate bond market, also the world’s second largest, that to date remains largely untouched by foreign investors. Of the total of 1.73 trillion yuan ($255 billion) in foreign holdings of Chinese debt, only about 8%, a minuscule $20 billion, is invested in debt other than sovereign or quasi-sovereign.
But why have foreigners been shying away from the far more attractive yields of domestic corporate and financial bonds? One simple and straightforward answer is because of the utter lack of PRC credible ratings. A more nefarious reason are the widespread allegations of flagrant rating shopping.
Indeed, among the 1,744 Chinese bond issuers rated at the end of June 2018, 97% were rated AA, AA+ or AAA, according to China’s National Association of Financial Market Institutional Investors (NAFMII). Of these, 464 issuers were rated AAA. A Beijing regulator “cash for ratings” investigation in 2018 found conflict of interest discrepancies across the system. In August 2018, Dagong Global Credit Rating Co. was suspended by the Chinese financial regulator for a year after it was found to have been selling ratings to issuers. Among China’s ratings agencies, Dagong, with 20% market share, was both well known and highly regarded.
It was these factors that led Pengyuan International (PYI), the wholly-owned Hong Kong subsidiary of the PRC’s CSCI Pengyuan Credit Rating Co, to start rating mainland corporates and financial institutions in accordance with international standards.
On April 10, PYI entered the fray in the crowded US$500 million offshore market for US dollar denominated bonds issued by Chinese corporations and financial institutions – or “Kungfu bonds” as Bloomberg calls them – and became the first Chinese rating agency to issue an international-standard rating to a mainland Chinese corporate. It assigned a Long-Term Issuer Credit Rating (LTICR) of BBB- to Huai’an Water Conservancy Holding Group Co. Ltd. (HWC), and gave the company a “stable” outlook. On April 17, it confirmed this BBB- rating for HWC’s US$300 million 6.2% notes.
Local factors with international criteria
Huai’an is a municipality in China’s eastern Jiangsu Province, is home to 5 million people, and Huai’an Water is wholly owned by the municipality’s SASAC (State Owned Assets Supervision and Administration Commission.
With its strong local government ties and a clear public infrastructure focus, the Huai’an issuance could be understood as a typical example of PRC’s burgeoning offshore bond market. However, there is a significant difference here, according to Pengyuan, as the Huai’an bond has been issued internationally and its credit rating is the first ever that maps local Chinese economic and political factors alongside international rating criteria.
“Fundamentally this rating is about our detailed understanding of Chinese government,” Pengyuan’s CEO Jonathan Hu told Asia Times. “This understanding allows us to provide detail and an additional layer of transparency.”
Unlike in the States, there are no actual municipal bonds in China, explains Hu. And this, he thinks, has caused confusion for international investors. “These investment vehicles, these LGFVs,” explains Hu, “normally sit underneath the provincial level of government and are focussed on core infrastructure projects like water, electricity, city development or railway building.”
“In the west,” continues Hu, “it is a big economy with small government… but in China we have big government and small economy. It means different layers of government can and do play significant roles in supporting these types of [infrastructure] companies… US dollar bond issuance has recently seen exponential growth in China and there are now many Chinese company doing USD issuances. But we believe to understand how this really works, you have to really understand China and that means understanding the market sensibilities.”
According to Hu, Pengyuan can do this by making a dual assessment.
“We look at the standalone strength of the company, using conventional international criteria. But, because of the way different government departments allocate different finances, an entity may not make money so its standalone rating will be low.” However, says Hu, “their assets can actually be considerable, worth a few billion dollars. To accurately assess them, you need to know that information. And if you do, you can offer international investors a different opinion.”
Government policy fuels market growth
China’s bond market has grown rapidly in recent years. Valued at less than $2 trillion a decade ago, it will, soon top $13 trillion. This expansion has been underpinned by Beijing’s policy of attempting to stimulate a sluggish economy through local-level infrastructure investment while at the same trying to control escalating domestic and corporate debt and managing the risk of loan defaults.
In October 2017, when the 19th National Congress brought in a raft of new legislation that set out to reform domestic investments reforms and control capital flows, it started the push toward offshore dollar bonds and this helped open the market for international investors.
However, China’s onshore bond market is still almost entirely dominated by quasi-sovereign financial institutions and banks, and a Goldman Sachs report from last month shows foreign investors still only make up 2% of this onshore sector. The Goldman report says international players have stayed away because of a fear of PRC investment bureaucracy, because of liquidity risks, and of course because of the above mentioned widely perceived lack of credibility and transparency from China’s domestic credit agencies who have regularly been accused of not just corruption but also complex conflicts of interest that has led to inabilities to fully disclose risk.
China’s road to global ratings
Global bond markets have long relied on alphabetic-based credit ratings systems – that, in summary, range from multiples of “As” for the best prime investments to multiples of “Cs” for so-called junk – to provide evaluations, that in theory are independent, about an issuer’s creditworthiness.
However, the system in China has remained muddied because domestic agencies have regularly issued starkly higher ratings for Chinese bonds than the ratings issued by international agencies. As the NAFMII data shows, the standard issue in China has been a double A or higher, while a Bank for International Settlements report from 2017 found that the “big three” international agencies, Standard & Poor’s, Moody’s, and Fitch, regularly graded PRC bonds six levels below their Chinese counterparts.
Frank Gong, founder of First Seafront Financial and former Chairman of JP Morgan’s China Investment Banking division told Asia Times that, for China’s bond market to fully open up to foreign investors, credit rating “usability” is key, and added that the combined local-international approach by Pengyuan should prove “very helpful.”
A lot of domestic bonds, says Gong “have not, in my view, been rated properly, which means, of course, their credibility is very low. Credibility directly effects how usable that rating is, and usability is key for global investors.”
Gong adds that China will continue to “modernize” its ratings infrastructure and, once the US and China reach a trade deal, these factors will combine to transform the local bond market into a truly global one. What we are seeing now, says Gong, “is just the start.”
Connecting international bond flows
Julien Martin, General Manager of Bond Connect– a Hong Kong-based investment platform that facilitates overseas investment in Chinese bonds – says local-global credit agencies can play an important role in “bridging the information gap” between issuers and international investors.
“But it is in both directions,” says Martin. “Chinese regions have different legislation and market infrastructures” which means operations like Pengyuan’s “can allow offshore investors a better understanding of these local market factors and political structures while also teaching Chinese issuers about international requirements.” And this, says Martin, will also help Chinese issuers raise their credit profiles.
Martin adds that the move by a domestic Chinese rating agency to rate an international US dollar bond is “an important milestone .” Others, he says, are the continued publication of professional research papers and company prospectuses, the continued expansion of international credit agencies into China and April’s establishment of Barclays / Bloomberg Index.
Unsurprisingly Martin also says Bond Connect, that is a joint venture between China Foreign Exchange Trade System and Hong Kong Exchanges and Clearing Ltd, will make a significant difference to the opening up of Chinese bonds. It only started in 2015, says Martin, but in recent months it has “boomed.”
“We now have more than 900 investors, with significant numbers from the UK and USA. The process is accelerating and, as it does, the infrastructure that facilities this process will only expand too… The market is developing more and more and 2019 has been a fantastic year. It is,” concludes Martin, “a milestone year.”
Pengyuan International’s move to international ratings may have come just in time. On January 29th, S&P was granted a license to conduct credit rating business in mainland China and Moody’s and Fitch have both opened wholly owned subsidiaries in the country and are awaiting government permission to start operating.
Some have expressed concerns that these big three players will, because of the complexities of China’s state-entwined market, be forced to create a custom credit-rating scale for China but for Jonathan Hu, the expansion by international players and the modernization by local players, is to be welcomed.
“By China showing strong corporate governance, showing transparency for data, and with the rise of modern domestic credit rating agencies,” concludes Hu, “these are things that will provide the granularity that global investors require.”