Government revenues are down in China as provincial authorities told to tighten their belts. Image: Facebook

China’s freewheeling bond market is increasingly fraught with unseen risks, as AAA ratings handed out by local agencies often mean debentures are just as vulnerable to defaults as lower-rated notes. 

Those increasingly flawed local assessments have raised bigger questions about the health of China’s US$7 trillion bond market, a trust deficit that could soon be addressed as international credit rating agencies such as Standard & Poor’s and Fitch enter the market.

When Brilliance Automobile, one of the largest state-owned enterprises (SOEs) in China’s northeastern Liaoning province, issued bonds a few years ago, investors enthusiastically snapped them up.

They were allured by Brilliance’s AAA rating given by China’s leading bond credit agencies, the SOE’s perceived cozy ties with provincial authorities and its lucrative joint venture with German auto giant BMW. 

But despite stated assets of 200 billion yuan (US$31 billion), Brilliance’s default on a mere one billion yuan payment at the end of October roiled China’s bond markets, causing research agencies and others that once churned out glowing reports and ratings scrambling to downgrade the automaker’s creditworthiness. 

Cars roll off a production line at a plant operated by a joint venture between Brilliance and BMW in Liaoning. Photo: Xinhua

To the chagrin of Brilliance’s lenders, the Liaoning provincial government’s State-owned Assets Supervision and Administration Commission did not rush to bail out the automaker but instead looked on as the enterprise’s financial crisis spiralled.

Creditors are now in bankruptcy proceedings with Brillance, with prospects of recovering their loans reportedly dimming by the day. 

Chinese bond markets also shuddered in November when mine operator Yongcheng Coal & Electricity Holding Group, ultimately owned by the provincial government of the resource-rich Henan through a holding vehicle, failed to amortize its maturing short-term commercial paper of about one billion yuan issued in February at a fixed interest rate of 4.39%.

The coal producer eventually made a 50% principal payment in December, drawing on its fiscal reserves and tapping other loans, but the damage to its previous AAA rating was done. 

Yongcheng’s major bond-issuing partner, the Beijing-based China Chengxin Credit Management Co, Ltd, one of China’s largest rating agencies whose name means “trustworthy” in English, was barred by the National Association of Financial Market Institutional Investors (NAFMII) from engaging in new loans and bond issues for three months for its flawed assessment.

Still, many saw the disciplinary action as too soft to deter others.  

It has been suggested by Chinese media, including the influential Economic Observer newspaper, that with their local economies ailing and fiscal revenues ebbing, provincial cadres in Liaoning and Henan had been warned by Beijing not to step in to salvage Brilliance and Yongcheng as their bids could deplete the two provinces’ already thin coffers.

Reports also hinted that Beijing’s attitude was that investors suffering losses should chalk it up to risk-reward, market experience.

But the growing list of defaults threatens to shake broad investor confidence in Chinese bonds. Tsinghua Unigroup, a Beijing-based state-owned chip and electronic component producer affiliated with the top-flight Tsinghua University, defaulted on its bonds in November despite receiving a AAA rating from Chengxin.

The Shanghai bourse temporarily halted trading of the company’s shares to arrest a mass sell-off.

The People’s Bank of China has granted permits to international rating firms like S&P for them to operate independently in the country as part of Beijing’s drive to open up its bond market. Photo: Xinhua

Last year, there was a spike in defaults among Chinese borrowers, many of which had been recognized and recommended by domestic debt analysis agencies for their supposed strong financial positions and small risk premiums.

Among 46 defaults by Chinese debtors who carried AAA ratings since 2014, 32 have occurred within the past 12 months, according to preliminary figures from market watchdog NAFMII. 

While ratings and picks from Chengxin and other local ratings companies now face rising skepticism, some institutional investors in China are now reportedly establishing their own divisions to screen which bonds are truly AAA and which are not.

Investors’ predilection for SOEs, with their implicit state backing, has played a part in the inflated ratings. But beyond the defaults in Liaoning and Henan, SOEs in better-off coastal provinces like Zhejiang, Guangdong and Jiangsu also failed to pay back debts last year. 

Others with heavy debt profiles but strong political backing can still raise funds. Examples include China Minsheng Investment Group, backed by the semi-official All-China Federation of Industry and Commerce, and HNA Group, supported by its home province of Hainan.

Both firms, once mired in debt due to ill-conceived mergers and acquisitions and later forced to offload assets to reduce their gearing ratios, now maintain AAA ratings. 

Yet questions are swirling about how many more SOEs with top ratings should be downgraded amid the storm of defaults. More than 63% of new bonds issued in 2020 in China were given top AAA ratings by domestic rating companies. 

The fact that most Chinese rating outfits rely on bond issuers for the lion’s share of their income means that they are de facto paid by borrowers to favorably rate their debts and outlooks.

The emerging trust deficit means international ratings agency competitors could soon fill the gap as part of Beijing’s liberalization drive to open up China’s bond markets to more foreign participation. 

Standard & Poor’s sees a market opportunity in China. Image: Facebook

Standard & Poor’s has acquired permits from the China Securities Regulatory Commission and People’s Bank of China for a wholly-owned subsidiary to operate in the Chinese market. Fitch Ratings will reportedly follow. 

Last year, S&P Global (China) said in a statement marking its first year in mainland China that its corporate methodology for the country was designed to describe key areas affecting the credit quality of corporate issuers, with an emphasis on stand-alone credit profiles and issuer credit ratings based on independent investigation and analysis. 

Chen Hongshan, S&P’s China chief, told reporters in December that the company would gradually expand its analysis to cover more issuers like SOEs and key private entities in 2021.

She added that applying S&P’s China-specific appraisal methodology, a “retrospective” risk assessment of Yongcheng would give its bonds an initial grade of BB, as opposed to Chengxin’s AAA rating, and that S&P would further downgrade Yongcheng bonds to BB- and B+ to reflect heightened risks.