China struggles to contain its corporate bond morass.
Maybe the US government refused to pay China’s Dagong Global Credit Rating for an AA or AAA rating. And in January 2018, Dagong let the US know how things worked in China: It downgraded US Treasury debt from A- to BBB+ though there is near-zero credit risk since the Fed can always print the US government out of trouble.
At about the same time, Dagong gave Sunshine Kaidi New Energy Group, a privately-held Chinese company, an AA rating though there were already reports about the difficulties the company had with its debt. In June, the company defaulted on 18 billion yuan ($2.6 billion) in bonds. In July, the Shenzhen Stock Exchange warned that a publicly traded subsidiary – Kaidi Ecological and Environmental Technology Co. – may be delisted after its auditor refused to sign off on its financial statements.
Since the default, Dagong slashed Kaidi New Energy’s rating four times to C.
Despite the government’s struggle to contain the growing corporate-debt meltdown in China, Dagong upgraded about a fifth of its clients’ credit ratings since the start of 2017, according to the South China Morning Post.
It’s a broader problem. Dagong isn’t the only credit rating agency in China. There is a whole industry, of which Dagong has about a 20% market share, though the three major US rating agencies – Standard & Poor’s, Moody’s, and Fitch – have been locked out of the market. Of the 1,744 Chinese companies that have issued bonds, 97% were rated AA or higher by Chinese rating agencies, with 27% (464 companies) being AAA-rated. In the US, only a handful of companies are still AAA-rated.
And now two Chinese regulators have disclosed why rating agencies issue these AA and AAA ratings even as corporate debt meltdown becomes difficult to contain: Dagong had effectively sold high credit ratings to bond issuers.
And as punishment, the regulators decided to suspend Dagong’s credit rating services in China for one year, according to the South China Morning Post:
NAFMII, an agency under the People’s Bank of China, said in a statement on Friday that Dagong had been found to have “directly provided consulting services to rated companies,” which is prohibited, and “charged high fees” that compromised its independence between November 2017 and March 2018.
In also said Dagong had provided false statements and untrue information to the watchdog during its investigation, adding that its actions had a “very negative” impact on the market.
The Chinese Securities Regulatory Commission said in a separate statement cited by the SCMP that a site inspection had found serious problems at Dagong, including:
- “Chaotic internal governance”
- “Charging consulting fees from those being rated”
- “Hiring executives without professional qualifications”
- “Loss of original documents for some rating services.”
Dagong released its own statement, apologizing for its actions.
Investors in China’s corporate bond market have to navigate the Wild West of bond markets where debt creation is opaque, where companies, often with inscrutable ownership structures, have loaded up on enormous piles of debt to fund acquisitions, overcapacity, and foreign adventures, but where outright defaults are rare only because the government, via its state-owned megabanks, keeps bailing out troubled borrowers. This includes measures like telling those state-owned banks to convert some defaulting debt into equity.
No investor can trust anything Chinese companies – or Chinese rating agencies for that matter – disclose about their debts, and the only hope is the history of corporate bailouts by the Chinese government. But Chinese authorities are trying to wean investors ever so gradually off these assurances and have allowed a few bond defaults here and there to proceed to the great astonishment of befuddled investors.
The punishment handed to Dagong – effectively not being able to do business for one year – shows that the government is getting more serious about trying to tamp down on the corporate bond morass and bring some glimmers of sunshine to its opacity. But categorically allowing corporate debt to default, and allowing market participants to restructure this debt on the backs of shareholders and creditors, would accomplish a heck of a lot more in that department.