A passage to covered bonds
The introduction of covered bonds in India could allow issuers to reach beyond the domestic investor base and tap a US$3 trillion global market
CHINA’S rating standards system offers a “China perspective” to local and foreign renminbi investors on China’s sovereign credit quality.
The internationalization of China’s bond market and ongoing international cooperation around the Belt and Road initiative are opportunities for the domestic credit rating system to gain some recognition from these investors.
Unfortunately, this is not the case. Local and foreign investors in search of a “China perspective” are inclined to seek the services of the world’s Big Three, which have dominated the market for sometime now.
This should bring us to the realization that much needs to be done to fix the domestic rating standards system.
The domestic rating standards system offers a fair picture of the “China perspective”. However, this doesn’t mean that the system offers users of ratings adequate information around credit risk.
For example, as most of the disclosed credit ratings are one of AA, AA+ and AAA. The slight difference among the ratings is increasingly inadequate to meet investor demand for refined risk management.
Firstly, some investors are of the opinion that the information and reference value of the ratings provided by domestic credit rating agencies are on a decline in terms of quality.
And so some would use external credit ratings to meet regulatory constraint requirements, other than as pricing bases, and let in-house credit rating teams to judge credit risk instead.
Secondly, the spread of issued or traded bonds rated as AA+ or AAA by some domestic rating agencies are statistically insignificant. That points to some wide disagreements between investors and external credit rating agencies and impact the comparability of credit ratings.
Domestic rating agencies should thus acknowledge the weaknesses of the domestic rating standards system, and take practical measures to enhance the consistency and comparability of ratings.
Rating agencies and their associates should strengthen consistency and comparability management of their credit rating standards system and rating policies, especially the monitoring and inspection of cross-market credit rating standards. They should also strengthen the oversight on rating policies and interest rate spread, implement integrated management, and raise the transparency of information disclosures regarding the rating methods, models, spread inspection and default inspection.
To meet investors’ requirement for refined credit risk management, rating agencies should, apart from assigning ratings, further conduct industry- and region-specific research on investor needs for credit risk transaction and management, as well as credit risk research on enterprises and debts. They should also consistently improve services and communication with investors based on ratings and research results, and tap into the investor services market.
Rating agencies should reinforce self-discipline during competition to avoid further aggravation of inadequate differentiation of credit ratings caused by harmful competition.
To gain the confidence of international renminbi investors, rating agencies should step up research on sovereign credit ratings and country-specific credit risks, disclose rating methods, data, models and results to investors, and fulfil multilingual information disclosure as early as possible.
Rating agencies should consistently launch activities for communicating with investors such as non-transaction roadshows, enhance the ability to communicate with overseas investors as well as raise their confidence in China’s sovereign credit quality and recognition of the domestic rating standards system.
Enhancing rating standards
The rating standards system in China and abroad cater for the risk management of different investors, and one isn’t superior over another.
China’s rating standards system should be one that is anchored on China’s sovereign credit quality to realize relative sequencing of global ratings, other than a regional system. It should also chiefly serve Chinese and overseas renminbi investors anchored on the quality of China’s sovereign credit.
The key opportunity for China’s rating standards system is that Chinese investors need to judge credit risk from the “China perspective”, while its core competitiveness lies in the recognition from Chinese and international renminbi investors.
Despite some misunderstanding arising from scepticism about inflated ratings in China, the existing defects in the domestic rating standards system, if left unresolved, are enough to affect investor recognition both at home and abroad.
It is hence imperative that domestic rating agencies work together to further boost the competitiveness of China’s rating standards system.
On the one hand, they should strengthen comparability management of rating standards, enhance information transparency and reinforce self-discipline amid competition; on the other, boost their ability to serve domestic and overseas investors and consistently carry out communication and exchanges with them.
Role of regulators
As the government attaches greater importance to financial risk prevention, control and coordinated regulation, it is suggested that relevant regulatory authorities work together to reinforce the supervision of inconsistency and incomparability in cross-market credit ratings, monitor, inspect and penalize cases that violate the consistency and comparability principle.
Regulators should also strive to eliminate spread deviations caused by systemic differences in cross-market credit ratings, and enhance the comparability and consistency of credit ratings across markets.
In contrast to adopting the rating from one credit rating agency, overseas bond issuers normally employ several credit rating agencies for bond issuance. Such a rating mechanism can best meet the risk management need of different investors so as to reduce inconsistency between credit rating agencies’ opinions and investors’ judgments on risk.
Therefore, regulators are advised to enrich and improve the dual rating mechanism for China’s bond market by formulating relevant regulations and encourage issuers to employ a number of rating agencies to conduct credit ratings tailored for investor needs.
Inadequate differentiation of credit ratings is, to a certain degree, related to the way regulators and investors use credit ratings. If the conditions to use credit ratings can be regulated properly and the bond issuance registration mechanism can be implemented at a faster pace, the issue that there are now only three credit ratings (i.e. AA, AA+ and AAA) is likely to be solved fundamentally, and a full range of credit ratings may be assigned.
Chinese investors should be encouraged and guided to adopt the “China perspective” to judge credit risk when they invest at home and abroad.
Encouraging the engagement of domestic and foreign credit rating agencies to conduct credit risk management is a good start. This has been proposed in The Code of Conduct for the Operation of Overseas Investments by Private Enterprises, which was jointly issued by National Development and Reform Commission and other national authorities. Chinese investors must also be guided to further apply the “China perspective” to judge credit risk throughout the whole process of making outbound investment.
Investors also play a role in boosting the credit rating system. It is recommended that investors make reasonable use of external credit ratings, assess the applicability of external credit rating standards and ratings based on their own asset allocations and risk management appetite, and make credit risk management decisions by balancing the external credit ratings and the results from the internal credit risk management mechanism.
Investors are also advised to maintain continuous and effective communication with credit rating agencies about credit risk management strategies and ratings and boost communication efficiency. Investors must also obtain customized credit risk analysis and early warning management services for investment portfolios from trustworthy external credit rating agencies to meet their more sophisticated requirements for credit risk management.
Meanwhile, issuers should evaluate their own credit quality, submit accurate materials to credit rating agencies and investors during the preparation for bond issuance, as well as the periods of issuance and duration.
They should maintain adequate communication, and ensure that their judgment about their own credit quality does not materially deviate from those of credit rating agencies and investors so as to avoid invalid ratings.
For first-time bond issuers, some of them can employ a number of credit rating agencies recognized by investors to conduct credit ratings in order to enhance the efficiency of communicating with potential investors.
The article has been translated from Chinese and edited for style and clarity. This is an excerpt of the original article that first appeared in the Financial Market Research magazine, a publication sponsored by China’s National Association of Financial Market Institutional Investors (NAFMII). Luo is chairman of Golden Credit International, one of the leading credit rating agencies in China. Yu works in the same company as vice director.