China bond market: Dodgy numbers undermine ratings

News and opinion on finance

By Rebecca Feng

A borrower’s financials are a crucial element of any credit rating. Yet in China, ratings analysts privately complain that some of the financial statements being presented to them are either dressed up or entirely falsified, even though local auditors have signed off on them.

This is just one area where there is scope to improve the ratings business in China.

“These financial statements are stamped by the auditing firms,” says an executive at a local credit rating agency. “We do not have the right to audit or validate the audited financial statements.”

A senior debt banker at a big-four bank says that local rating agencies could not be expected to verify all the numbers that are sent to them. The division of labour between auditors and rating agencies means that most numbers have to be accepted as fact.

“While the credit rating firms should always reasonably question the financial statements companies provide them, the opinions from the auditor have legal force,” he says. “Banks and credit rating agencies cannot just refuse to use these statements.”

There is an obvious solution: rating agencies could turn down business from companies if they think the accounts cannot be trusted. Few seem willing to go that far.

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Three onshore bankers told GlobalCapital, Asiamoney’s sister publication, that they are aware of some companies forging financial statements to raise funds, without being discovered.

One case that has become public concerns Hangzhou-based Wuyang Construction Group Co. The company defaulted on two bonds worth Rmb1.36 billion ($197 million) in August 2017.

Yi Huiman, China Securities and
Regulatory Commission

In May 2019, the Hangzhou Intermediate People’s Court opened a case in which the plaintiff – 16 retail investors who bought the bonds – sued not only the issuer and its auditor, Wuyige Certified Public Accountants LLP, but also the lead underwriter of the deal, Tebon Securities, the legal adviser, Allbright Law Offices and the credit rating agency, Dagong Global Credit Rating, which had rated both deals double-A.

The parties involved either declined to comment or did not respond.

The phenomenon is not limited to bond issuers. The Shanghai Stock Exchange put out a statement in May listing some of the mistakes that IPO applicants had made in response to the regulator’s enquiries about their IPO prospectus.

The applications were for listing on the Shanghai tech board, which regulators hope will become China’s answer to the Nasdaq stock exchange.

The exchange says that some companies gave poor answers, while one bold applicant even edited the questions.

Chinese regulators have taken steps to standardize the credit rating industry, but insiders think the rules are ineffectual.

The National Association of Financial Market Institutional Investors (Nafmii) published its long-awaited standards for information disclosure for rating agencies in May: these standards apply when rating non-financial issuers and their bonds.

Previously published guidance and rules simply required rating agencies to disclose “basic information of a company” without specifying what that entailed.

New rules

The new rules set out what that basic information is, including, at the very least, a company’s name, founding date, registered address, paid-in capital, net assets, operation scope, shareholder and organization structure, number of employees and important contacts.

The top two local credit rating agencies, China Chengxin Credit Rating and Lianhe Ratings, already disclose this information.

Rating agencies are also required to disclose information about their general grading scales, methodologies and their own internal control and management rules, including how they manage conflicts of interest and maintain information on disclosure standards.

The new rules also demand that rating agencies publish the actual default rate of past rated credits, changes in ratings and yield spread between different grades to evaluate the accuracy of their ratings.

Foreign rating agencies have also been given a more prominent role. In January, S&P Global Ratings became the first foreign rating agency to obtain permission to rate onshore deals, although so far it has not done so.

The People’s Bank of China says it hopes the entry of foreign agencies could improve the quality of the domestic rating industry. But local sources say it will do little to improve accounting standards.

“They simply won’t be exposed to these dishonest companies,” a DCM banker at a big-four bank says.

This is acknowledged by some regulators, albeit privately. One regulatory official told GlobalCapital that the real solution was not going to come from introducing more rating agencies but from tightening the rules on those that already operate in the market.

Regulators are taking action. The China Securities and Regulatory Commission, which appointed Yi Huiman as its new chairman in early 2019, has banned the sale of anything but triple-A bonds to individual investors.

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