It’s been a bit of a mystery to many CFOs just how credit-ratings agencies come up with their judgements on the creditworthiness of corporates and sovereigns. The questions became louder during the global financial crisis, when top-rated companies like Lehman Brothers went bankrupt, and even today, as previously investment-grade Greece suddenly imploded.
Inside the Mind of a Credit Ratings Agency
Eyebrows were raised again when Dagong Global Credit Rating, a little-known agency established in China in 1994, recently rated China’s foreign-currency debt at triple-A – and gave the foreign currency credit of U.S. a lower double-A. Few took Dagong seriously, but the amount of media attention its action received showed just how unsettled the credit-rating industry had become.
CTRISKS, a Hong Kong-based credit-rating organisation founded in 2007 by City University academic Michael Wong, takes a different approach from Dagong and the international majors such as Moody’s and S&P. It focuses on short-term ratings, typically over one year, of banks and corporates in China, Hong Kong and Taiwan, as well as sovereign ratings.
“Traditionally the capital market demands long-term credit ratings, say three to five years, because investors tend to hold debt securities to maturity,” Wong explains. “However, with the prevalence of credit derivatives that help mitigate credit risk, investors and banks can easily monitor their credit risk on monthly or quarterly basis . . . There is no point for investors to consider long-term credit risk.”
CFO Innovation’s Cesar Bacani spoke to Wong to delve into credit ratings issues in the post-crisis environment. Excerpts:
CTRISKS rates China at the highest rating of CT3A. Is this the same rating you have for the U.S.? Do you think the U.S., in fact, should be rated lower than China, as Dagong Global Credit Rating has done for foreign currency debt?
We still rate the U.S. and many European countries at CT3A, the highest rating our company can offer, which indicates their superior ability to deal with economic stress. The U.S. does not have much foreign currency debt. If the U.S. government needs funds to bail out troubled banks or government-related institutions, it can easily issue USD-denominated debt. Of course, this may weaken market confidence in the U.S. dollar, but the government will not default.
For sovereign ratings, we consider several major inputs. They include GDP per capita, GDP size, economic competitiveness and the soundness of the banking system. We have a model that quantifies all these major factors. So if they are strong in economic size, they are strong in economic competitiveness, strong banking system and also economic growth, usually they can get top-rated.
It is rare for a country to default; the default of a country is mainly related to political issues. But the credit quality [of sovereign debt] will affect the bond price and also the credit spread, so we need to provide the market information about the credit quality [of the sovereign].
Does the sovereign rating have an effect on the corporate ratings? For example, if the sovereign is CT1A, no corporate can be rated higher at say CT2A or CT3A?
Why is this the case?
If the economic prospect is not good, the government will face trouble in many areas, including the banking system and social stability. For example, if the unemployment rate is high, it’s easy to have social unrest.
RATING CHINA FIRMS
So I take it the highest rating a Chinese corporate can get would be CT3A, which is what you give to the sovereign?
No. [CT2A is the highest rating given to a China corporate]. Data quality is also an important factor in risk assessment. The basic principle of risk analysis is that we should be more conservative if there is no information or inadequate information on risk. CTRISKS analysts have considered the issue of data quality in assessing the risk of China companies. China scores low in data quality; the accounting standards and also the enforcement of accounting regulations are not that tough.
What we do is assign a discount to reflect the [poor] quality of data. For example, according to normal standards, a company may be triple-A, but because of data quality issues, we may give it a single-A rating. This discount is to reflect the data quality.
However, the size of China companies, in terms of their assets, earnings and sales, is tremendously bigger than that of Hong Kong blue-chips, for example. “Too-big-to fail” may be untrue sometimes but it is true in most cases [in China]. A small company tends to have greater risk in economic stress, while a large company tends to have better fund sources to deal with crises.
After the 2008 crisis, China exports dramatically dropped by around 30%. Most analysts worried about the prospects of the export-driven economy. We now rate the majority of companies at CT3B [50.4% of the 1,700 companies rated in China], which is still investment-grade, but obviously more risky than those rated CT1A [33.6% of 1,700 companies] or CT2A [1.6%].
However, the flexibility of China’s government policies enabled the country to have robust economic growth in 2009 and so far in 2010. All the fundamental factors, including data quality, support [our position that] the current ratings assigned to China companies are fair.
The reason why no company is rated CT3A like the sovereign is data quality?
That’s true in part, but it is also because the [macro-economic] risks remain very high. China is very export-oriented, so the economic performance of the U.S. and Europe is fundamental for economic growth. We are still waiting for signals of a recovery in Europe [and sustained GDP growth in the U.S.], so demand in terms of factory orders will not be that [strong] for many China companies.
Default is strongly associated with the ability of a company to deal with economic stress. Small companies tend to have strong earnings growth, but they easily go bankrupt in economic downturns. In addition, CTRISKS analysts consider many external indexes or risk indicators or news to track the risk of a rated company. The volatility level of equity indices, industry indices and the equities themselves has good information value.
Some observers argue that China’s state-owned enterprises or SOEs are too big to fail, and therefore are safer than, say, privately owned companies. Is this taken into account in rating these entities?
Size is one factor to be considered, but if there are rumours and equity volatility rises to a very high level, we might need to downgrade. All the very big companies in China are state-owned enterprises. There are some big private companies, but compared to state-owned enterprises, they are still small-sized. SOEs have many employees and contribute greatly to the local economy, so local governments want to see them [survive].
SOEs find it easier to get funding from state-owned banks, for example. If you are a foreign company, no matter how big, you’ll find it [difficult to] borrow 10 billion yuan. If you’re a state enterprise in China, that 10 billion yuan is easy to get.
Aren’t you worried about the level of transparency among SOEs, including the accuracy of their financial results?
In the U.S., one reason for accounting manipulation is to inflate asset value or earnings, or both. This helps management get better bonuses or get funds from their lenders. However, many argue that China SOEs intentionally understate their asset value and earnings power to save on taxes. There is also no incentive to inflate the SOE’s earnings because the CEOs of state enterprises have their annual salary capped at US$70,000. This argument may be true, although it is very hard to verify because it is politically sensitive.
Isn’t it the case, though, that some too-big-to-fail companies in China were allowed to go under anyway? I remember Guangzhou Investment, for example, which went bankrupt in the 1990s.
Of course, it can happen. Look at Lehman Brothers in the U.S. The government chose to rescue AIG, but not Lehman.
Lehman has not experienced any default in the past 150 years. But when the U.S. banking sector got into trouble and the banking index fell sharply, all banks in the U.S. got into trouble.
Would your models have predicted that Lehman was in danger of default?
We don’t rate U.S. companies, but if we applied the same model, the risks [for Lehman] should at least be BBB. And if you look at the credit default swap for Lehman Brothers [debt] at that time, it was around 700 basis points, implying a single-B rating.
Yet the international credit rating agencies did not actually downgrade Lehman until much later.
That is because of corporate interest. Lehman gave them a lot of business. If they downgraded and nothing happened, they will lose all the business.
RATING CHINA BANKS
Let’s talk about banks. CTRISKS has ratings for 85 banks and other financial institutions in China. Are anyone of them given top ratings?
Ten banks are rated CT2A, including ICBC, CCB and Agricultural Bank. Ten other banks are rated CT1A.
This means that 65 banks are below investment grade, since investment grade for banks is single-A and higher?
Correct. The balance sheet information for banks is very different from that of corporations [where investment grade is triple-B and higher]. We have a different model to assess the risk of a bank; we follow the Basel II requirements on capital adequacy to measure the risks.
Isn’t it true that banks in China are doing informal securitisation, where they package mortgages and other loans for sale to other parties, and thus take these assets off their balance sheet?
The way it works is, the banks sell the assets to trust companies, which then repackage them into wealth management products that are sold to [institutional and individual] investors. This means that the banks can offload their credits exposure and so they can keep on lending. However, the China Banking Regulatory Commission (CBRC) has looked into this and given a very strong message that banks should not do it.
Is this practice reflected in the ratings that you give Chinese banks?
Many banks, the big ones, had similar packages, but now the regulations from the CBRC are clear, so I believe they have stopped doing it.
Does this mean that when CTRISKS looks at the bank balance sheet, you would not see these offloaded assets?
Yes, that’s true because the accounting information does not include this off-balance sheet items. But if the bank follows the Basel II capital adequacy ratio, this risk will be reflected in the bank capital requirement.
CTRISKS has access to these Basel II reports?
No, only the central bank knows. We know the capital the banks have. We know the capital ratio; we know there is a profit or not. But we don’t know the components of the assets. That’s secret.
Does this mean that your bank credit ratings are incomplete?
I cannot say my capital rating is perfect, but I think the operational items of China banks are very small in terms of price as compared with US banks or European banks.
Unlike other agencies, CTRISKS focuses on obligor ratings over one year for its ratings. Don’t you issue longer term ratings?
The Basel requirements on credit quality assessment have been standardised to be one-year probability of default (PD). Under this global standard, ratings agencies or banks can use their own metrics to measure credit risk, say, Grade 1 to Grade 10, AAA to C, or Very Good to Very Bad. However, all these metrics must be converted into PD for comparison.
Traditionally the capital market demands long-term credit ratings, say three to five years, because investors tend to hold debt securities to maturity. However, with the prevalence of credit derivatives that help mitigate credit risk, investors and banks can easily monitor their credit risk on monthly or quarterly basis. Also, if credit migration occurs, bond price will drop severely over a short period. There is no point for investors to consider long-term credit risk. Furthermore, the money market, which deals with short-term funds, is much bigger than the bond market. Lenders and investors need to think more about the risk in the short term.
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