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China rating agencies see Chaori default as only a hiccup

An employee works along a solar panel production line at a factory of Shanghai Chaori Solar Energy Science and Technology Co Ltd, in Jiujian
An employee works along a solar panel production line at a factory of Shanghai Chaori Solar Energy Science and Technology Co Ltd, in Jiujian

By Adam Rose

BEIJING (Reuters) - China's rating agencies are likely to keep a long-held assumption of government bailouts built into most ratings despite the country's first domestic bond defaults and warnings from Beijing that there is no blanket guarantee of support.

Last month, Shanghai Chaori Solar Energy Science and Technology (Chaori) <002506.SZ>, defaulted when it missed an interest payment on a bond, and this week a newspaper reported a small construction materials company had also defaulted on an interest payment.

The central bank and government have both indicated in recent weeks that they are prepared to tolerate some failures as they reform financial markets.

Chen Dongming, chief credit officer at China Lianhe Credit Rating, which has global rating agency Fitch as a shareholder, said Chaori was not a harbinger of larger defaults that posed a systemic risk.

Roughly 90 percent of publicly issued bonds are issued by large or mid-size state-owned enterprises which are still likely to get government assistance, Chen said.

"Their likelihood of getting bank capital or government support is still a lot higher than for a private enterprise," he said.

NO INCENTIVE

Until now, it had been widely assumed that even high-yielding debt carried an implicit state guarantee so there was little incentive for investors to demand ratings that reflected creditworthiness.

For example, Chaori narrowly avoided a bond default in January 2013 after a Shanghai district government persuaded banks to defer claims for overdue loans.

"A lot of local investors were not looking at ratings agencies' reports, but were just looking at the yield, thought that no company would ever default in China, and looked at who distributed the bonds," said Geoffroy Wallier, the managing partner of OrfiCapital, a Hong Kong-based asset management firm that invests in offshore Chinese corporate bonds.

Any fallout from Chaori's default is expected to be seen most in the ratings of smaller private firms, as investors become more aware of the need to price in risk.

"Chaori's default is a warning," Guan Jianzhong, CEO of Dagong Global Credit Rating Co, which did not rate Chaori, told Reuters. "We'll draw lessons from it, and improve our ratings system and standards."

Chaori's default is having an impact in the secondary market. Yields on AA- five-year medium-term notes have shot up more than 50 basis points, while yields on safer AA and AAA medium-term notes have remained steady.

But exactly how it will change the broader industry is not clear, particularly as investors and rating agencies still expect favorable treatment for state-backed firms.

RATING MAINTAINED

When Chaori filed a bond prospectus in March 2012, Pengyuan Ratings said its "current orders are comparatively full, and future business has definite surety."

Indeed, Chaori had only days earlier forecast its 2011 profits at 83.5 million yuan. But, after the bond sale opened, its annual report revealed a loss of 54.8 million yuan.

Still, in June 2012, Pengyuan re-rated Chaori and its bond AA, while acknowledging the company's "profits have fallen substantially, debt has grown substantially, and liability pressure has enlarged."

On its website, Pengyuan defines AA as "very strong ability to repay debt, low vulnerability to foreseeable events, very low risk of default."

Pengyuan eventually downgraded Chaori three times in five months, ending at the CCC rating in May 2013.

Pengyuan declined to comment when contacted by Reuters.

PLEASE THE ISSUER

Around half a dozen rating firms dominate the Chinese market, and a debt issuer only needs a rating from one agency. Most agencies don't publish detailed methodologies, which leaves investors with little to judge the quality of the ratings.

"We are a bit worried that local agencies want to please the issuer," Wallier of OrfiCapital said.

This is not an issue just in China -- in the aftermath of the 2008 global financial crisis, major international credit rating agencies have been accused by investors, regulators and politicians of inflating the ratings of risky mortgage-backed and structured securities in a bid to win new business.

Fitch and the other two leading global credit rating agencies, Moody's Investors Service and Standard & Poor's, aren't licensed to rate onshore debt in China, although each has a relationship with a local firm.

Ivan Chung, chief credit officer in Hong Kong for Moody's, which has a minority stake in China Chengxin International Credit Rating, said a weakness in the Chinese market was that debt subordination and creditor priority were generally not reflected in ratings.

"If you continue to be inaccurate or cannot meet the expectations of investors, your market position will progressively weaken," Chung said.

Guan the CEO at Dagong, was confident of avoiding that fate.

"Our methodologies are constantly changing," he said.

"Dagong isn't going to have a problem like Chaori."

(Additional Reporting By Pete Sweeney; Editing by John Mair)

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