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Battle to rate China's $11 trillion bond market may intensify amid reported deal

A second U.S. rating agency may soon make strides in the race to rate China's $11 trillion bond market.

Moody's Corp. has reached a "framework agreement" to boost its stake in China Chengxin International Credit Rating Co. Ltd. from 30% to more than 50%, according to a weekend Bloomberg report citing unnamed sources. The potential move to take over China's largest corporate rating firm comes at a time when foreign companies are vying to gain access to the Chinese bond market. Beijing pledged to open up the nation's credit rating industry to foreign ownership in 2018.

Moody's and Chengxin, commonly referred to as CCXI declined to comment on the reported transaction.

US rating agencies competing for China access

In January, S&P Global Inc. was the first U.S. credit rating company to receive regulatory approval from China to establish a presence in the country and begin rating domestic bonds. S&P Global has "first mover" advantage in the market, President and CEO Douglas Peterson said on a call to discuss fourth-quarter 2018 earnings. At the time, S&P Global had 36 employees in its new China business, and Peterson said his company would have its choice of top talent.

That advantage would be challenged were Moody's to acquire CCXI, said Piper Jaffray analyst Peter Appert. Owning CCXI would give Moody's a "head start" over S&P Global and fellow U.S. peer Fitch Ratings in establishing a presence in the region. Both Moody's and Fitch have filed applications with Chinese regulators for independent licenses but have yet to be approved.

Allowing global raters into the market independently could help improve the quality of China's ratings industry and provide more transparency around the creditworthiness of its issuers. Appert said that raises a fundamental question for foreign firms interested in entering the market: do they pursue their own independent license or seek to acquire a domestic company and then improve the quality of their ratings?

There are advantages to both paths to China's bond market, which was valued at about $11.4 trillion at year-end 2017, according to the most recent IMF data.

"From S&P's perspective, they start fresh," Appert said in an interview. "There [are] no legacy ratings that they have to explain. They bring a new perspective to the market." But S&P also has a steep hill to climb to establish a firm presence in the domestic market. If Moody's were to take control of CCXI, it jumps in with an established footprint but instead is faced with an integration challenge. Roughly 97% of domestic Chinese debt is currently rated AA or better, Appert said.

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Although S&P Global was the first to receive licensing approval, the analyst said he has no reason to think that Moody's and Fitch should not ultimately receive approvals as well.

Before applying for its license to rate domestic Chinese bonds, Fitch sold its 49% stake in China Lianhe Credit Rating Co. Ltd., a credit rating agency. Appert questioned whether Moody's ownership stake in CCXI, which it initially acquired back in 2006, has presented a hurdle to getting an independent license. If so, acquiring a majority stake in CCXI would be a logical alternative strategy, he said.

Both S&P Global and Fitch declined to comment on the reported Moody's transaction.

The ratings segment at S&P Global posted $2.88 billion in revenue in 2018, representing 46.1% of the company's overall revenue. At Moody's, the ratings segment brought in $2.84 billion for the year, or 63.8% of total revenue, according to S&P Global Market Intelligence data.

S&P currently generates about $60 million in revenues from rating cross-border Chinese debt, Appert wrote in a note following the company's license approval. He expects the opportunity to rate China's domestic bonds could add 100 basis points or more to S&P Global Ratings' revenue growth rate going forward.

The opportunities and risks

Currently four major Chinese rating agencies — CCXI, Lianhe, Dagong Global Credit Rating Co. Ltd. and Shanghai Brilliance Credit Rating & Investors Service Co. Ltd. — dominate the domestic market, accounting for over 85% of the market share in China, according to Shenzhen-based securities firm Great Wall Securities.

Among them, Dagong Global was ordered to suspend rating services for a year in August 2018 as it charged bond issuers high fees for consultation services in exchange for providing favorable ratings for the issuers.

Critics say China's credit rating industry downplays risks and provides favorable ratings for local issuers. As of Dec. 31, 2018, over 97% of nonfinancial corporate bond issuers in China had ratings of AA or above, according to a Feb. 12 statement from the National Association of Financial Market Institutional Investors.

Wu Jinduo, head of fixed-income research at Great Wall Securities, believes that the entrance of foreign rating agencies will break the monopoly of domestic rating agencies and improve the accuracy of risk assessment in the domestic bond market.

The government has been trying to improve the sector. In September 2018, the People's Bank of China and the China Securities Regulatory Commission issued a joint statement calling for unified vetting of rating agencies and stronger oversight and information-sharing among regulators. They also called on rating agencies to "guard against conflicts of interest" to ensure the quality of their ratings.

The lack of trustworthy credit ratings in the domestic market is expected to change, but it will be a long-term process, according to Wu. The analyst highlighted the stricter standards adopted by foreign rating agencies as well as potentially higher service fees as key challenges. Issuers in the China bond market will not rush to seek ratings from foreign agencies, Wu said.

But Wu expects that opening up the domestic bond market will attract greater participation by foreign investors, which will in turn increase demand for credit ratings by foreign agencies.

Still, Stifel analyst Shlomo Rosenbaum cautioned that China is "very wary" of negative press. Moody's was previously fined by Hong Kong's Securities and Futures Commission for a 2011 report that tagged some Chinese companies as having a high number of red flags. Rosenbaum said U.S. agencies face a "balancing act" between the incredible business opportunity that China presents and the still-evolving level of transparency.