While international media focuses either on the Party cadre social-ranking aspect of China’s new credit rating system or the politics of sovereign credit ratings, many have missed the more substantial development of domestic Chinese credit rating agencies and their battle to price local government debt.
Rather than allowing foreign competition in to improve its debt instruments, China is seeking to institutionally strengthen its own credit rating system, inviting foreign credit ratings agencies into the system in order to attract technology transfers in services. However, deeper structural problems in China’s local government bond architecture are unlikely to be solved by simply allowing U.S. firms in without deeper structural reform of local government debt instruments.
China’s recent opening of its domestic bond markets to the U.S. credit ratings triopoly of Fitch, Moody’s, and Standard and Poor’s will not mean better bonds. Foreign firms will still not be able to issue debt in China and the structural local government bond problem shows no sign of abating despite various accounting experiments such as center-local debt swaps, debt-for-equity swaps or the expansion of the asset management debt-cleaning model to the provincial level.
China has been struggling with a local government debt problem and wider underlying center-local fiscal issues for around four decades. Under the command economy line-ministry system, provincial and prefectural governments simply borrowed money from commercial banks for fiscal spending. This is quite extraordinary accounting practice. Due to financial repression in China’s deposit savings system, the commercial bank network still effectively operates as another form of taxation, and state institutions — government as well as enterprise — can simply take loans from state-owned commercial banks for government services spending.
China’s Ministry of Commerce and State-owned Assets regulator SASAC have jointly overseen the development of national credit rating agencies since the reform of the banking system in the early 1990s. However credit ratings agencies were largely ignored by both government and market debtors in the subsequent development of China’s capital markets. The state-owned banking system offered such easy credit that there was no need for ratings. And most outside critique of endogenous risk in China’s capital markets centered on the dominance of the banking sector or of these banks’ non-performing loan books, with little heed paid to the lack of institutional development in credit rating.
Since it has become clear that there is no credible plan to clean up the local government debt obligations that have piled up over the past 20 years of investment-driven growth, desire for a viable credit ratings system has emerged in central government policy circles. However rating local government debt is as sensitive as opening public procurement markets, China has zero intention of opening more than it needs to. China is currently refurbishing its existing domestic credit ratings system to shore up the credit risk of bond issuances by provincial, prefectural and township governments. At the provincial level, governments are being empowered to develop a modal system to rate local firms and governments, independent of the central government.
Asset management companies are being used to clean existing provincial debt, replicating the model of the four asset management companies established to clean the non-performing loan books of the four state-owned commercial banks. Devolving this model to the provincial level in 2016 saw a proliferation, with effectively one established for each province, effectively airlocks for principal government debt. But asset management Ccmpanies are not private equity, and the closed-loop of China’s bond system means there is no clean way to dispose of existing debt while new local government debt is being constantly pumped into the system.
Wenzhou, Zhejiang is leading the local credit reform pilots with a prefectural level asset management company and a highly developed provincial credit rating agency network. It is currently the policy testing ground for a comprehensive national credit rating system slated to be deployed by 2018. The local pilot in Wenzhou is organized under the “Construction of Wenzhou social credit system 2016-2025.” Wenzhou itself is a progressive independent polity operating more like a city-state. It benefited early from the household responsibility reforms but was later sent down to the sea to sink or swim under Zhu Rongji’s enterprise reforms, resulting in huge speculative asset bubbles developing in the private economy.
Credit rating developments in Wenzhou include the local Development and Reform Commission developing a prefecture-wide credit black list and an information-sharing platform to consolidate existing credit data into a single accessible platform. Wenzhou also pushed to establish a local city government asset-management company, despite national regulation limiting the asset management model to the provincial tier of government. China Everbright Asset Management Company was licensed by the banking regulator in late 2015, the first for a prefectural city. With 293 prefectural cities in China all mired in local government debt, expect a blossoming of asset management companies to obfuscate past debt obligations and repackage them into creative “wealth management” products.
However, even if the new credit rating system were to effectively rate new provincial and prefectural bond issuance, two huge problems remain: the existing debt pool and the fiscal constraints of the provincial and prefectural governments. Local government debt problems stem from unorthodox borrowing and off-budget bookkeeping. New fiscal responsibilities and revenue sharing powers are now rolling out across all levels of local government, but the changes are not deep enough to shift the structural problems of center-local tax arrangements, where local government lose most of their tax revenue to the center, but are forced to hold all the risk from bonds issued to cover the shortfall between tax and spending.
Opening China’s domestic credit ratings market to international competition is good for the global economy. But focus on credit rating reform in China should not be blinded by the red herring of Party social credit ratings or sovereign credit ratings competition by U.S. firms. Rather, the importance lies in the internal audit and development of a vast domestic Chinese credit ratings system at the local government and local state-owned enterprise level. And unfortunately for the global economy, China’s local government credit rating system is likely to be as methodologically hollow as the current U.S. rating system.
Tristan Kenderdine is research director at advisory Future Risk and PhD Candidate in Political Science and International Relations at Australian National University