U.S. China Economic and Security Review Commission
Tom Byrne, VP/Sr. Credit Officer,
Financial Institutions and Sovereign Risk Group, Moody’s Investors Service
April 16, 2004
Thank you Chairman Robinson, Commissioner Wessel and Members of the U.S.-China Commission for inviting me to share a credit rating agency’s perspective and to discuss China’s use of international capital markets as part of the country’s economic development strategy.
Moody’s opinions on the creditworthiness of the Chinese government and the country’s financial and non-financial corporations dates back to 1988 when the rating agency assigned an A3, investment-grade rating on the foreign currency obligations of the government. Moody’s ratings on China have since expanded, mostly in the financial sector, including the big four state-owned banks. Moody’s has relatively few ratings on non-financial corporations, domiciled in the mainland or in Hong Kong, reflecting the nascent developmental stage of China’s financial markets, which have been dominated by bank rather than capital market intermediated funding. Moreover, the government has been cautious in allowing state sector firms to tap international markets for funding, mindful of the weak credit culture in the state-sector dominated economy and its desire to protect the creditworthiness of the sovereign.
When Moody’s assigns credit ratings on Chinese entities, we are careful to distinguish sovereign risk from corporate risk. In fact, and in practice, we take the cue provided by China’ Ministry of Finance. Although we raised the sovereign’s foreign currency credit rating one notch to A2 in 2003, reflecting the sound external credit fundamentals of the government itself, we noted in our most recently published quarterly Credit Opinion that “the creditworthiness of all other issuers (domiciled in China) should be assessed separately from the sovereign, taking into account their fundamental creditworthiness. This is consistent with the government’s external debt management and foreign exchange control policies.” This has also been a consistent practice in our rating approach to Chinese corporations, at times to the displeasure of important corporations who think that their franchise or name alone merits a high rating equal to that of the sovereign—the government of the PRC.
The scope of the Commission’s interests in China’s uses of international capital markets covers both equity and bond markets. Moody’s focuses on the latter. Although the number of Chinese companies listed on international stock exchanges has grown at a rather steady clip, Moody’s rates only a small number of companies that are listed on either the Hong Kong or New York stock exchanges. Most of the China-domiciled firms rated by Moody’s are financial institutions, 14 in total. Moody’s rates about half a dozen non-financial corporations, of which only several are listed on foreign stock markets. The total amount of rated debt is less than $10 billion, including Hong Kong domiciled issues whose ultimate parents are in China. In addition, Moody’s also rates about $5 billion in bonds issued by the sovereign, the Ministry of Finance.
These numbers are relatively small in the context of China’s substantial use of external financing in its economic development strategy. But Moody’s expects more firms to tap the international bond markets in the years ahead. In anticipation, Moody’s corporate analysts have started to analyze industrial sectors which are likely to have a larger profile in the international capital markets in the future. I will turn to their observations on the credit concerns shortly, but first I will complete a sketch of China’s external financing patterns.
Foreign direct investment dominates the landscape, with a total stock of around $500 billion invested since the Open Door Policy was announced in 1978. On a flow basis, FDI continues to eclipse all other forms of external financing, even after scaling down the officially reported numbers that include offshore shell companies or some other conduit that allows mainland companies to register the source of their investments as nonresident to take advantage of preferential tax treatment granted to foreign-invested enterprises. In my opinion, some of this so-called “round tripping” is in the investment inflow form Hong Kong, which comprises about one-third of annual inflows. Other sources are offshore financial centers—the British Virgin Islands and Cayman Islands in recent years have channeled more FDI than the European Union, than the U.S, and than Japan, individually. FDI gross inflows amounted to $53 billion in 2003, up from an annual average of about $43 billion in the years after the 1997 Asian financial crisis. Of this, only $4 billion come from American firms in 2003.
FDI certainly is a key element in China’s economic development strategy, yet it is also as important or even more important for a good number of other developing countries. The trend in China’s annual inflows of FDI equates to about 4 percent of the country’s GDP since the mid-1990s. In the cases of Slovakia and the Czech Republic, the share is much larger, at times reaching 10 percent of each country’s GDP. The record in this category belongs to an advanced, albeit much smaller, economy, Ireland, where FDI has at times reached 20 percent of GDP. In addition, the IMF notes that the magnitude of FDI in China has not been unusual in comparison with the experience of other newly industrializing East Asian economies.[1]
In contrast to FDI, stock and bond portfolio investment inflows have been much lower (and sometimes negative on a net basis), even in years of heightened IPO activity. The annual numbers have fluctuated, ranging from a negative $0.7 billion to a positive $8 billion, rounded off between 1997 and 2002 (China has not yet released its 2003 balance of payments statistics). Even with the flurry of completed IPOs from China last year and so far this year, most likely the level of portfolio investment inflows this year will not vary greatly from the upper bound in recent years. Moreover, it would be very difficult for such inflows to approach anywhere near the level of FDI inflows, in my opinion, even if bullish sell-side predictions are realized, that foreign IPOs could range from $15 billion to $25 billion in a good year with favorable liquidity and interest rate conditions. The absolute level of portfolio investment inflows into China have been less than those recorded by smaller economies in the region, and far below amounts received by Japan or other advanced economies.
The constraints on China’ ability to expand its access to the international capital markets lie in Beijing’s current policy regarding state enterprise reform and external debt management, as well as the current state of corporate governance. These are both self-imposed and self-inflicted. The central government’s conservative policy towards external debt management inhibits or precludes corporations from gaining approval to raise debt unless they can be assured of receiving a credit rating in line with, or close to, that of the sovereign. The central authorities have taken a lesson from the experience of the provincial international trust and investment companies, a number of which went bankrupt and defaulted on their international debt obligations in the late 1990s. The authorities did not bail out creditors, neither domestic nor foreign, thereby minimizing moral hazard, but also making international investors, as well as Moody’s, more wary of assessing credit risk at the sub-sovereign and corporate level.
China could potentially induce a much greater inflow of foreign investment in its listed corporations if it shifted its ownership policy towards large and important state-owned enterprises and banks. Although the Bank of China, China Life, and SMIC IPOs were very big, the government only relinquished partial ownership, retaining majority ownership of shares and control of the firms. In contrast, the case of Korea provides a gauge to assess the unrealized potential of a more robust liberalization policy. Foreign investors, among the largest being American, invested $13.5 billion in domestic firms listed on the Korean Stock Exchange (KSE) alone in 2003. Foreign investors now own more than 40 percent of the shares listed on the KSE, and own more than 60 percent of Pohang Iron and Steel Company, a former flagship state-owned enterprise that the government completely privatized, eliminating limits on individual and foreign ownership.
A gradual opening of Chinese firms to foreign share-holding seems prudent, however, in view of the evolving nature of China’s place and responsibilities in the global economy, as well as its adaptation to global capital market practices and norms. Indeed, only in the past few years has the central government begun to comply with standards set by the International Monetary Fund for timely and full disclosure of macroeconomic and national financial data. China’s subscribing to the IMF’s basic criteria, the General Data Dissemination Standard, means that it has started to provide to the global capital markets balance of payments data consistent with international practice. However, China’s national statistical capabilities and transparency are not yet up to the level of the IMF’s Special Data Dissemination Standards, by which most emerging market countries active in the global capital markets subscribe. Moreover, the IMF standards do not directly address the issue of data quality, in which China has made progress (in the early 1990s much of the country’s domestic and external financial data were a state secret) but there remains much room for improvement, although various agencies should be given credit for striving in this direction.
Turning to Moody’s work on China corporate ratings, our fundamental credit analysts have started to publish research on China’s leading companies and industries. This initiative is being done to build a foundation for credit analysis of unrated Chinese companies and their industries. This not the same thing as publishing a rating, but is being done in anticipation of future demand for more ratings, both by Chinese companies themselves and by the market. Moody’s has already published extensively on the banking industry (where we have published credit ratings on 14 institutions, and have also published financial strength ratings on 12 of these institutions). Non-financial published ratings are on companies in the telecommunications, power generation and oil and gas sectors. Moody’s has also started to look at the airlines industry and will turn to other sectors in the future.
Moody’s has noted that some common analytic themes—prospects for strong growth, evolving regulatory regimes and consequent uncertainty, and a lack of transparency not only in regard to government policy, but also to corporate structures and practices. Because the State Council is the ultimate majority and controlling owner of China’s important state sector companies, political pressures can be brought to bear on a company’s operating strategy as well as on a company’s fortunes through mergers or acquisitions. These are the companies with the highest profile in the international capital markets. In addition, China has yet to develop a rigorous legal framework that clearly sets out the rights of creditors. Another systemic challenge is the difficulty in acquiring sufficient and reliable data. Moody’s believes that such studies will contribute to strengthening transparency and analytical knowledge of China’s corporate structures.
Because weak or opaque corporate governance structures can affect earnings and a company’s equity base, Moody’s approach to rating China domiciled corporations is to stress strong credit fundamentals, including low leverage and high liquidity. This approach is not unique, as Moody’s rating approach to U.S. corporations has, in some instances, built in a ratings “cushion” where elements of corporate governance are considered to be weak.[2] On the other hand, good corporate governance has been an explicit factor supporting an upgrade of a U.S financial institution[3]. Government support is a double-edged sword in China. Such support is a strong positive credit factor in the banking industry (where there is a wide discrepancy between credit ratings and financial strength ratings, which exclude outside support to an institution from the government or shareholders, which is one and the same in China’s case).
In the case of corporate ratings, a company’s status as a state-owned entity is not an automatic credit enhancement, even in strategic industries, and can be a cause for concern. For example, companies listed on foreign stock exchanges pay dividends to their parents, which retain 70 percent of the equity, if not more. These dividend payments help the parent fund its social welfare obligations (e.g., housing, health and education) to its employees. But this practice inhibits the listed company to retain earnings for its own use, and thereby hampers the listed companies financial flexibility.
Such factors will continue to be crucial ratings concerns. In the past we have communicated them in our published opinions on rated companies, from one of which I quote: “The rating also incorporates the relatively undeveloped regulatory policy governing the telecommunications industry and the consequent uncertainty as to future market structure. Moody’s expects greater competition in the industry….although the lack of clear, rule-based regulations created uncertainty as to how competition will be introduced….Moody’s also takes into consideration the possible negative effect on bondholders should the central government implement policy that serves the nation’s interests, possibly at the expense of the rated corporation’s profitability, leverage, and growth prospects.”[4]
In summing up, China’s access to the international capital markets is not likely to be a dominant and steady source of financing until state control of the economy is liberalized further, predictability is enhanced in regulatory and legal systems, and until confidence is enhanced by improved disclosure, transparency and governance. If China progresses on these fronts, foreign investment in Chinese companies listed on the domestic stock exchange would potentially attract far greater financing inflows than the current flurry of IPOs on foreign stock exchanges in Hong Kong and New York.
[1] “The Global Implications of the U.S. Fiscal Deficit and of China’s Growth,” Chapter II, World Economic Outlook. IMF. April 2004.
[2] Moody’s April 7, 2004 press release confirming the rating for Tyson Foods, Inc. cites this reason as a factor.
[3] Moody’s September 25, 2003 press release upgrading Wells Fargo Bank cite this reason as a rating factor.
[4] China Mobile Credit Opinion, January 2002.