Frequent downgrades of various ratings in the Chinese market, can the bearish ratings of rating agencies hold up?

Recently, the latest reports from international rating agencies have snowflakes in China, and almost the entire Chinese market has been suffering from rating downgrades: on April 17, Fitch announced that its outlook for internet giants Tencent and Alibaba was downgraded from "stable" to "negative". Earlier, Moody's downgraded the ratings or outlooks of eight Chinese banks, including China Development Bank, Bank of China and China Construction Bank, as well as Chinese real estate companies such as China Shipping, Yuexiu, Greentown, Vanke, Poly and Longfor.

However, the capital market has not reacted much. A Hong Kong institutional person told the media that this is because the release of the negative in the early stage has been relatively complete.

This has also triggered a new wave of questions from the market about rating agencies: if the bearishness has been fully released, is the continued bearish just bias and is there still value?

1. Prejudiced "referees"

Rating agencies originated after the American Civil War, and the construction of infrastructure such as railways brought new opportunities for the development of the bond market, and it was at this time that the three internationally renowned rating agencies of Standard & Poor's, Fitch and Moody's were established, and then gradually entered the global market and occupied a monopoly position.

The main role of a rating agency is to rate different assets and give investment advice from a professional point of view. In a way, they are like sideline referees in a ball game, helping investors determine whether a company has crossed the risk red line, and complementing the overall perception of the company for investors. From this point of view, rating agencies do have value in their existence.

On the other hand, rating agencies cannot guarantee absolute impartiality, and the rated companies are also the largest customers of rating agencies. According to public information, S&P charged around $750,000 per transaction in its ratings before the 2008 financial crisis.

Under such a profit model, rating agencies cannot warn of risks before a crisis erupts. As an extreme example, before the 2008 subprime mortgage crisis, rating agencies maintained a "AAA" rating on most subordinated bonds.

The greater risk comes after the exposure. When the financial crisis erupted in 2008, rating agencies, including Standard & Poor's and Moody's, quickly downgraded a large number of financial products, triggering even more intense market panic. Under the constant trampling, the crisis is like a tsunami, forming a catastrophe that overwhelms the mountains and seas. As a result, after the financial crisis, the three major ratings were sued by either the market or the government.

What is happening to China today is almost a replica of the stampede of the past. The difference is that there is no tendency for local risks to spill over from China at this stage. The regulators are also constantly speaking out and will firmly guard the bottom line of no systemic financial risks.

Nonetheless, on 10 April, Fitch reported that it would keep China's sovereign credit rating unchanged but revised its outlook to 'negative' from 'stable'.

In this regard, the Ministry of Finance said that it is regrettable to see Fitch downgrade the outlook of China's sovereign credit rating. "We have had a lot of in-depth communication with the Fitch Ratings team in the early stage, and the report also partially reflects the Chinese view. However, the results show that the index system of Fitch's sovereign credit rating methodology fails to effectively and forward-looking reflect the positive effect of fiscal policy on promoting economic growth and stabilizing the macro leverage ratio.

2. New perspectives that can't be mentioned

In addition to downgrading China's sovereign credit rating, international rating agencies are also constantly downgrading Chinese companies, whether it is banks, real estate companies, or Internet giants such as Alibaba and Tencent.

As a result, some domestic enterprises, led by real estate companies, decided to give up their ratings in order to avoid continuous stampede. Poly Development, a state-owned enterprise, announced on April 12 that it would adjust its credit rating agencies: among the three international credit rating agencies that have been hired, only one will continue to provide the company's main credit rating to reflect the company's credit status.

The biggest reason why Poly was able to make such a decision was that its overseas debts had been fully paid off, and there was no need to continue to issue overseas bonds for the time being. It is reported that Poly Development has previously issued a total of US$2.5 billion of five-year fixed-rate bonds, and as of the time of the announcement, the principal and interest have been fully settled, and the domestic financing channels have remained unimpeded. Like Poly, basically all domestic real estate companies currently have no hard demand for overseas financing;

In addition, the market side has also questioned the professionalism of the rating agencies themselves: the ability of rating agencies to survive is the rating model. But now, it seems that the rating model has fallen into a pattern and has not followed the new model of the company. This also makes the credibility of its rating much less credible.

On April 12, Standard & Poor's downgraded Longfor's long-term issuer credit rating to "BB+" from "BBB-" and its long-term issuance rating of senior unsecured notes to "BB+" from "BB+". However, in fact, in the context of the overall property market recession and the cold housing sales, Longfor Group has been more affected by the industry, and it has not seen obvious negative changes in business operations.

On the contrary, Longfor has truly achieved timely and effective response: in addition to the traditional development business, Longfor's two business segments, operation and service, have also become a stable source of contribution to its revenue and profit. In 2023, the profit contribution of Longfor's operating business, including operation and service business, exceeded that of the real estate development business, accounting for more than 60% of the Group's net profit for that year. This proportion is unmatched among mainland real estate companies.

This change means that Longfor's previous investment in commercial real estate, long-term rental apartments, property management, etc. has begun to have a significant return. As early as the glorious period of real estate enterprises, many large enterprises in order to fight the cyclical changes in the property market, proposed diversified business development and cultivated the second growth curve, but at present, in addition to Longfor, there are not many real estate companies that really use the stable income of operating business to fight against the cyclical property market.

However, even with the optimization of the business structure, Longfor is still viewed by rating agencies from an outdated perspective, using traditional EBITDA measures (i.e., earnings before interest, taxes, depreciation and amortization).

In the case of Moody's, the rating reference indicator they use is the adjusted debt/EBITDA ratio, which is consistently below 5.5x-6.0x, the rating is stable, and if it is consistently above 6.5x-7.0x, it is considered to be downgraded.

In other words, the higher the EBITDA value, the better, if the adjusted debt is the same. In the past, when calculating this indicator for the traditional development business of real estate enterprises, EBITDA was actually affected by high land appreciation tax, but now Longfor's operation and service business accounts for a high proportion, and this part of the profit is not affected by land appreciation tax and has more cash flow attributes. So the absurd thing happened - the profit structure was optimized, and the rating indicators were worse.

The reason for this result is not that there is anything wrong with Longfor's business strategy itself, but that the rating model of the rating agency is not used reasonably. Whether the rating results produced in this way can be called authoritative is a question mark.

Whether the rating agency made a similar judgment out of pride or bias is unknown. However, when both the country and enterprises have chosen a higher quality development path, whether we still need to "follow the old way" rating agencies may need to make a new judgment.