The effect of corporate governance on credit ratings: Evidence from China's bond market

• DOI: http://doi.org/10.1111/jifm.12094
• Author: Chao Chen,William Bradford,Yang Zhao
• Date: 01 June 2019
• Published date: 01 June 2019

J Int Financ Manage Account. 2019;30:113–144.

|

113

wileyonlinelibrary.com/journal/jifm

DOI: 10.1111/jifm.12094

ORIGINAL ARTICLE

The effect of corporate governance on credit

ratings: Evidence from China’s bond market

William Bradford1,2

|

Chao Chen3

|

Yang Zhao4

© 2019 John Wiley & Sons Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

1Department of Finance and Business

Economics, Foster School of Business,

University of Washington, Seattle,

Washington

2China Academy of Financial Research,

Shanghai Jiao Tong University, Shanghai,

China

3Department of Accounting,School of

Management, Fudan University, Shanghai,

China

4Accounting School,Shanghai University

of International Business and Economics,

Shanghai, China

Correspondence

Chao Chen, School of Management, Fudan

University, Shanghai, China.

Email: chen_chao@fdsm.fudan.edu.cn

Funding information

National Natural Science Foundation of

China, Grant/Award Number: 71472048 and

71772050

Abstract

This paper examines the association between firms’ cor-

porate governance and credit ratings (both bond ratings

and issuer ratings) in China. In addition to considering the

financial attributes of bond issuers, we ask to what extent

do credit rating agencies consider the corporate govern-

ance attributes of issuers? In concept, bondholders are

concerned with the financial effects of how corporate gov-

ernance resolves the agency conflicts between bondhold-

ers and managers, majority and minority shareholders, and

shareholders and bondholders. We find that corporate

governance affects bond issuer credit ratings in China.

After controlling for firms’ financial attributes, we find

that issuer ratings are positively related to dual- listing,

whether the firm is a state- owned enterprise, the owner-

ship of the second to the tenth largest shareholder; and

negatively related to the relative scale of audit fees. We

attribute the positive association between dual-listing and

credit rating to higher quality and transparency of infor-

mation reported by the dual- listed firm. The value to bond-

holders of the implicit government guarantee of debt

payments more than offsets the negative association be-

tween firm value and being an SOE. Bond rating agencies

expect that the change in agency costs with a reduction in

the ownership of the largest shareholder benefits bond-

holders. To credit rating agencies, the scale of audit fees

114

|

BRADFORD etAl.

1

|

INTRODUCTION

This study concerns issuer and credit bond ratings in China. While China has become the world’s sec-

ond largest economy, its bond market has also rapidly expanded and is the world’s third largest (behind

the United States and Japan). Corporate bonds in China have been growing even faster, increasing

from ten percent to one- third of the Chinese bond market between 2009 and 2014. As their demand for

holding China’s currency (the RMB) has increased, global investors have increasingly sought to hold

income yielding RMB investments. Given the growth trajectory of China’s capital markets in gen-

eral and its corporate bond market in particular, understanding China’s corporate bond market is an

important issue for global investors and researchers (Deutsche Bank, 2016; Invesco Global Insights,

2016).

Major sources of information on China’s bond market are the credit ratings of bond issuers and

bond issues provided in institutional credit rating firms. This study examines the association of corpo-

rate governance on the ratings that credit rating firms place on bond issuers and bond issues in China.

To our knowledge, this is one of the first studies to examine the makeup and influence of corporate

governance factors effecting bond credit ratings in China.

As global investors review the bond markets and related credit ratings of market issuers, it is import-

ant to understand that China’s corporate bond market markedly differs from that of a developed bond

market such as that in the United States. In China, each corporate bond issue can be rated by only one

rating agency and the bond must be rated at least AA- in order to be publicly issued. These require-

ments do not exist in the U.S. corporate bond market (Bowe & Larik, 2014). While the use of one rating

agency has been found to be more efficient, credit rating agencies are more prone to inflate ratings when

their gains from inflating ratings (from competition for the ratings) are less than the ex- post reputational

damage from inflated ratings (Bolton, Freixas, & Shapiro, 2012). China’s rating agencies are also less

experienced and may have different motivations and different standards when they are rating bonds.

China and the United States also differ in the blend of the agency problems that bondholders en-

counter in the firm. As discussed in Jensen and Meckling (1976), bondholders have agency conflicts

with both managers and stockholders. Corporate governance activities that monitor and motivate man-

agers to expropriate less value from the firm benefit bondholders (and shareholders) by increasing the

firm’s cash flows. In the bondholder–shareholder agency conflict, corporate governance activities that

benefit the shareholders may harm bondholders: for example, changing the risk of the firm’s invest-

ments such that shareholder equity value rises while the value of debt declines.

In China, controlling shareholders are more dominant in the selection and compensation of manag-

ers than in the United States (Oliver, Qu, & Wise, 2014). Thus, as the firm’s ownership concentration

(relative to total assets of the accounting firm) signals in-

terest binding between the client firm and the accounting

firm that threatens the independence of auditing and the

quality of financial reporting. We also find that bond-

specific attributes: collateral and issue size, are positively

related to bond credit ratings.

KEYWORDS

agency problems, corporate governance, credit rating

|

115

BRADFORD etAl.

increases, there is a lower emergence of agency problems between owners and managers than in the

United States; in turn, the lower value expropriated from the firm by managers benefits creditors.

However, the ability of controlling shareholders to expropriate value from minority shareholders is

greater than in the United States (Kang, Lu Shi, & Brown, 2008; OECD, 2011). Higher ownership

concentration that makes it easier for controlling shareholders to expropriate firm value is harmful to

creditors. What is the net relation of these differences as perceived by bond rating agencies?

Also unlike in the United States, in China a majority of firms issuing corporate bonds are state-

owned enterprises (SOEs). Previous studies have found that in China the SOE status negatively im-

pacts the market value of equity, due to poorer financial performance (e.g., Bai, Liu, Lu, Song, &

Zhang, 2005; Wang, 2003). Is the bond issuer credit rating of SOEs similarly downgraded relative

to non- state- owned enterprises (“NSOEs”)? State ownership might sufficiently influence the issuing

firms’ perceived capability of making debt payments so that SOEs might be systematically rated

higher than NSOEs.

In an earlier study of bond issues of SOEs in China, Chen and Guo (2008) found that corporate

financial risk and performance do not accurately predict corporate bond ratings. Their study ended

in 2004. There have been subsequent efforts by Chinese regulators to increase the transparency of

corporate bond issuer risks to investors. The entry of NSOEs into the pool of corporate bond issuers

has expanded the continuum of risks in China’s corporate bond market by including issuers of higher

default risk. How do the unique traits of issuers and rating procedures mentioned above affect the

credit ratings of China’s bonds?

In this paper, we focus on the corporate bonds issued in China during 2007–2014, and use issuer

ratings and bond ratings as the dependent variables. We use ordered logistic regressions to explore the

incremental association of corporate governance on credit ratings. We include 13 indicators of corpo-

rate governance that consider six dimensions—shareholder equity and controlling shareholders, board

governance, director and executive ownership, infor mation disclosure and financial transparency,

compensations of directors and management, and business conduct and ethics—to comprehensively

reflect firms’ corporate governance traits. Our models also include firm financial-characteristics and

bond characteristics.

After controlling for the issuer’s financial attributes, we find that in China, issuer ratings are posi-

tively related to dual- listing, whether the firm is a state- owned enterprise, t he ownership of the second

to the tenth largest shareholder; and negatively related to the relative scale of audit fees. Dual-listing

is associated with higher credit rating because it validates the quality and transparency of information

the firm reports, and confirms that the f irm undertakes certain desirable corporate governance prac-

tices. The positive association between state- owned enterprise status and credit rating indicates that in

contrast to a shareholder’s goal of maximizing firm value, bondholders are more concerned with the

certainty of receiving interest and principal payments. The positive association between the ownership

of the second to the tenth largest shareholder and credit rating indicates that bondholders anticipate

the change in agency costs with a reduction in the ownership of the largest shareholder benefits bond-

holders. The scale of audit fees (relative to total assets of the accounting firm) can be seen as a sign

of interest binding the client firm and the accounting firm. Credit rating agencies perceive that such

interest binding threatens the independence of auditing and the quality of financial reporting. We also

find that bond- specific attributes: collateral and issue size, are related to bond credit ratings.

Three major contributions of this paper are as follows. First, previous research on China’s bond mar-

ket focuses on financial indicators and excludes corporate governance when studying the factors affecting

credit ratings. We combine financial indicators and corporate governance indicators in this study, and

show that the governance indicators have predictive content in credit ratings. Second, previous research

has focused on how corporate governance affects the returns to shareholders rather than bondholders.