The Significance of Credit Rating on Chinese Auto Industry - Research Proposal Example

Research Proposal Xiaochen Ren MSc Investment Management Module M21EFA Research Methods ID: 5326558 Dr Timothy Rodgers Content Aims: 3 Introduction: 3 Research Objectives: 4 Literature Review: 4 Methodology 11 Conclusion 12 Title: The significance of Credit Rating on Chinese auto industry Aims: Credit rating can be explained as an assessment of credit worthiness of an issuer who attempts to borrow money in the market. The credit rating is normally produced by credit rating agency, a participant of the financial market, such as Moody’s. It is very important for the lenders and investors because the credit rating agencies reduce the information asymmetry between them. In the developing countries, such as China, credit rating agency becomes more popular in recent decades whilst this research area has been developed in the western developed countries. This study will mainly concentrate on the importance of credit rating of Chinese auto companies and how credit rating affects auto industry in China. The reason of focusing on Chinese auto industry is that auto industry in China has less influences of Chinese government policies, which could combine more experiences and academic results from western countries into this study. This study will also explore the significance of credit rating to the sustainable development of Chinese auto industry. Introduction: In order to solve the problems about asymmetry information between lenders and investors and existence of credit risks, credit rating agency appears in the market. Focusing on the Chinese auto industry, this project will demonstrate the specified risk factors in the auto industry and how the ratings are determined by studying the features of Chinese credit rating market and comparing with the western countries’ experiences. The mathematical modelling can be applied in this part to show the ratings clearly and also case study will be used here. Moreover, this project will also introduce the impact to the large auto enterprises in China. This can be illustrated from two points: on one side, the significance of credit rating on developed corporate bonds of the auto companies will be studied; on the other side, the role of credit ratings on new products of asset securitisation of Chinese auto firms will be analysed. Furthermore, based on the studies, this project will discuss the sustainable development strategies for Chinese auto industry. Research Objectives: 1. The positions and importance of credit rating and credit rating agencies in the western countries and China need to be shown. 2. The risk features of Chinese auto industry will be concluded. 3. The methods to evaluate each risk feature of Chinese auto industry and the specified mathematical modelling will be demonstrated. 4. The impact of credit ratings to Chinese auto corporate bonds which are already in the market need to be discussed; the important role of credit ratings on new financial products of Chinese auto asset securitisation will be analysed. 5. Sustainable development strategies of credit ratings in Chinese auto industry will be analysed. Literature Review: Credit risk in the financial market can be defined as the uncertain ability of an obligor to repay the money owing. Adams et al. (1999) mentions thatCredit rating started back in 1837 by Mercantille agency, which was founded by Louis Tappen; before John Moodystarted applying credit ratings to bonds in 1909 through his Poor Publishing Company (Adams et al., 1999). Moody defines credit ratings as “A rating simply helps investors determine the relative likelihood that they might lose money on a given fixed income investment. More technically, it is an opinion regarding the future ability, legal obligation and willingness of a bond issuer or other obligator to make full and timely payments on principal and interest due to investors” (Reitz and Clark, 2006, p.341). As mentioned by Gestel and Baesens (2009) credit risk involves risk of default, recovery, exposure and maturity. Credit ratings are done through collecting information from public and private sources and then at first running a quantitative analysis of gathered information on debt structure of the company, historical and current financial statements, data from balance sheet and sector specific information (Izzi Oricchio, and Vitale, 2012). After that the quantitative findings are backed by qualitative analysis of information regarding quality of the management, competitive position of the company and future growth prospects. Ratings obtained this way are regularly evaluated to witness any improvement or degradation of the credit worthiness of the company over the time. When credit ratings were introduced for the first time then the prime objective of this tool was to separate the investable debt securities from the non-investable grade securities. However, with time credit ratings were started to be used to judge the default risk of the issuer and the loss and recovery risk of the issue. Following the Basel II credit ratings have become immensely important with much wide reach and purpose than before. A slight change in credit ratings nowadays has substantial impact on the capital market in terms of changed equity and bond prices as well as risk management strategies. Credit ratings can be short, medium and long term in nature depending upon the promised time frame of risk management. Moody’s credit ratings is a widely accepted credit rating method for long term credit that assign nine statuses to any credit under consideration regarding its risk exposure. Moody’s credit rating is expressed in nine symbols as Aaa, Aa, A, Bbb, Bb, B, Ccc, Cc, C. Symbols are in ascending order of their risk exposure. Apart from these nine ratings; Moody’s credit ratings also associate 1, 2 and 3 as intra band ratings to depict relative risks within a band of credit rating. 1, 2 and 3 are introduced from Aa to Ccc credit ratings in Moody’s credit ratings. Aaa refers to the highest credit rating; it conveys that the particular credit has very low credit risk and almost no chance of any repayment default. Aa again refers to a credit with extremely strong credit quality owing to low credit risks and high repayment possibility. The difference between Aaa and Aa rate credit in terms of credit quality is minimal. A on the other hand still reflects strong credit quality with low credit risk, the repayment prospect is strong but comes with low level of risks that might be operational owing to sudden economic change. Bbb refers to credits with substantial credit quality with moderate risks. Financial obligation regarding repayment is at a satisfactory level at present but might be exposed to risks owing to sudden adverse conditions and negative economic change. Regarding the investment grid; Bbb is the lowest credit rating. Bb signifies the speculative risks. It is almost certain with this kind of rating that though at present the credit is worthy of consideration but with time there is every possible reason that its repayment would be subject to risks owing to speculative factors and substantial uncertainties. B reflects significant speculative credit risks. Here a safety margin is still available but owing to business, economic and financial adversaries that might pop up in the long run; its repayment might become doubtful. Ccc denotes the beginning of vulnerable credit quality and high level of credit risks. When the ambience is favourable these risks would remain hidden but would come in front once faced with business, economic and financial risks. However these credits have satisfactory recovery prospect. Cc depicts highly vulnerable credits, with every possibility of default if something goes wrong in terms of the economic, financial and business environment. These issues have medium recovery prospect. C at last denotes credits with extremely low quality with high exposure to risks and low recovery prospect. C rate credits might face immediate brunt of credit events and have a very poor recovery prospect (Bhatia, 2002; Anson et al., 2004;Gestel and Baesens 2009). It is worth mentioning that D credit rating has also been introduced and that depicts extremely poor credit rating (Cahill, 2010). There is significant difference between issue specific and overall issuer credit ratings. Issue specific credit ratings refer to the status of the issuer regarding that particular issue. On the other hand issuer credit rating refers to the entire financial capability of the issuer regarding the repayment of credit. Credit ratings can be both qualitative and quantitative in nature. Quantitative ratings as mentioned before consider quantitative information such as balance sheet figures; financial statements etc. qualitative ratings are used in those fields where the quantitative data are meagre. Though, this distinction does exist but often quantitative and qualitative credit ratings are used in conjunction (Gestel and Baesens 2009; Alcubilla and Pozo, 2012;Izzi, 2012). Mattarocci (2014) has mentioned about the use of qualitative information in conjugation with quantitative analysis while determining the credit ratings. He opined that the credit risk of an issuer might vary depending upon the qualitative ambience surrounding the same (Mattarocci, 2014). Again based on type of risks; credit ratings might be of four types namely, default, recovery, exposure and expected loss ratings. Apart from them there are several other types of credit ratings namely; local and foreign currency ratings, national scale ratings, stand-alone ratings, claims and pay-ability ratings, municipal ratings, support ratings, country and country ceiling ratings (Gestel and Baesens 2009). According to Brown and Moles (2012), credit risk can be referred as default risk, performance risk or counterparty risk.Some research results consider credit risk as systematic risk and hence money borrowers try to reduce or avoid this risk. As mentioned above, due to the asymmetry of information the credit rating is an appropriate financial instrument to reduce the credit risk (Hilscher and Wilson 2013). Hilscher and Wilson (2013) have also claim that the ratings could be informative indicators of credit risk. The credit risk management and credit rating agency are emerging in Chinese financial market. Therefore, there are more researches need to be done in this area. Dalla (1995) has emphasized that development of credit rating agencies and development of financial markets are directly proportional; however the coefficient of impact varies over the countries (Dalla, 1995). According to Boochun Jung (2012), credit ratings have significant implications for companies. Moreover, credit ratings affect companies’ future borrowing; on the other hand, several research studies point out that bond and stock valuations may be immediately affected by the changes of credit ratings (Holthausen and Leftwich1986; Ederington and Goh 1998; Dichev and Piotroski 2001). Hence, bond issuers and listed companies who need to attract investments from the market apparently try to keep the credit ratings stable or further higher the due to the fact the sensitive reactions of the credit ratings from the market. Shah (2008) and Kisgen (2006) confirm this point with arguing that firms with no matter positive or negative notch ratings engage in real activities to stabilise or improve their ratings. Therefore, the importance of credit rating implies the importance of credit rating agencies (CRA) which are the institutions analysing and evaluating bond issuers and listed companies. From this prospective, Marwan Elkhoury (2008) confirms that in the new financial architecture, CRAs are expected to become more important in the management of both corporate and sovereign credit risk. The credit rating agencies are growing rapidly from 1970s. From that time companies became immensely interested to approach the financial markets and to be precise the bond markets to raise capital for their business. In 1990s the bond market became the largest contributor to the private companies in terms of capital and left banks behind for the same. Thereafter with the advent of globalization and its gradual acceptance all over the world; credit rating agencies gained importance like never before. Globalization along with many benefits and opportunities also embraced high level of volatility and risk identification, risk assessment and risk management became part and parcel of lending. After that the Basel committee on banking regulations imposed capital requirement related conditions on credit and that gave a boost to the rating organizations. Basel II made assigning credit ratings mandatory to any sort of lending and strictly advised to determine the minimum capital charges required for each borrower in tune of their credit ratings. Thus it is apparent that credit rating agencies thrived and gained importance with the advent and successive time period of Basel II (Siddaiah, 2011). Bharati (2008) mentions that “Ratings have assumed a much larger role in the global financial market.Sovereign ratings affect the quantum of financial and investment flows to a country. Fund managers, international banks, and foreign direct investors look at ratings for portfolio allocation as ratings reflect the overall health of a country’s economy” (Bharati, 2008, pp.679-680). Levich et al. (2002) have also emphasized the role of Bank of International settlement’s Basel II in making credit ratings more important than ever before and expressed that in coming time the credit rating industry would witness more prosperity (Levich et al., 2002). They have also mentioned that credit rating firms help both the lenders and borrowers out of the asymmetric information cloud that covers the lending and borrowing scenario. Here another important aspect regarding the reason of existence and importance of credit rating agencies comes into light. Considering the bond market not only the specialist lenders like banks and other lending institutions but the general public who are not capable of gathering information on credit worthiness of the borrowers (here companies issuing bonds) also acts as the lenders. Credit rating agencies for these lenders are a boon (Levich et al., 2002). Darbellay (2013) though has accepted that in modern times with globalization and number of issuers credit rating agencies have become a subject of immense importance but also has casted doubts regarding the neutrality of these agencies courting series of recent financial debacles (Darbellay, 2013). Starting from the year 2000 the western world has been subject to several financial crises. Financial crisis in United Sates of America, United Kingdom and Western Europe though often blamed on the credit ratings agencies but also announces the need of the credit rating agencies in an improved manner. Rhee (2014) mentions that if the credit rating agencies would have performed properly that the financial crisis of 2008 to 2009 would have never happened and the global history would have flowed in different terrain (Rhee, 2014). Sharts (2013) has mentioned that in western world debt is a way of life and it is obvious that such dangerous life style would seek for the existence of strong credit rating agencies. Moreover the capital market in western world is far more open and that is another reason that it might be exposed to risks of any type at any time. This again seeks for the credit rating agencies in increased number and better manner. However, it should be kept in mind that a NiSM (2009) survey mentions that the credit rating agencies of the western world are far more stringent than that of eastern world, yet needs to be improved owing to the changing nature regarding credit related environment. Shah (2008) considers the existence of large corporate debt market in the western world for the need of the existence of credit rating agencies. The author illustrates that in 2005 corporate debt in USA was USD 714 million and that rose to USD 1 trillion in 2006. A backward induction process would also help to understand the need of credit rating agencies in western world. Developed financial market seeks for developed credit rating agencies and as western world’s financial market is far more developed than the eastern world; hence the need of credit rating agencies in western world is much higher than in eastern world (Shah, 2008). Based on a benchmark of a Chinese credit rating agency, released on 2011, the parameters of Chinese automaker companies introduce that competitive position, service power, financial policies, cash flow, financial strength and some other factors need to be analysed and evaluated. These features are divided into specified characteristics to demonstrate each automaker’s creditworthiness holistically.Gup (2005) has mentioned that courting massive defaults and the Asian Financial Crisis; Chinese authority became very stringent regarding credit ratings. However, since the corporate bond market in China is smaller than other prime Asian nations, hence credit rating agencies gained momentum at a much later stage in China (Gup, 2005). In same tune, Zhen (2013) mentions that the credit rating agency sector of China, is not well developed and lacks independent players. Furthermore those who are entrusted with providing neutral trustworthy ratings are often criticized for their biased opinion and eventual erroneous ratings (Zhen, 2013).Weston (2013) mentions that on 25th December, 2011; the governor of the People’s Bank of China Zhou Xiaochuan emphasized on lessening the dependence on foreign credit rating agencies in China and assured that the government would now consider developing government backed credit rating agencies. China’s credit rating agency sector is dominated by wholly foreign or partially foreign owned credit rating agencies. Only Dagong is an indigenous credit rating agency that is free from foreign lineage. The Chinese government does not trust the ratings of the foreign or partially foreign owned credit rating agencies. Bian (2014) also confirms the distrust of the Chinese government regarding the credit rating agencies of foreign or half foreign origin (Bian, 2014). On 20th December 2011 People’s Bank of China was entrusted as the sole and prime credit regulatory agency. Following this action, on 19th March, 2012 China framed and announced its first official credit rating guidelines as an enhancement of the present CRA practises (Weston, 2013). Marwan Elkhoury (2008) argues that the calculations of credit ratings are based on a quantitative and qualitative assessment reviewed and finalised by a rating committee, not any individual credit analyst. This is also confirmed by ‘A Guide to Moodys Sovereign Ratings’ (Moody’s special comment 2003). In this part, the rates assessment methods of Standard and Poor’s, Moody’s and Fitch’s need to be referred. According to Marwan Elkhoury (2008), ratings of Standard and Poor’s only show the forward-looking probability of the occurrence of default; conversely, ratings of Moody’s reflect the Expected Loss which combines both Probability of Default and the expected Recovery Rate; Bhatia (2002) points out that ratings from Fitch’s reveal not only both Probability of Default and the expected Recovery but also the analysing of historical records and future trends. What is more, Jens Hilscher and Mungo Wilson (2013) finds out that ratings are inaccurate measures of raw default probability – they are dominated as predictors of failure by a simple model based on publicly available financial information. Hence, the credit ratings cannot be evaluated in a simple model, meaning that there are different models can be applied depends on different cases and there should be several models or methods can be used for the calculation. On the other hand, empirical assessments of credit ratings are applied in evaluating credit ratings. A lot of research achievements show that many economists have estimated econometrically the determinants of credit ratings for both mature and emerging markets (Cantor and Packer 1995, 1996; Juttner and McCarthy 2000). After the calculation, credit rating agency will produce a credit score for each company or bond issuer, which can be called score cards in credit rating agencies. Tony Van Gestel and Bart Baesens (2009) defines that Credit scoring is a credit risk management technique that analyses the borrower’s risk. Each parameter will have a score. Then credit rating agencies will rank all of the companies in the same industry and publish to the public.Langohr and Langohr (2008) mention that credit ratings in the automobile industry are mainly based on company fundamentals. S & P downgraded the General Motors to credit rating B in courting a comparatively poor company fundamental than before for the company. Their finding is in tune with Jansen (2006). Jansen has also opined that to improve their credit ratings the large car companies like GM, Ford etc. resorted to offer own loan to purchase cars and that led to a rise in their credit ratings.Montie has also mentioned about the importance of the company fundamentals for automobile companies to the credit agencies while determining their credit ranks. The author has mentioned as well about GM and has found their poor balance sheet figures responsible for the company’s credit ranking down gradation (Montie, 2012). However,Lehmann (2007) has pointed out one interesting transition in credit rating of automobile companies by the credit rating agencies nowadays as he emphasizes that recently while rating an automotive company the credit rating agencies are putting more emphasis on the future growth prospect of the company than its ability to survive (Lehmann, 2007). Methodology Generally, this project will use qualitative research method to study the significance of credit rating on Chinese auto industry. Specifically, case-study will be applied in this project. The object of this study will be a credit rating agency in China, CRA A (due to the reason of privacy agreement with this agency). The reason CRA A is approached will be explained as follow. Firstly, CRA A has the first ranking market share in Chinese credit rating industry, which implies that this agency has most historical data comparing with other agencies. Secondly, CRA A’s business almost cover all kinds of industries in China, including real estate, auto, energy, agriculture industry and so on. As a result, more resources can be approached during this study. Thirdly, the CRA A is a joint venture enterprise with the most powerful credit rating agency in American market. Apparently, the western countries’ experiences are able to be learned. Apart from this, CRA A also understands the Chinese market features, which could lead the study of importance of credit rating to Chinese automaker firms more and more efficiently and historically. Therefore, CRA A could be the best object for this project. In the case-study, questionnaire and face-to-face interview will be the methods to complete the research. For the questionnaire, there will be about ten questions related to functions and influences of credit rating to Chinese auto industry and on the other hand, the number of people surveyed will be 30 at least. The questionnaire will be mainly handed out to the employees of credit rating agencies. Then the pie-chart will be plotted to analyse the research questions. For the face-to-face interview, I need to visit the business supervisor of CRA A to further understand the significance of credit rating on Chinese auto industry. Also, the financial employee of a Chinese automaker firm will be interviewed to help me study the importance of credit rating to auto companies. Now the reasons why the questionnaire and face-to-face interview are applied in this project will be stated. Because of the characteristic of transparency of information of credit rating every company or investor is able to obtain the ranking and value of rating calculated by credit rating agencies. The objectives of this project are not to find the methods that how credit rating agencies evaluate borrower’s creditworthiness and score cards. Nevertheless, the key research point is about the significance of credit rating to Chinese auto firms. Therefore, I need to acquire the information from inside of the Chinese credit rating agencies and the people serving this kind of agencies. In this way, the real significances can be concluded. So in this project, the real life situations of the credit rating agencies and their customers are very important. Then the best idea to understand these is to apply case-study research including questionnaire and interview. Conclusion Based on the case-study, this project should be able to conclude that combining the western countries’ experiences and Chinese auto market features, the credit rating demonstrates the auto markets’ risk points and quantises these risk points, which makes up the lack of information for investors. Bond issuers would like to preserve or improve their level of credit rating and also credit rating agencies evaluate the score cards rigorously and they are supervised strictly by the government. Moreover, more and more financial products of Chinese auto companies, such as corporate bonds and emerging asset securitisation products, rely on the information of credit ratings. All of theselead the fact that the role of the credit rating becomes more and more important in Chinese auto markets for whatever automaker firms or investors. References 1. Adams et al, (1999), International Capital Markets, IMF 2. Alcubilla, R. and J.R. Pozo, (2012), Credit Rating Agencies on the Watch List, Oxford University 3. American Society of Comparative Law, (2006), American law in the 21st century, International Academy of Comparative Law 4. Anson et al., (2004), Credit Derivates, New York: John Wiley and Sons 5. Bhatia, A.V. (2002). Sovereign Credit Ratings Methodology: an Evaluation. 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