Evaluating China’s “Ratings Inflation” Problem as Supply Chains Restructure

Corporations worldwide are restructuring away from China because of still effective U.S. and European tariffs, new China COVID lockdowns, and power rationing which have brought about both a surge in product costs and longer lead times. Chinese suppliers concealing their financial health is another more sinister threat to procurement risk evaluators. 

In 2022, CreditRiskMonitor discovered a significant discrepancy in the distribution of Altman Z’’-Scores for Chinese companies compared to other regions globally; we view this phenomenon as what we’re calling “ratings inflation.” In the face of ratings inflation, our 96%-accurate FRISK^® score provides more reliable scoring supported by its nonlinear modeling techniques and other data components. We offer that procurement professionals must use the FRISK^® score to consistently – and effectively – see past the Chinese vendor ratings inflation mirage and avoid harm to their supply chains.

China Suppliers Hide Financial Risk

China continues to be a critical trade partner for most industrialized nations, and yet supplier financial stress is increasingly important as GDP growth decelerates to levels not seen since 1989. This slowdown may ignite China’s $27 trillion corporate debt powder keg – the most indebted corporate sector worldwide. The first falling domino has been China’s property developer industry, which recently entered a depression and tripped several companies into bankruptcy. 

Despite relative secrecy, China is known for having poor accounting practices. Chinese companies may inflate sales, hide costs, overstate cash balances, shift debt off their books, and use aggressive accounting, which artificially boosts credit ratings and scores. According to Fitch Ratings, companies carry out these tactics with limited disclosures:

While Chinese companies themselves lack transparency, certain auditors have not kept their end of the bargain either. In September, the SEC charged Deloitte-China over failure to conduct proper audits on numerous Chinese operations of U.S. issuers and Chinese companies listed on U.S. exchanges:

“[Deloitte-China] failed to adhere to numerous PCAOB auditing standards, including due professional care of audit evidence, sampling, documentation, internal control over financial reporting, audit supervision, and quality control.”

Chinese-domestic and globally recognized auditors have produced audit deficiencies – and these failures in meeting regulatory standards are alarming. The SEC informed that the PCAOB would conduct investigations on auditors registered in mainland China. Noncompliance with the order will result in the delisting of 200 Chinese companies from U.S. markets with a total valuation between $1 trillion to $2 trillion. This lack of financial transparency to date should concern supply chain and procurement professionals. Risk models, including the Altman Z’’-Score, require certified financial statements to function properly. Otherwise, the ratios listed below can be manipulated and skew supplier financial health assessments:

• EBIT-to-total assets (EBIT/TA)
• Working capital-to-total assets (WC/TA)
• Total equity-to-total liabilities (TE/TL)
• Retained earnings-to-total assets (RE/TA)

The FRISK^® Score Advantage

After reviewing all nonfinancial public companies, only 16.5% of Chinese companies were classified as high-risk under the Altman Z’’-Score, a metric commonly cited and leveraged in the world of credit. This figure stands out because China’s corporate financial leverage is 2-3x higher than the U.S. and worldwide cohorts. Another disparity was the median Z’’-score of 4.2 in China compared to 2.3 and 3.1 for the U.S. and worldwide, respectively. 

For context, the Z’’-Score only considers financial data whereas the hybrid model FRISK^® score uses four distinct data components and nonlinear modeling techniques. Supply chain professionals should note the different outcomes below:

The FRISK^® score provides more normalized distributions relative to the Altman Z''-Score

The results of the FRISK^® score offer the following benefits for risk assessment:

• Low risk scores transition from 67.2% to 31.4% of all Chinese companies
• 10% more Chinese companies are newly classified as high risk
• The FRISK® score is more consistent and useful across regions 

The Z’’-Score’s broad strokes indicate companies are usually low risk (i.e. understating vendor financial risk); however, the FRISK^® score’s breakdowns provide more cautious assessments. In fact, three out of every five (3/5) Z’’-scores worldwide reclassify into a worse risk classification with the FRISK^® score. There are a plethora of recent historical examples where the Z’’-Score failed to identify bankruptcy/corporate failure while the FRISK^® score correctly warned of it.

One scenario is China-based oil & gas equipment manufacturer Hilong Holding Ltd. In the last few years, the supplier’s FRISK^® score signaled high risk while the Z’’-score never did in any fiscal period. The company defaulted on its debt in June 2020 and completed a debt-restructuring scheme by May 2021. 

Another case is China-based Fantasia Holdings Group Co., Limited, which defaulted in October 2021 and filed a Winding-Up Petition in May 2022. Leading up to the event, the Z’’-Score never signaled high risk but the FRISK^® score correctly indicated high risk for years. The company’s FRISK^® score used stock market performance, financial statement ratios, and credit agency ratings – and continued to signal high risk even after the agency ratings were withdrawn post-default leading up to the bankruptcy.

It is also important to distinguish credit rating agency firms. Research by the Bank for International Settlements shows that Chinese-domestic rating agencies assign optimistic evaluations versus global rating agencies: “We have documented that domestic ratings agencies rate Chinese companies at much higher levels than do global rating agencies.” This finding confirms the issue of ratings inflation in Chinese credit rating agencies. To avoid this pitfall, the FRISK^® score only integrates global agency ratings from Moody’s, Fitch, and DBRS Morningstar for dependable risk assessments. 

Generally, professionals must be cautious with Chinese company Z’’-scores, Chinese-domestic agency credit ratings, and other risk evaluations dependent on Chinese audited financials. Instead, the FRISK^® score uses multiple objective data sources and produces more reliable bankruptcy predictions. By reducing Chinese ratings inflation, supply chain professionals can uncover risk and identify reliable

Bottom Line

Supplier financial risk in China calls for increased scrutiny and the FRISK^® score helps sort through this complexity. Now is the time to conduct objective audits as supply chains restructure. In fact, industrial giant ABB Ltd. surveyed U.S. and European executives and found that 70% of companies plan to reshore or nearshore to address supply chain issues. Proactive reviews of your prospective and existing suppliers can uncover problems before they affect your company. Contact CreditRiskMonitor if you would like access to sample supplier risk reports and to learn more about the FRISK^® score.