HONG KONG, June 27 (Reuters) - China has opened its corporate bond market to foreign investors but billions of dollars in potential inflows are being held back because they are wary of the credit ratings applied by domestic credit rating agencies.
About 80 percent of Chinese companies are rated AA, the third-highest rating, or above, by domestic ratings agencies, largely because historically the government has rarely allowed a company to default on its obligations.
International ratings agencies only assess a few Chinese bonds, but where they do, the ratings compared with domestic agencies vary sharply - another reason foreign investors are wary of committing money to the market.
"We definitely will not adopt China domestic ratings, which can not differentiate good companies from bad ones. We still need to rely on international ratings and our internal analysis when entering onshore market," said Penny Chen, a fixed-income fund manager at Manulife Asset Management in Taiwan.
At the end of May, China's central bank announced operational details to open up the $6 trillion interbank bond market to foreign investors at a time when China is trying to deter capital flight following last year's stock market crash.
Foreign investors hold about 17 billion yuan ($2.5 billion) in Chinese corporate debt on the interbank market. But they hold about 620 billion yuan, or 2 percent, of the overall Chinese debt market, mostly in government bonds or policy bank bonds.
By comparison, foreign investors own about 6.5 percent of South Korea's debt and 4.5 percent of India's debt.
"We are very cautious on China corporate bonds as most of them do not have an international rating and would prefer not to touch it unless we have to," said a fund manager in Hong Kong who invests in China's government bonds.
More than a quarter of China's outstanding debt is made up of corporate bonds. If foreign investors put a similar proportion of their debt portfolio into corporate bonds, it would amount to between $20-$30 billion, the fund manager said.
Even where a firm is rated by both domestic and international ratings agencies, the assessment varies sharply.
For example, Yanzhou Coal is rated AAA by domestic ratings agencies Dagong Global Credit Rating and China Chengxin International Credit, the highest possible rating that indicates the lowest level of risk for an investor.
But it is rated BB- by Standard & Poor's Ratings Services, 13th in its risk rankings and non-investment grade.
"When I was a fund manager and went to do road shows, every time it was like a joke when I told them more than 50 percent of Chinese onshore bonds are rated AA or above," said Meng Xiaoning, chief executive at TF International Securities in Hong Kong.
China did not allow a bond default until March 2014, when Chaori Solar said it was unable to make interest payments on its bonds. Since then the government has allowed other defaults as it gently lets market forces exert greater influence.
Ariel Yang, overseas business general manager at China Chengxin, said the increased risks in the market offered domestic agencies an opportunity.
"We hope to see more defaults as we can then differentiate our ratings to show different risks and that is the value of us rating agencies," Yang said in an interview.
There are no regulations in China that prevent any rating agency from providing a rating on onshore bonds, but the regulations are on whose ratings can be used and how they can be used.
"Onshore bonds require one or more ratings before they can be issued in the public market. The ratings must be from rating agencies that are accredited by the respective regulators overseeing that part of the capital markets. Currently, only domestic rating agencies are accredited by Chinese regulators," said a Fitch spokesman.
Moody's said none of its ratings are eligible or intended for use within mainland China. S&P was not immediately available for comment.
China's three main domestic ratings agencies - China Chengxin, Dagong and United Ratings - dominate ratings with an aggregate market share of over 90 percent. United Ratings was not immediately available to comment.
Now that the government is allowing more defaults, China Chengxin and Dagong have begun to assign both global scale ratings and national scale ratings to yuan-denominated bonds issued by foreigners on the mainland, known as panda bonds.
"What we are trying to do is mapping between international ratings and national ratings," said Warut Promboon, chief rating officer at Dagong in Hong Kong.
National scale ratings assess macro risks and cross-industry risk comparison in China; while global scale ratings consider macro risks and cross-industry risks in different countries, similar to the approach of international agencies.
"We will consider introducing global scale ratings to onshore yuan bonds issued by domestic companies as well so that foreign investors can tell the difference of two firms that are both rated AAA under national scale," Yang said. (Reporting by Michelle Chen; Editing by Neil Fullick)