Blessing or Curse: The Real Effects of Rating Inflation

Abstract

Rating inflation in China’s corporate sector was met with reduced bond financing costs and increased corporate borrowing. Firms with inflated ratings increased leverage ratios and cash reserves, but not investment or research and development (R&D) inputs. They exhibited higher default probabilities accompanied by lower profitability. Textual analysis reveals that the more inflated firms tended to issue bonds to roll over existing debt rather than invest in new projects. The results highlight that whether more favorable ratings will have positive feedback effects on firm operations crucially depends on the availability of growth opportunities and responsible use of funds. Implicit guarantee, regulatory arbitrage, and conflict of interest embedded in the issuer-pays business model gave rise to rating inflation in China.

Keywords: Rating inflation, real effects, probability of default, investment, R&D, textual analysis.

JEL Classification: G21, G24, G28