Blessing or Curse: The Real Effects of Rating Inflation

38 Pages Posted: 13 Oct 2020 Last revised: 13 Dec 2021

See all articles by Shida Liu

Shida Liu

Tsinghua University - School of Economics & Management

Hao Wang

Tsinghua University

Date Written: August 22, 2020

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

Suggested Citation

Liu, Shida and Wang, Hao, Blessing or Curse: The Real Effects of Rating Inflation (August 22, 2020). Available at SSRN: https://ssrn.com/abstract=3680291 or http://dx.doi.org/10.2139/ssrn.3680291

Shida Liu (Contact Author)

Tsinghua University - School of Economics & Management ( email )

Beijing, 100084
China

Hao Wang

Tsinghua University ( email )

318 Weilun Building
Tsinghua University
Beijing, 100084
China
86 10 62797482 (Phone)
86 10 62794554 (Fax)

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