Building a New Sovereign Rating Standard
Dagong Global Credit Rating Co., Ltd.
The unprecedented global financial crisis, largely caused by credit defaults, inspired our exploration into the laws of social development in the era of credit economy, which yields the fruit of a new sovereign rating standard described in this document.
1. Background of Building a New Sovereign Rating Standard
In the era of credit globalization, the law of credit economic development repeatedly manifests its importance through financial crises, requiring our attention and respect. In the background of credit globalization, credit, as a common form of capital, is playing an increasingly important role in propelling the global economy. Sovereign credit stands at the core position in the global credit system, influencing the sustainable and balanced development of the global economy. Sovereign credit determines not only the allocation of the world’s credit resources, but also national economic competitiveness and the multilateral framework of debt claims and obligations. The developed countries have been taking advantage of their higher credit ratings to control over 90% of global credit resources, and maintain their economic privileges despite their heavy debt burden. The unfair distribution of global credit resources is a main cause to the current imbalanced global economic development.
With the development of international credit relationship, a country’s credit has been closely connected to its sovereign rating. Sovereign credit represents the central government's capacity to repay debts and sovereign credit rating demonstrates the potency of this capability. Sovereign rating is not only one of the decisive factors for the interest rate of a country’s foreign currency debt, but also the main element in the pricing mechanism in domestic bond markets, stock markets, foreign exchange markets and monetary market through affecting the interest rate of local currency debt. Sovereign rating system originated in theUnited Statesbefore the World War I. Since then, as the main suppliers for sovereign rating information, the three credit rating agencies, Moody’s, Standard and Poor’s and Fitch rating, have dominated the current international credit rating practice for nearly a century.
The sovereign rating standard determines whether the rating result is reasonable or not. The lasting monopolization over the standard-setting by the three rating agencies has deeply impacted global economic development. By granting sovereign ratings to various countries, the three agencies have actually been guiding the allocation of international credit resources. However, the current sovereign rating standard, failing to fairly evaluate the real credit risk of various countries, provide the false rating information to the whole world. Guided by the high ratings of developed debtor economies, international capital continuously flows into those high-risky countries, which evolves into an unfair setting in debt claims and obligations, and accumulates enormous credit risks destructive to the world economy. Moreover, high ratings enable the heavily indebted countries to finance at low lost and to encroach on creditor countries’ interests by currency devaluation. The unfair credit rating information led to misguided financial decisions and repeatedly triggered the financial crises. Especially, the latest world financial crisis, originated from a ramshackleU.S.credit system caused by credit rating mistakes, attested to the utter failure of the existing sovereign credit rating standard.
In the post-crisis era, sovereign debt crisis will be the biggest risk source for the global credit economy. Therefore, sovereign credit plays an important role in the recovery and growth of global economy. Sovereign rating should provide fair assessment of sovereign credit and reasonable early warning of sovereign credit crises, make an effective and balanced allocation of world credit resources, lay the foundation for a balanced development of global economy and guard against the reoccurrence of the global credit crisis. The current sovereign rating standard fails to fulfill this mission. It is high time that a new rating standard should be established.
2. Importance of Sovereign Rating Standard to Global Economic Development
Credit relationship refers to the creditor-debtor relation. The credits’ function of demand-creation pushes forward a fast globalization of credit relations. International credit relationship has become one of the fundamental economic relationships and constituted the international credit system, on which the modern economic society exists and develops. Each credit relation is a ring in the chain of global credit relationship. The more complex the credit relationship is, the more convergent the international capital flow will be, and consequently the higher credit risk. On one hand, the credit globalization, which is based on debt repayment, facilitates the global economic development; On the other hand, it also evokes the globalization of credit risks, aggravating the vulnerability of the world economy. A sovereign state is a special entity that creates and controls credit resources, shouldering more complex credit risks. The asymmetric credit risk information is the main conflict in the global credit economy and only transparency can ensure stability. Therefore, sound sovereign rating standard become a decisive factor for world economic sustainability. Its significant impact can be illustrated in the four aspects as follows.
2.1 Sovereign Rating Standard Impacts the Fulfillment of Government Functions
Two milestone events play crucial roles in focus-shifting of governmental functions in the 20th century. The first one is the breakdown of Bretton Woods System: consequently the issuance of U.S. dollars was no longer anchored to gold. It became possible for a sovereign entity to adjust its credit size according to its needs. At present, the macroeconomic management relies heavily on the fiscal and monetary measures, which are realized mainly by adjusting macroeconomic demand. In fact, the essence of such policies is government’s intervention in general credit volume.
The second is the ending of the Cold War, since then peace and development became the pursuit of human society. The competitions among countries are more and more prominent in the field of economy. The economic competitions took place not only between enterprises, but also between countries, which have become the mainstream of world economic competitions. The nature of the international competition is the contest of the economic governance. Holding sufficient credit resources enables a government to deploy economic strategy by adjusting credit volumes. However, the adjustment is heavily restricted by fiscal revenue and monetary issuance. Therefore, borrowing becomes direct solution to boost government’s control over the credit volumes, and allows more flexibility in economic strategy. Borrowing is an effective means for the government to fulfill its functions.
As of the end of 2009, Dagong estimated that the total of global government debt amounted to USD39.7 trillion, about 71% of the nominal world GDP. Comparative studies by the Economist found that, from 1999 to 2009, the global government debt annually increased by 6.46% on average. A government’s borrowing capacity has increasingly evolved into the capability of seizing world credit resources, and it becomes one of the driving forces of economic development. Therefore, the sovereign rating, ultimately determined by the rating standard, directly affects the government’s ability to obtain credit resources via both domestic and overseas channels.
2.2 Sovereign Rating Standard Affects the Effectiveness of International Capital Flows
Analyzing the effectiveness of international capital flows from the perspective of the influence of credit relationship to the global economy refers to the research on security of cross-border capital flows and its impact on macro-economy. The capital convergence follows a different pattern on sovereign than on other economic entities. On one hand, the exploitation of credit resources under-lied by state will influences each country’s economy respectively and the global economy on the whole; On the other hand, the international capital absorbed by various sectors in domestic market is also affected by the sovereign credit status, whose impact will reach the global phase indirectly. Therefore, the government solvency is the key factor to influence international capital flows. A higher solvency means a better investment security. The current sovereign sating standard, by providing positive information to global investors on the solvency of developed countries, enable those countries with poor endogenous solvency to obtain excessive credit resources, and consequently harm the security and sustainability of world capital market.
2.3 Sovereign Rating Standard Affects the National Wealth Transfer
The reasonable national wealth transfer means that a country repays its international debts with interest that matches its sovereign risks, and maintains the stability of its currency value to protect its creditors’ interests. The national wealth transfer between governments and between non-government economic entities is affected by sovereign ratings determined by the rating standard. As a pricing mechanism, a reasonable rating can correctly reflect sovereign risks and largely match the financing costs with the risks, so that the two parties’ interests are both ensured. Otherwise, one of them would be impaired. For example, some highly indebted countries, covered by high ratings, can finance at very low cost, harming the creditors’ interests quietly. Once the credit crisis breaks out, the creditor’s national wealth -- in the form of credit -- is very likely to vanish within a split second. The devaluation of debtor’s currency would also reduce the debt’s true value, transferring the national wealth from creditors to debtors. If sovereign rating standard ignores the change of the currency value, it objectively supports the behavior of plundering the creditors interests by currency devaluation, which should be treated as actual default. The unfair sovereign rating could as well actuate the unfair wealth transfers in a bigger scale among other non-government entities. Capital profit is the primary driving force of international capital flows, and a reasonable wealth transfer is the basis of the effectiveness of international capital flow, which facilitates the balanced development of the global economy. Therefore, it is necessary to develop a fair environment for national wealth transfer through formulating sound sovereign rating standard.
2.4 Sovereign Rating Standard Affects the Stability of International Credit Relations
The stability of international credit relations indicates that the international credit system runs smoothly, while the damages of international credit relations would lead to the erosion of international credit chain and even the outbreak of credit crisis. Therefore, a feasible cure to the information asymmetry of credit risks is the prerequisite to maintain the stability of international credit relations. From the investors’ perspective, the sovereign rating standard should follow the natural law of the credit risks and reveal sovereign credit risks fairly and scientifically. Only in this way can it function to send early warning against risk crisis, stabilize international credit relations, and contribute to the healthy development of world economy. However, if purely from a certain country or interest group’s perspective, and assessing sovereign risks under the guidance of certain ideology or values, the rating results will surely deviate from the reality. The mistakes in judging credit risks will aggravate the information asymmetry in credit market and mislead the flows of international capital, jeopardizing the stability of international credit relations.
The relationship between the sovereign rating standard and global economic development fully demonstrates that credit integrates the economy globally and act as a carrier and an accelerator of economic development. A country’s competitiveness largely depends on its access to the international credit resources. When a country, as an independent economic entity, engages in global economic activities, its sovereign credit becomes crucially important. The sovereign rating, produced under the guidance of sovereign rating standard, determines a country’s position in the global credit system. As the credit economy develops through the ever-changing financial practice, it is time to re-examine the impact of sovereign rating standard to global economic developments, and summarize the intrinsic laws of credit economy from a global perspective.
3. Impact of Current Sovereign Rating Standard on Global Economic Development
The credit rating standard is usually composed of rating methodology, rating procedures and rating information support system. The rating methodology is the core guidance to identify the credit risks. It embodies the essential ideas underlying the whole system. In other words, to study the rating methodology equals to study the whole rating standard.
Although Moody’s, Standard & Poor and Fitch Rating set up their own rating methodology, yet they share the same essential ideas and all together enjoy the absolute monopoly over the international rating business. Thus we refer to the three agencies’ methodology as the current rating standard. In the current rating standard, selected key indicators are employed in measuring rating factors, then producing rating grades. Therefore, to explore the basic ideas of current rating standard, we can simply focus on analyzing these core indicators.
3.1 The Core Content of Current Sovereign Rating Standard
The core content includes the following seven aspects:
I. The assessment of political risks or the institutional strength is closely related to the rating grades. The key indicators in this aspect include a variety of issues that represent the western political concepts, such as the rule of law, separation of powers, political participation, media independence, and so forth.
II. When evaluate the economic strength, the GDP per capita is regarded as the most crucial indicator and is closely connected with the rating grades, the reason of which is that higher income per capita indicates higher debt endurance.
III. In the analysis of economic structure and prospects, the main criteria are the degree of a country's privatization, liberalization and openness. The concrete indicators include trade liberalization, participation in the global financial system, and the liberalization for current account and capital account.
IV. When evaluate the financial risks, they mainly focus on the risk level of the banking sector and the degree of banking privatization, liberalization and openness.
V. When assess a government’s debt repayment capability, the government’s financing capacity is considered as the primary determiner, while increasing fiscal revenue through fiscal adjustment is the second source of debt repayment.
VI. Whether the country has an independent central bank and an international reserve currency is the indispensable condition for a high rating grade.
VII. A large number of indices produced by external institutions are employed to support their rating results.
3.2 Analysis of Current Sovereign Rating Standard
We comprehend the current sovereign rating standard by examining the intrinsic relationships among various credit risk factors. Meanwhile, the development of international credit relationship, the financial crisis and the practice of sovereign credit rating provide us with sufficient empirical evidences to verify our comprehension. Therefore, as long as we analyze the core element from the perspective of their intrinsic relationship, we can make an objective conclusion.
Firstly, the indicators used to assess a sovereign's political risk or the strength of its political system, are based on the western political ideology, so they can not objectively evaluate the central government’s governance of all types of states.
Positioned as the dominant determiner by all three rating agents, the political rating is regarded as the direct crucial factor in granting a high sovereign rating. They believe that in the political system with power separations, citizens have a wide range of political rights and participate in policy-making process, and the media is independent. All of the above ensure the political transparency and stability, which provides an institutional guarantee for economic development.
However, there are two obvious defects in their analysis. Firstly, by using political criteria to measure a sovereign's debt repayment capacity, the credit rating is politicized. Secondly, to evaluate the superstructure’ counter effect on economic development in various regimes by only western political theory, this practice seriously deviates from each country’s reality, and fundamentally splits the correlation between a sovereign’s debt repayment capability and its government’s intervention in the economy. These rating criteria have been proved to be inappropriate. Deeply rooted in the western political tradition, the western political ideology, which only came to mature when the economy reached a certain stage, does not apply universally or eternally. Thus, as human society marches on, the western countries also need to adjust their political system to keep up with the time. That the three rating agents insist on evaluating political risks and institutional soundness by western political ideology only reflects their failure to study various countries’ social reality, leaving the impression of advocating western values without distinction.
After the World War II, the East-Asian countries made remarkable economic achievements, when their political system had yet to reform into western style. The relatively centralized political power enabled them to concentrate on solving the most urgent issues in the economic reform step by step, and guaranteed the basic social stability in the period of interest transition. Their political system has proved to be very successful. By contrast, however, other countries copying the western system encountered many political obstacles in maintaining stability and development. Therefore, every country should stick to its own political system according to its own social characteristics, and make corresponding reform along with changes in reality. In this respect, there is no single best standard exist.
Secondly, measuring a sovereign’s credit rating mainly through GDP per capita, leads to the neglect of many other important factors. As there is no necessary correlation between GDP per capita and government’s repayment capability, it leaves the current rating methodology in question.
According to the existing standard, GDP per capita is regarded as the core indicator reflecting a sovereign’s economic strength-- the higher GDP per capita, the stronger national debt sustainability. However, the fact is that no necessary correlation has been proved between GDP per capita and government’s repayment capability, not to mention that other indicators must be also employed when evaluating a sovereign’s economic strength.
When analyzing the economic strength, GDP per capita indicator applies with the following defects: Firstly, GDP per capita can not reflect a country’s overall economic development level, especially for countries heavily dependent on natural resources. Secondly, it can not reflect the economic diversity and dynamism. Thirdly, it can not reflect the income distribution, for example if income is highly concentrated to a few people, serious economic and social problems will happen, which hampers the economic development.
More importantly, there is no inevitable correlation between GDP per capita and government’s repayment capability. Countries with higher GDP per capita, may possess sizable budget deficit or have huge debt burden, or lack enough fiscal revenue to repay debts. Their government potential to finance from domestic market is also likely to be limited by low or even negative saving ratio. In addition, restricted by institutional factors like legal system or electoral system, taxation could be a painful procedure with strong resistance, which makes it difficult to convert personal income to government revenue to strengthen its solvency.
On the contrary, if a country operates on sound economic structure fitting its own market characteristics, with favorable fiscal revenue, saving ratios and promising economic growth prospect, its borrowing capacity and repayment capability should be considered strong, even if its GDP per capita is relatively low.
Rated by GDP per capita,Australia, theUnited StatesandCanadaall ranked among the top 20 economies in 2008, but they were also among the top 15 countries with highest net liability. They have been long rated as AAA by theU.S.rating agencies. In contrast, GDP per capita of Venezuela and China ranks at 54th and 105th respectively, even though they are both among the top 10 countries in term of net claims, their credit rating is B and A+ respectively. The fact that the close correlation between GDP per capita and credit rating enables the biggest net debtors to enjoy far higher rating than the biggest creditors, manifests that GDP per capita is an unreliable factor in assessing the government solvency. The improper ratings that reverse creditor-debtor legitimate relationship have left the fairness of current rating standard open to serious questions.
Thirdly, to use economic privatization, liberalization and openness as main indicators to assess a country’s economic structure and prospect is in fact to promote neo-liberalism and the Washington Consensus.
It is generally believed that economic growth is constrained by economic structure which can be perfected through privatization, liberalization and openness. This mindset originates from the market fundamentalism, that is, the neo-liberal economic views.
As far as privatization and liberalization are concerned, choosing what political or economic system is determined by each country’s social conditions. Ownership structure is the institutional foundation for the economic and political system of a country, and every country chooses its own ownership structure according to its own characteristics in order to achieve economic prosperity and political stability. Similarly, different countries choose different ownership structures to promote productivity. Among countries of private ownership, productivity level varies from one to another -- developed countries have long been plagued with cyclical economic recessions, and other transitional countries experience setbacks in their privatization effort. Blind privatization movements have forced many developing countries to become dependent economy to developed countries, and absorbed their endogenous energy for long-term prosperity. Since there is no necessary link between privatization degree and economic growth, to make privatization and liberalization as rating criteria is a false premise for sovereign rating.
As far as economic openness is concerned, the ebb and flow of any economy is the result of a complex mechanism involving many factors, such as political and economic systems, economic development strategy, natural resources, economic structure, financial system, fiscal policy, human resources, management competence, and international relations. Which factor is decisive or stands as priority varies for different countries. Economic openness is surely a factor in this formula, but among many other factors, its importance depends entirely on a certain country’s particularity. Therefore, ignoring other factors affecting the development of economic strength and making the economic openness as a main condition of judging a sovereign’s economic development situation is an extremely over-simplified solution. Regardless of the actual situation of various countries, using openness as the only indicator to measure all countries economic growth models deviates from the economic development rules.
In the era of globalization, all countries will inevitably open the international trade, investment and financial market in the process of economic development. But it is each country’s own decision to make when and to what extent to open its market, and there is no such thing as international standard. If economic openness can’t solely determine a country’s economic growth pattern, it should not be considered as the main factor to measure a sovereign’s economic strength. History has proved that not only developing countries suffer from frequent financial crises caused by overemphasizing on non-differentiating economic openness, so do developed countries. The world has paid gravely to verify the feasibility of this rating concept.
Privatization and liberalization, supported by the neo-liberal economic theory, certainly has its own value, but any theory applies with certain limitations. If a theory is applied in all circumstances, the result will only turn out to be absurd. The existing Sovereign rating standard sadly makes such mistake.
Fourthly, a sovereign’s financial system can’t be comprehensively evaluated by assessing banking sector’s risk level based on the degree of privatization, liberalization and openness.
To simply analyze banking sector’s role in economic growth can not completely reveal the modern financial system’s contribution to national wealth. Modern financial system, primarily consisting of the banking industry, securities and insurance, is in fact a system of credit trading, which includes direct and indirect financing functions such as bonds, equities, foreign exchange, gold, and futures. It provides inexhaustible fresh blood to economic development through those components which are inherently related and interact on each other. Under the impetus of credit globalization, the functions of the financial system have gone beyond national boundaries and promoted the development of the world economy. To find the role of financial system in the national economic development and more importantly, to understand the relationship between the financial system and the economy, only in this way can we discover the special operating law linking financial system and economy, and its impact on government’s repayment capacity, and thus produce the right rating results. Banking sector is only one part of modern financial system. Thus, the analysis of the banking sector cannot substitute for a comprehensive analysis of the impact of the whole financial system on national economic development. The existing credit rating standard, solely focusing on banking sector, deserves some serious criticism on its incompleteness and backwardness.
The credit rating methodologies of Standard & Poor’s and Fitch Ratings unduly favor privatization, liberalization and openness of financial system, but ignore the threat to financial security posed by possible misuses of these policies. They emphasize that foreign capital participation in domestic financial sector will bring an advanced financial management concepts and techniques so as to reduce the risk of banking failures. They also believe that if crisis happens, the foreign parent company can better provide rescue capital than government. Over privatization, liberalization and openness in the financial system will bring similar problem as in economic reforms. However, as the financial sector stands at the core of modern economy, the damage is even more severe.
The outbreak of the financial crisis in 2008 made a perfect counterexample to the feasibility of this rating concept. The American banks in the extent of privatization and ownership structure completely follow the existing rating standard, but the systematic financial risks created through financial innovation almost destroyed the sovereign’s entire financial system and made the global financial system suffer heavy losses. The financial crisis was triggered by the sub-prime loans, which indicates that the direct financing market is not only the blood pump to theU.S.economy, but also the systematic financial risk incubator. Consequently, such phenomenon does more harm to the macroeconomic and national credit system. It proved that the entire financial system plays a role of systematic constraints to the economic development. Reality proves that the existing credit rating concept they have flaunted is so weak.
Fifthly, iit is impossible to accurately reveal the developed countries’ credit risks caused by higher government budget deficits, when the government's financing capacity is regarded as the first source of repayment or when the liquidity’s role in protection of sovereign debt is over-emphasized.
Such concept is contrary to the basic principle of credit relationship and the common knowledge for the credit rating agencies to identify the risks. The normal relationship between creditors and debtors is guaranteed by the debtor's repayment ability that comes from the newly created cash flow, rather than the premise that the debtor has capacity to borrow more money. The credit rating agency's responsibility is to follow this rule, and to interpret the credit risk with the methodology based on the essence of credit relationships. By the end of 2008, the developed countries’ external debt is USD61.1 trillion, accounting for 91.3% of the world’s total of USD55.8 trillion, while the developing countries has only USD5.3 trillion, accounting for 8.7% of the total. Developed countries’ external debt is 130% of their GDP, while developing countries is only 21%. The world's overall foreign exchange reserves are USD6.7 trillion, of which 37% is in developed countries, while 63% in developing countries. Taking the financing capacity as the primary source of repayment reflects the fact that the creditor-debtor relationship is reversed fundamentally and advanced countries rely on borrowing to maintain economic development.
When the three rating agencies assess the corporate credit risk, they always insist on the increase of the net cash flow as the first source of debt service. The huge contrast between these two theories not proves their stance in rating and pragmatism. It covers up the systematic risks of the debt crisis that may outbreak in western developed countries. It also demonstrates the inevitable decline of its rating theory.
Doubtlessly, to use such standard to evaluate the sovereign risk is to encourage the globalization of debt-based economy and to distort the normal international credit relations. It can not protect the fundamental interests of major debtor countries, but eventually pushes the world economy to the verge of breakdown.
Sixthly, taking the independent central bank and the international reserve currency as a prerequisite for a high-rating sovereign country covers up the specific risk of such countries, which may lead to a huge damage to the international credit relations.
The existing standard considers that an independent central bank and an international acceptable currency is the premise for AAA level, which is clearly embodied in credit rating standard by Standard & Poor’s. Usually accepted without questioning, it is this rating standard that cleverly fits the hidden agenda to protect the interests of its makers’ host sovereign.
They believe that “independent central bank can implement a stable monetary and exchange rate policy,” and take this as a premise for judging the effectiveness of monetary and foreign exchange policy. In other words, that is, the central bank independence is equivalent to the stability of monetary and exchange rate policies. According to western political theory, the central bank should be independent from the government. Such independence is conducive for the central bank to make flexible monetary policy according to the market demand. However, the government’s administrative intervention will increase the instability of the currency issues. Therefore, it should grant the central bank an independent status from judicial or administrative system. Rating agencies directly taking this institutional designing as the standard to test the effectiveness of monetary policy inevitably deviate from the facts that countries follow different approaches when formulating and implementing their monetary policy. It is an extremely complex mechanism of various factors to affect the formulation of a sovereign's currency and foreign exchange policy. Even though the country has an independent central bank, only when it implements the monetary and exchange rate policies according to practical conditions, will it achieve good effect. In evaluating those policies of a country, in order to validate the reasonability, rating agencies should focus on analyzing on what basis a policy is made and what effect it takes.
If taking an international currency as the prerequisite for AAA level, about 20 countries and regions will qualify, and other countries and regions with non-international currency will be excluded from the highest credit rating. In their views, for the countries whose local currencies are international currencies, when repaying foreign debt, they can easily avoid the restrictions caused by the imbalance of payment or exchange capacity. However, statistics show that, as for some international currency issuer countries, particular the international reserve currency issuer country, their domestic and international debts are accumulated, their wealth creation growth can’t keep up with their national debt growth rate, and their savings ratio is extremely low, in short, they are tumbling at the verge of bankruptcy. The advantage of being the international reserve currency issuer country conceals its huge external debt and the actual inability to repay the debt through wealth creation. What’s more, the high credit rating enables it to maintain its strong financing capability. It is evident that the existing credit rating standard’s main purpose is to help the world's largest debtor to have access to international capital markets rather than reveal sovereigns’ real credit risks. Having absolute monopoly in sovereign credit ratings, the international reserve currency issuer countries become the largest debtor countries and the most developed countries at the same time. The international reserve currency issuer countries also export their debt to the world openly, and plunder other sovereign’s wealth by adjusting the value of their currency.
The fact whether the local currency is internationally accepted is taken as the criteria to grant AAA rating has once again exposed the existing standard’s basic stance to safeguard the debtors’ fundamental interests. Such standard has lost their impartiality.
Seventhly, the result independence is damaged as a large number of indexes used in the rating process are produced by external agencies, leading to a strong similarity pattern occurring in three agencies’ products.
The existing credit rating standard uses five types of indicators to decide the rating, of which World Bank Governance Index and Corruption Index are used to evaluate the sovereign's political risks and rank them in order accordingly, and the Ease of Doing Business Index, the Global Competitiveness Index and Human Development Index are used to predict the sovereign's economic prospects. Close examination on these indicators finds that they all bear specific uses and purposes, but does not bear connection with the formulation of the sovereign’s credit risk. For example, the Ease of Doing Business Index, evaluating a country's economic growth prospects, describes and evaluates how legislation and policy implementation influence its business. It involves supervision level, regulatory effect, property rights protection and the labor law enforcement and so forth. It is obviously that there is no direct relationship between the above composing elements and the government’s repayment ability. Another example is World Bank Governance Index, which values democratization, transparency, and protection of property rights. All three rating agencies use this index in political risk quantitative analysis. However it has nothing to do with the credit risks evaluation, except that it does fit in their political ideology.
To use many remotely-related indexes as rating criteria undermines the independence of rating results. At the same time, when identical indexes are shared by all three competitors, they normally come up with the similar conclusions on sovereign ratings. Instead of independent analysis, the employment of indexes leads to the herd effect that reduces the reliability of the sovereign credit rating. Among the 17 rating failures occurred during 1997 to 2002, fourteen of them happened to both Moody’s and Standard & Poor’s.
In conclusion, privatization, liberalization and openness derived from the western neo-liberalism is the current rating standard’s theoretical basis; “Washington Consensus”, that advocates western capital monopolists to expand their capital globally is its ideological principle; and to safeguard the fundamental interests of developed countries is its basic position and stance.
The existing rating standard ignores the fundamental changes in the relationship between international creditors and debtors and its profound impact on human society over the past fifteen years. It discards the basic objective and fair principles that the rating agencies should follow and neglects the inherent relations among the elements in formation of the risks. Rating agencies select the indices in favor of the western countries’ interests, fully exposing its subjectivity, bias, utilitarianism and politicalization. The existing rating standard has become the spokesman to advocate the rationality of developed countries’ debt-based economy. Its biased nationalism finally has lost its internationality and impartiality. There is not a clear logic in its analysis due to the pragmatism of existing rating standard. It is difficult for professionals to use this standard to find the internal relations between the rating elements and capability to repay debts. It is also mysterious for the general public to understand. Based on this principle and stance, the existing rating standard has lost the usefulness in finding the world credit risk development trend, drawing lessons from the financial crisis and carrying out innovation in rating methodology. The existing credit rating standard, failing to meet the new requirements in the era of credit economy, can not undertake the historic mission entrusted by the credit globalization.
3.3 The Current Credit Rating Standard is the Root Cause of Damages to International Credit Relations
Since the mid 1980s, the international credit relations have undergone historic changes. For example, in 1986, theUnited Statesturned from a net creditor into a net debtor. In 2005, foreign exchange reserves held in developing countries exceeded those in developed countries for the first time. During the past ten years, Asian economies have become the world's major creditors. There were eight developed countries among the top 15 net debtor countries in 2008, while the top 15 debtor countries were all developed countries. The reversal of creditor-debtor relationship is the sign of an imbalanced economic development in the world. The employment of the existing standards on sovereign credit rating yields a significant impact on the international credit relations.
Firstly, the debt growth rate for most large debtor countries has exceeded that of GDP, and therefore they are unable to repay debt through creating wealth on their own. However, the current credit rating standard fails to reveal their credit risks to the world. Instead, by using thepro-cyclical approach, it continues to elevate the debtor credit rating. The number of net debtor countries on AAA level increased from five to ten, and the number of net debtor countries on AA level increased from nine to twelve. These insolvent economies have taken advantage of the existing credit rating standard to possess global credit resources and maintain their prosperities. When the inequality between the international credit relationships is exacerbating, the accumulation of the credit risk is also accelerating. The high concentration of credit risks ultimately accumulate tremendous energy that burst into crisis.
Secondly, when creditor countries export material wealth into debtor countries and at the same time loan money to developed debtor economies, it indicates that the creditors have a strong ability to repay debts. However, the existing credit rating standard can not reveal the real repayment ability of creditors and haven’t made much significant change in their ratings. The number of net creditor countries on AAA level increased from four to five, and the number of net creditor countries among AA level increased from one to three. The economies with the world's strongest debt repayment capability and the biggest wealth creation potential without the support of existing credit rating standard, encounter great difficulties in future development.
Thirdly, the current standard causes a direct imbalance in possessing the global credit resources. According to the statistics in 2008, more than 90% of the world's capital flows to developed economies, which brought enormous investments in various forms to these countries. Polarization of credit resources is the main reason to the imbalance in world economic development.
Fourthly, the current credit rating standard grants the highest rating to the largest debtors, which enable them to finance global capital with the lowest cost. In our report, thirteen developed countries are granted lower ratings by Dagong than by the other three agencies. Estimated on the total amount of external debt for developed countries at the end of 2008, the countries with AAA credit rating save the government debt issuance costs of about USD67.5 billion every year, and overall external debt issuance cost of USD235.1 billion, which should have been the borrowing interests paid to the creditors. On the contrary, granted with lower ratings, developing countries have to bear a much higher financing cost, which makes their net savings flow to developed countries. Wealth is transferred from creditors to debtors not only through regular loaning transaction, but also through interests difference. This peculiar phenomenon occurs only because of the existing rating standard. The international reserve currency issuer countries, at the same time, manage to transfer their debts to others by currency devaluation. For example, USD has depreciated by 97.2% to gold from 1971 to 2010, which causes great damage to creditor countries with large USD reserve. However, the current rating standard, failing to reveal this phenomenon, facilitates the wealth and debts flow in the same direction, which causes the unfairness in international competition.
Fifthly, the fundamental flaws of the existing standard lead to the distorted information it provides to the world, which directly or indirectly affects the sovereign's macroeconomic policy and investment decision-making. Reflecting state will, these policies play a decisive role in the global economy, and further influence the international credit relations.
With its dominant position in the global credit system, the sovereign credit determines the flow of international capital and national interests of various countries, and fundamentally affects the stability of international credit relations. The world's most indebted economies have long been troubled by the lack of inner ability to create capital, once they encounter difficulty in financing, the domino effect of the international credit system will inevitably lead to catastrophe in world economic system. However, the existing standard fails to reveal these hidden risks to the world. Almost sixty financial crises happened during the past fifteen years, especially this current global financial crisis caused by sub-prime mortgage crisis in theU.S.have resulted in unprecedented damage to international credit relations.
3.4 TheUnited Statesis the Biggest Beneficiary of the Current Credit Rating Standard
The existing standard is a highly Americanized product, with its content reflecting not only American values, but also referring its country strategies as a core rating element. In fact, the sovereign credit rating system is the key component of theU.S.national strategy. As the relationship between creditors and debtors gradually evolves, theUnited Stateshas reaped monopoly benefit as arbiter of sovereign credit rating, and as the international reserve currency issuer. With western-style democracy, privatization,marketization, and liberalization as the core determinants, along with the wide acceptance in the world, the current rating standard have become the mass destructive weapons for the monopoly capital to expand globally. To continuously grant high sovereign rating to theU.S.ensures a stable inflow of financial resources and high GDP growth even under high debt burden. At the same time, theU.S.transfers debt burden through dollardepreciationand directly damages the interests of its creditors. The existing standard has turned a blind eye to this obvious malpractice, which proves the fact that sovereign credit rating helps theU.S.government to shift its debt burden to other countries. As the rating can determine the direction of capital flow and its value, the operation of world financial system relies on the rating information provided by three rating agencies; therefore, it has the ability to destroy a sovereign. Not surprisingly, the monopoly position ofU.S.in international rating system provides it with huge power to control the international financial system.
As we closely examine the content and essence of the existing standard, it is easy to find that what lay behind the so-called authoritativeness and fairness is the narrow national interests, and it is used to possess credit resources and maintain its hegemony. As the developing countries have no position in international rating system, they lost the weapons to safeguard their interests in the credit resources war. Thus, the credit balance will always tilt to theUnited States.
4. The Theoretical Basis for the New Sovereign Credit Rating Standard
Credit risk is the biggest risk for the mankind since they entered into the credit economy, and its impact on global financial environment and economic development is most comprehensive and profound. Sovereign credit risk as an important risk in international credit relations operates on its own rules. The role and the inherent relation of its key constituent elements lay the foundation to build a new Sovereign credit rating. The economic and social development practice provides a historical opportunity for such kind of theoretical innovation.
Impartiality and scientific integrity must be honored by the new rating standard. In order to realize this, "four new principles" are to be followed. First, new stance - We should abandon the narrow-minded nationalism and national interests, live up to the responsibility to the historical development of human society, and plan and design the new standard from a global perspective. Only in this way, can we justly evaluate the credit risk of each country. Second, new thinking approach - We need to change the traditional mindset to understand the world, recognize the credit world through examining the nature of credit and searching the development pattern of human society in the credit economy. The new standard will reflect the right direction of the credit era. Third, new theory - based on the objective reality, learning from practical experience, we should investigate the inherent relations among the various factors, and discovers the general laws that govern their interactions, which lies as the theoretical basis for the new standard. Fourth, new method - Pragmatism should not be honored in rating methods. We should follow the dialectical materialism, select key elements that most reflect the inherent relations of credit risks, and ensure the scientific integrity of the analysis path, so that credit rating can stand the test of practice.
Under the guidance of innovated rating theory, a new sovereign credit rating standard, which conforms to the historical requirements and reflects the inherent operation law of sovereign credit risk, is bound to triumph. The new theory mainly includes six aspects as following:
4.1 ACountry’s Wealth Creation Capability is the Basis of Debt Repayment Capability
The ability to create national wealth means the steadiness and sustainability of a country’s real economy. Economy to finance is like root to stem or spring to river. The current and potential national wealth serves as pillars to country credit.
The main factors affecting a country's debt repayment ability should be based on its ability to create national wealth. From the perspective of the government's debt capability, a country's borrowing capacity depends primarily on the affordability of the economy. Specifically, the size of a country's economy, national savings and economic growth prospects are the fundamental elements constraining its debt capability. From the perspective of a country's solvency, the decisive factor in a government’s debt repayment capability lies in whether the fiscal situation can be continuously improved. This depends on whether the real economy is able to provide the Treasury with abundant financial resources by its endogenous energy rather than relying on fiscal stimulus, and whether the real economy growth is able to stay stable so as to ensure fiscal stability. The issuance and repayment of external debt more heavily depends on the country's economic strength. As for non-reserve currency issuer country, sufficient and stable foreign exchange income or strong capability to get the foreign exchange relies on its strong economic strength. However, as for reserve currency issuer country, the key condition to keep economic strength is to maintain their currency's international status and stability.
As the national wealth creation ability plays a primary role in the national credit risk evaluation, how to evaluate a country's economic strength is essential. In order to make a comprehensive and objective judgment, we should not refer to one specific indicator as the major criterion on economic strength, or apply an economic ideology to all countries. Instead, we should take into consideration all the relevant factors like economic vitality, competitiveness, anti-crisis ability and the ability to achieve a balanced growth. We should concern not only its current economic scale and structure characteristics, but also its economic stability, especially focus on its economic development potential. These factors are interactive and affect the real economy in the above four aspects.
The national wealth creativity can be evaluated not only by its internal economic characteristics, but also through the comprehensive analysis involving the following three aspects, namely, the National Governance, Financial System and Credit Rating System. In the next three parts, we’ll elaborate the relationship between the three aspects and the country’s capacity to create national wealth.
4.2 Economic Growth Potential Relies on National Governance
As far as sovereign rating is concerned, national governance means a central government’s ability to effectively manage the country and maintain and promote a stable economic growth. National governance affects economic growth through its control on the institutional environment, social environment and international situation.
First of all, central government governance restricts the institutional environment which affects the total efficiency via the system and mechanism of economic operation. The superiority and inferiority of the institutional environment rely on whether the government can constitute and carry out the national development strategy and macroeconomic policies. Secondly, the central government governance restricts the social environment which affects the people’s enthusiasm for economic development and economic operational cost. Central government can alleviate social conflicts and create social stability through appropriate policies. Lastly, central government’s governance affects the international environment which plays an increasingly important role in domestic economic development in the era of globalization. The government serves the needs of national economic development by devising appropriate international strategies and utilizing various factors in international security, international politics, and international economy.
To include the national governance capacity in sovereign credit rating is to find out whether the central government can implement effective national governance to realize macroeconomic stable growth and ensure debt payment. Therefore, any evaluation standard focusing on political ideology should be dismissed; instead, it should focus on various objective and subjective factors affecting the government performance. The empirical study indicates that, any political ideology and the corresponding institutional arrangement have their limitations when they are applied and accepted in sovereign credit rating. Accordingly, it can not provide reliable standard to assess the government capability. Only the practical test as the convincing evidence can be used as reliable criteria to evaluate the government governance capacity. Based on the analysis above, the political proposal and the relevant institutional characteristics of certain type of countries can not be used as the fundamental factor to inspect all countries. Instead, we should focus on analyzing the development strategy and macro-economic policies, seeking truth from each country’s practical conditions, dialectically examining the feasibility of those strategies based on the interactions between internal-external and subjective-objective factors. Furthermore, the indices produced by external agencies should be excluded from the evaluating procedure, in case they undermine the rating result accuracy due to their incompatibility with the essential ideologies and methodologies of governance evaluation.
4.3 The Financial System is the Driving Force to National Wealth Creation
The financial system is another factor to promote the national wealth creation. As the real economy's blood and artery, financial system provides funding support to the real economy through credit expansion and innovation, which impels market demand and promotes national wealth creativity. If the national governance externally affects the economic development in fundamental and basic way, then the financial strength internally provides nutrition to the real economy in a direct way.
We should summarize the experience and lessons from different countries' financial reforms, pay close attention to the effects of current systematic risks in international financial system, and incorporate both financial development and financial stability into our assessment on a country’s financial system’s impact on its national wealth creation.
When evaluating the financial development level, it is necessary to focus on not only the micro-financial operation mechanism, but also the macro-finance in order to achieve a strategic and prospective conclusion. Therefore, it is necessary to make prudential analysis on financial and monetary policy.
When evaluating the financial stability, lessons must be drawn from all previous financial crises, which prove that financial market has the same importance as the banking system, so merely focusing on banking risks is not enough. Therefore, the evaluation of the proportional relationship between credit scale and real economy is required. This approach arises from the following practical background: after the link of U.S. Dollar issuance with gold was cut off in 1971, the global excessive liquidity has attacked various countries' financial system for a number of times. In addition, inappropriate financial policies and monetary policies have caused the excessive credit scale expansion in some countries, especially the intractable asset price bubbles which destroy the world financial stability and economies of various countries. Therefore it is necessary to assess the financial stability through evaluating on the compatibility between credit scale and real economy. Moreover, to be realistic, the adoption of large scale financial liberation and opening policy without distinction shouldn’t be recommended as complete positive. Instead, the well-schemed development should be encouraged. Underpinned by overall economic environment, the financial system reform should be conducted with cooperative measures in other spheres, avoiding the damage caused by blindness and hastiness.
4.4 ACountry’s Credit Rating System Pertains to its Financial Security
The increasing importance of Sovereign Rating System, together with the complicated credit relationships and difficulties in recognizing credit risks caused by the financial development, makes it an important infrastructure to maintain national financial security. The credit rating has the following functions via supplying independent credit risk opinions: first, to guide the investors to improve the efficiency of resource allocation; second, to encourage the debt issuer to reduce the credit risks and lower the issuance cost; and third, to help the regulators to monitor the credit risks. Apart from the functions above, it helps to create the favorable environment to maintain financial stability through the information provided by rating standard and rating results, such as enhancing market transparency, improving accounting and auditing work, and promoting a clear consistent predictable legal and regulatory environment. The credit rating system assists the financial system to steadily drive the economic development by safeguarding financial security, and eventually facilitates the real economy growth.
However, not all credit rating systems can fulfill the aforementioned functions. The credit rating system which can properly reveal the credit risk must satisfy three requirements, namely the independence and soundness of credit rating agencies, scientificity of the rating standard and government regulation.
The sound credit rating agency can reveal the various credit risks to the maximum. The independence of the rating agency refers to that the rating agency should surpass the interests of itself and its own country when evaluating the domestic and international credit relationship, so that it is able to reach objective judgment from independent perspective, which is the prerequisite for scientific rating results. The scientificity of rating standard means that the rating agencies should thoroughly examine the characteristics of various risks, consolidate the specification of risk formulation and consistence of the risk evaluation perfect its risk-identification skills and improve the rating accuracy. The government regulation refers to that government should ensure the healthy development of rating business by perfecting and innovating in the regulation mechanism. Rating agencies shoulder the special responsibility to maintain the financial security, but if the rating agencies are profit-oriented market entities, the competition pressure will force them to violate professional ethics, which will induce to rating competition and similar rating results, even the systematic rating faults. In order to avoid the above scenario, regulations on the rating system must be strengthened.
4.5 Fiscal Strength Directly Determines a Country’s Solvency
The fiscal strength refers to the government’s capability to secure the local currency solvency by means of fiscal revenue, expenditure and debt management. Fiscal strength is the direct factor to the country’s solvency. According to the previous government default examples, whatever the underlying cause were, either political, economic, financial or social problems, it is finally reflected as the sharp deterioration of the fiscal situation. Therefore, the country’s solvency can be explained by the degree to which the government revenue covers the debt repayment within a given period of time.
To make judgment on fiscal strength in the sovereign rating procedure should follow the three basic guidelines as below:
Firstly, among all evaluating elements, government’s current fiscal revenue and expenditure is the headstone to determine the debt service capability. This is because the current fiscal revenue and expenditure determines the tendency of primary fiscal balance, and the latter is the important factor to the future development tendency of the government debt when holding the interest rate and economic growth rate constant. The persistent primary fiscal deficit indicates that the current revenue can not cover the current expenditure which requires more borrowing to compensate the gap. Consequently, the debt burden will increase and probably cause the real interest rise and economic growth rate decline. If this kind of tendency develops continuously, unavoidable government debt crisis will eventually happen.
Secondly, the government’s current fiscal revenue is the primary debt repayment source, while debt issuance comes at second, because a government’s solvency can only be strengthened with the improvements in its ability to achieve fiscal balance. In cases of excessive government debt burden, the government should maintain its credit chiefly by making adjustments in its fiscal revenue and expenditure, reducing fiscal deficit, and decelerating the growth of debt. In such cases, to emphasize on the government’s debt financing capability is barking up the wrong tree. The increasing debt burden will eventually cause panic in government bond market, and bring difficulty in financing by cost increase. In addition, it could also raise inflation and cause major fluctuations in financial system and macro-economy which will undermine the economic growth.
Thirdly, each country, including the international currency issuer country has its debt limits. In order to accurately evaluate the government debt borrowing capacity and its debt burden risk, it is necessary to judge its sustainability in debt service by estimating the country debt limits.
4.6 Local Currency Value is the Key to the Real Debt Repayment Capacity
It is necessary to include the analysis of the local currency value when evaluating the central government solvency. Accordingly the government debt service capacity could be divided into nominal and real capacity. It should be considered as default behavior if a government devaluates the local currency intentionally to escape its debt responsibility, which, in fact, reduces its real debt service capacity.
The unique characteristic of the government as the debtor distinguishes itself from regular debtors. Government is the issuer of local currency and the protector of local currency credit as well. If the government debt is calculated in local currency, the government has the obligation to protect the creditor interests from the losses caused by the depreciation of local currency value. Therefore, the local currency's value is regarded as one of the intrinsic variables in the government debt service capacity
Generally, both the internal and external value of local currency will change when a government intends to realize certain macro-economic intervention through expansionary fiscal measures. In case of moderate devaluation, expansionary fiscal measures are acceptable as the necessary instruments of macro-control. But if the local currency devaluates in an accelerated or even vicious speed within a short time, it must directly pertains to the inappropriate government macroeconomic policy, monetary manipulation or deliberate devaluation. In this case, the debtor government, ignoring the damage to creditor’s interests, evades the debt responsibility by devaluating local currency and avoids its dual obligations of maintaining local currency credit and creditors' interests. This phenomenon must be paid close attention to.
Based on the analysis above, the judgment on the central government defaults can not only be made according to whether the principal and interests are repaid timely and fully. If the contract doesn’t specify how to protect the creditor when the local currency devaluate sharply, the debtor government should be regarded as default even if it has serviced the debt fully.
To include the analysis of local currency value into credit rating process makes it possible to reach an objective assessment on government defaults through debt monetization, so as to give a more comprehensive evaluation on government solvency, and provide a monitoring mechanism for analyzing the government's local currency debt and its debt-servicing approach, particularly for international reserve currency issuer. Given the fact that the current international reserve currency issuer countries are mostly high-indebted economies, with their local currency debt being widely held by non-residents, if these countries repay their debt through currency devaluation, not only will it seriously damage the interests of the creditors, but also transfer the creditor’s wealth to debtor countries without any cost. This could result in global inflation and drastic economic fluctuation. Therefore, new sovereign credit rating standard, in order to correctly evaluate each country’s default risk, must give solutions to the above practical issues.
The credit relationship between two countries is essentially supra-national economic relationship, which requires independent and unbiased evaluation. The new sovereign credit rating theory adheres to this principle and analyzes the complex economic relations from a global perspective. Therefore, the fairness of the establishment of the new credit rating theory is guaranteed.
The new sovereign rating theory follows general research methodology. By identifying the peculiarity of each element in the sovereign credit risk formulation, the new theory analyzes the interaction among these elements, from which it abstracts the theoretical foundation of the sovereign credit rating standard. This innovative approach recognizes the credit risk of different countries and guarantees the scientific integrity of the new credit rating theory.
The theoretical basis of the new standard is founded on the experience and lessons from the international credit relationship history as well as all rating practices. It fully reflects the new international creditor-debtor interaction tendency, discovers the direction for the new credit era, and effectively guides the practice of credit rating.
The birth of the new rating theory represents the progress in credit rating practice. It has historical significance to the impartiality of sovereign rating practice as well as to the stability of international credit relations. It will also guide a right direction for the development of world credit society.
5. The Content of Dagong's Sovereign Credit Rating Standard
Under the guidance of the new credit rating theory, with an objective and independent stance, being fully aware of responsible attitude towards the development of human society, and based on the long-term and in-depth study of credit risk of different countries in various periods, Dagong develops a new set of sovereign credit rating standard.
Dagong's sovereign ratings structure includes five elements and three levels. The five elements are: National Governance, Economic Strength, Financial Strength, Fiscal Strength and Foreign Exchange Strength. The first three elements are fundamentals, while the latter two are direct elements. As for the three levels of analysis, the first level is to analyze the three fundamental elements, which determines a country's current and potential wealth creation as well as the trends of fiscal revenue and future debt burden. and integrated with the fiscal strength, the second analysis level draws conclusion on the central government's local currency debt solvency. Finally integrated with external strength, the third analysis level finds out the central government's solvency of its foreign currency debt.
National Governance evaluates the central government’s ability to effectively manage the country as well as to maintain and promote a stable economic growth, which is mainly conducted on four sub-elements: national development strategies, administration level, domestic security and international relations. Dagong believes that among these four elements, an appropriate national development strategy aiming at promoting economic growth stands at the core position, because it reflects the government's decision-making ability which has a fundamental impact on a nation's economic development. The other three elements are auxiliary elements that facilitate the implementation of national development strategies. Administration level examines government executive capability, which includes the analysis of operational characteristics and effectiveness in accomplishing national development strategies. Domestic security and international relations mainly study whether the domestic and foreign environment is conducive to implement the national development strategies. In the analysis of the four elements, not only is the current situation examined, but also conclusion is drawn on the development tendency in the foreseeable future, on both of which the overall development tendency of the sovereign credit is predicted.
Economic strength refers to a country's current and future ability to create wealth in real economy. The analysis mainly composes three sub-elements: economic scale and system, economic stability, and economic growth potential. The relationship among the three elements is progressive. The analysis of a country's economy scale and system is the foundation which indicates the current wealth creation capacity. Economic stability examines the probability of future macro-economic fluctuation, factors that cause such fluctuations, and the amplitude of the fluctuation. It is also the foundation for the analysis of future growth potential, which comes at the last of the entire analysis. Economic growth potential predicts future structural changes and studies the factors that affect future economic growth. Together with the economic stability, the three sub-elements give a comprehensive evaluation of a country's economic prospects. This three-dimensional analysis provides us with a systematic approach to understand a country's future economic performance and growth path. It also provides the basic evidence to judge and predict the fiscal balance within the repayment period.
Financial strength refers to a country's financial structure and its comprehensive capability in economic promotion and crisis prevention. The analysis focuses on the theme that financial system is the driving force to national wealth creation. The purpose of the analysis is to assess the ability of a country's financial structure to promote economic stability and growth at present and in foreseeable future. The financial strength analysis is based on two sub-elements: the level of financial development and financial stability. The level of financial development indicates to what extent a country's financial system could create market demand through innovation in credit relations and expansion of credit scale, in order to promote real economy growth at a faster pace to a larger scale. So the analysis of financial development focuses on financial markets structure and size, monetary policy and financial policy. Financial stability assessment aims to find out whether the various entities within a country's financial system could maintain good credit relations in order to prevent financial crisis and to protect real economy. The analysis of financial stability is progressive. It starts with analyzing the stability of financial institution and financial markets from the financial systematic perspective. Then it analyzes the integrity of the credit information system from the financial security perspective. At last, it evaluates the effectiveness of various supervision entities within the financial system.
Fiscal strength refers to the government fiscal sustainability and solvency, which directly influence local currency debt repayment capacity. The analysis of fiscal strength mainly involves four sub-elements: the government's current fiscal balance, government debt burden, government income growth potential and stability of currency value. The analysis consists of four steps: first it analyzes current fiscal balance in order to determine current and future fiscal balance ability. Current fiscal balance is the basic element to influence the government solvency, which indicates future debt burden tendency. The second step is to analyze government debt situation focusing on debt stock and debt dynamics. The first two steps together determine the future size of fiscal deficit as well as the debt burden tendency. The third step is the analysis of government income growth potential. Dagong believes that the government income comes from three sources: tax revenues, debt income and other income. If a government is faced up debt-service difficulty, the analysis should focus on growth potential of various revenues that could be utilized for debt repayment. Finally, combined with the analysis on the local currency value stability, we will come to the conclusion on a central government’s current and future local currency solvency.
Foreign exchange strength refers to a central government's ability of obtaining sufficient foreign currency assets for its foreign currency debt repayment, which is the direct factor to a country's foreign currency credit rating. In general, foreign currency assets are obtained in three channels: the foreign exchange market, official foreign exchange reserve and external financing. Correspondingly, the analysis on foreign exchange strength is divided into three aspects: exchange capacity, foreign currency adequacy and foreign financing capacity. The exchange capacity mainly refers to local currency value VS foreign currency value. Fluctuation in local currency value changes a country's foreign currency debt burden as well as foreign exchange reserve; therefore, affects a government's ability to repay its foreign currency debt. On the other hand, it also influences a country's foreign currency adequacy through macro-economy. The foreign currency adequacy refers to a country's current foreign assets accumulation and its development tendency. It determines the government's foreign currency solvency by comparing with the foreign currency debt burden. The analysis of foreign financing capacity assesses the central government's ability to honor its foreign debt through external financing, especially when the country is short of foreign exchange reserve or external liquidity. The conclusion of the foreign exchange strength analysis is to find out whether a government's foreign financing capacity can guarantee the repayment of its foreign debt.
Dagong's sovereign credit rating methodology conducts in-depth studies of every key factor, identifies and analyses the core indicators of various countries respectively, as well as the relationship between these indicators. Therefore, it is a logical, rigorous, and scientific methodology.
6. Characteristics of Dagong's Sovereign Credit Rating Standard
Dagong's sovereign credit rating standard, based on Dagong's credit rating methodology, bears the following characteristics in stance, thinking approach, theoretical system and analytical methods.
6.1 Objectivity andIndependenceare Our Fundamental Stance
Dagong honors the interests of all parties involved in the international credit relationship with the same responsible attitudes and upholds a fair and impartial position to build sovereign credit rating standard. Objectivity andIndependenceis the principle we follow in the process of building the new standard, which specifies in two aspects.
Firstly, no pre-set values should be applied to guide the establishment of the standard. Any set of values has its own specific historical, geographical and cultural origins, and therefore should be equally respected. In the era of diversified values, when following some preconceived values to establish the standard, it's easy to take it for granted that the regimes that honor these values are superior to others. Thus, it is impossible to evaluate other countries with objectivity and independence, so that the standard will consequently lose its universal significance. In fact, the selective choice of values will tilt the scale of interests. The countries that share the same values with the standard setters tend to get more favorable treatment, whereas other countries may end up being treated unfairly.
Secondly, avoid narrow-minded nationalism or national interests preference in the rating process. Dagong believes that only when the objective and accurate credit rating information is guaranteed to circulate internationally, will the stable and healthy development of global financial system be fundamentally maintained, and will the interests of all countries in the world be honored for long term. The attempt to control the rating discourse power and satisfy a given interests preference will damage the interests of every country eventually. Therefore, Dagong's sovereign credit rating standard does not represent interests of any country, ethnic or social group. Dagong respects the status quo of all countries in current international credit relations, and oppose any form of interests transfer through credit rating.
6.2 Interms of thinking approach, the nature of credit risk lies as the basis of our research framework
Dagong's sovereign credit rating standard is established on the basis of exploring the nature of credit risks in all countries. On the one hand, Dagong recognizes the particularities of each country. On the other hand, we focus on the impact of global systemic credit risks on each country respectively, and study the credit risk transmission mechanism among countries. We also try to keep the standard updated according to practical changes.
Firstly, we give full consideration to the particularities of credit risks in different times, different regions and different types of countries. In different historical periods, the changes of political, economic, financial and other environments result in the change of the key elements that could trigger credit crisis. In geographic aspect, different humanitarian environments and development paths leave countries in different regions exposed to various credit risks. In terms of national type, the differences in political, economic and social characteristics between developed and developing countries, lead to different influencing factors and transmission mechanisms of credit risks.
Secondly, we pay attention to the transference of global systemic credit risks among countries. The globalization of credit economy relates various countries increasingly close with each other in the economic and financial fields. Therefore, one country's credit risks, especially the world's major economies, will transfer among countries through multiple channels such as trade, investment, credit, securities and currencies, and evolve into a global systematic risk. Paying sufficient attention to the formation and transmission mechanism of these risks can help to locate the external factors of credit risk in a certain country, and to fully understand the nature of credit risks.
6.3 Interms of the theoretical system, to study the general laws of sovereign credit risk formation and development is the prerequisite for theoretical innovations
Dagong thoroughly studies the key determinants of a country's credit risk and their intrinsic relations, discovers the general laws of the formation and evolution of sovereign credit risk, and establishes our new sovereign credit risk rating theory.
Based on our new sovereign credit rating theory, Dagong identifies National governance capability, economic strength, financial strength, fiscal strength, and foreign exchange strength as the five key rating factors unified into the rating framework by the computer-based operational system, and sets up the overall sovereign credit analytical framework. From identifying scope of the rating objects to eventually granting the rating grade, all steps are connected to each other organically. Dagong’s method provides detailed explanation of technical issues, such as repayment capacity and willingness, the linkage between local currency rating and foreign currency rating, and the rating determination procedure, which clearly elaborates to investors the main steps and necessary information in Dagong’s determination of the subject’s rating grades.
In the entire credit rating theoretical system, the most prominent contribution is the innovation in following ten aspects:
I. Analyzing the ratio between credit volume and real economy scale, and its impact on financial integrity;
II. Incorporating the change of local currency value into the assessment of the government's real debt repayment capacity;
III. Understanding the current situation of credit economy, recognizing the financial system and credit rating system’s increasing impact on a country's credit risk, therefore identifying financial strength as a key element;
IV. Redefining defaults, taking the hidden nature of certain sovereign defaults into full consideration;
V. Drawing lessons from financial crises over the past two decades, and making comprehensive assessment of financial integrity;
VI. Carefully monitoring the credit situations of major international reserve currency issuer countries and their general impact on the international credit relations;
VII. Proposing the belief that sovereign credit rating standard will impact the efficiency of international capital flows and the fairness of national wealth transference among countries;
VIII. Transcending current interpretations of international credit relations, taking the new perspective of how global credit relations impact world economic development, thoroughly analyzing the nature of economic cycles, and paying close attention to the impact of the highly leveraged economies on the global credit chain;
IX. Unveiling the fact that the excessive possession of international credit resources by the biggest debtor economies is the main cause to the imbalanced economic development in the world, and maintaining that it builds up the stresses that may lead to the next global credit crisis;
X. Emphasizing the credit risks transmission from the source country to others.
6.4 Interms of the rating analysis method, Dagong implements systematical and dialectical analysis under the guidance of sovereign credit rating theory, to ensure the feasibility and scientific integrity of the rating process
Dagong's rating standard emphasizes implementing systematical and dialectical analysis, thoroughly studies the key determinants of a country's credit risk, analyzes its formation mechanism and impact according to a country's practical conditions, and ensures a scientific and reasonable analysis path.
Systematical analysis method means that considering the complex relationships among political, economic, financial and external factors in assessing a countries’ credit situation, Dagong follows a systematical principle throughout the whole analysis process, focuses on the risk transmission and transformation between internal and external, and comprehensively analyze all aspects of key determinants of credit risks. When evaluating an individual element, Dagong considers its linkage to other elements, as no single element can particularly correspond to a rating level. When assessing complex rating object as sovereign, Dagong believes that to take a systematic perspective is the premise to the effective revelation of the risk status.
Dialectical analysis method means that when assessing the key determinants of sovereign credit risk, the subject’s practical conditions must be taken into consideration. It is necessary to understand the real particular circumstance which constrains or supports a country's credit situation. It requires that any elements need to be seen through the nature of the phenomenon, but not just surface or partial situation. When selecting the evaluation criteria for a specific indicator, judgment must be made on the full awareness of the given country’s own cultural and historic characteristics.
There is essential difference between Dagong's sovereign credit rating standard and the current standard, in terms of basic stance, thinking approach, theoretical system and analytical method. As far as the basic stance is concerned, Dagong aims to accurately reveal sovereign credit risks of any country, and to provide equal services for all the countries involved in credit economic globalization, and adheres to objectivity and independence. On the contrary, the current standard upholds western values and political system, and applies them in the rating process to safeguard the national interests of Western countries. As far as thinking approach is concerned, Dagong, insisting the essential causes to the credit risks be the theoretical basis of the sovereign credit rating system, studies carefully every specific cause to credit risks in various countries, examines the transmission of global systematic credit risks among countries, and thus abstracts the general laws of the rating theory. On the contrary, the current standard, insisting the western political and economic theories be the basic guidance, evaluates all countries’ credit risks solely by western values, which are oversimplified and unconvincing. As far as the theoretical system is concerned, always standing on the strategic height, Dagong makes innovation with the purpose to identify the key determinants of the sovereign credit risk and their inherent relations. On the contrary, the current standard is built on the Western political and economic model and follows the Western-interest-oriented guidelines. Hence, it is impossible for the current standard setters to make a valuable theoretical innovation, who have already produced a number of wrong ratings. As far as the analytical method is concerned, Dagong employs both systematical and dialectical analysis, so as to reveal the sovereign credit risks comprehensively, accurately, and objectively. On the contrary, the current standard often adopts unilateralism or preconceived experience, and emphasizes on the absoluteness of a particular theory or policy in all countries without distinction. Similarly, under such standard, a specific indicator’s linear correlation to the rating is sometimes overemphasized. The significant differences in the above four aspects distinguishes Dagong's standard from the current one. As the practitioner in building new sovereign standard, Dagong's standard characterized by a fair basic stance, scientific thinking approach, innovative theoretical system and objective analytical method, bears broad applicability with enormous explanatory power.
Why was the global financial crisis triggered by the collapse of U.S. credit relationship originated from the United States, a country that had dominated the existing international credit rating system? The whole world was shocked enough to question the reasonability of the existing sovereign credit rating standard, and to ponder the healthy development of human society in the post financial crisis era. The new sovereign credit rating standard comes into being to answer the historic calling. Its essence is how to understand the nature of credit world, and how to explain the development laws of credit economy. The sovereign credit rating theory formed under the guidance of dialectical materialism provides an ideological weapon to explain how to correctly recognize the social development laws in the era of credit economy, so does it show the direction to objectively reveal sovereign credit risks. The new sovereign credit rating standard is also the product of this theory. The construction of the new sovereign credit rating standard is a technological innovation in the credit rating technology. It analyzes and evaluates the increasingly complex sovereign credit risks in a more objective and impartial way, contributes new credit information to the world and enriches people’s understanding of credit risks. It stands as the lighthouse for people who search business opportunities among risks.
We look forward to a new age in the development of the credit economy.