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Special> APEC China 2014 > Opinion
UPDATED: March 31, 2014 NO. 14 APRIL 3, 2014
Why Are Western Rating Agencies Wrong?
By Guan Jianzhong

The global financial crisis has testified to the failure of the Western credit ratings system, with the entire world suffering from the ensuing consequences. Western rating agencies were widely criticized for having given their highest ratings to the debt instruments whose failure helped spark the global financial crisis in 2008. The incapability of disclosing the rules of the formation of credit risks is the reason for the fact that people are questioning and denouncing them.

China's economic rise and growing influence means it should have a commensurate voice in ratings. The irrational worship on the three big credit rating agencies (Standard & Poor's, Moody's and Fitch) should be abandoned. China is a creditor that sends out lots of capital. China should depend on its own credit rating institutions that are capable of doing the work. We cannot simply assume that Western credit rating institutions are always the best, or depend solely on rating agencies from a debtor country to make investment decisions.

The core theory of the three big rating agencies relies on the central tenets of default rate and sovereign ceiling. Default rate uses events of default in history to evaluate future risks. There is no logical link between previous default and future risks. A sovereign ceiling means the sovereign rating of a country is the limit of all debtors in the country. This is wrongheaded. There is no necessary connection between the debt-paying ability of the central government and other debtors in the country. Such a ceiling is overly simplistic.

The primary responsibility of a rating agency should be social responsibility and the value of a rating agency depends on whether or not it has an original rating theory and standard that can disclose and predict credit risks before they happen.

Therefore, as Western ratings don't seem to be able to shoulder the responsibility of global rating, they could instead be a source of future strife.

Only a correct rating theory can guide us in attempting to discover the rules for the formation of credit risks, and this can only be achieved by looking into the very core of this extremely complicated system.

Credit rating agencies should undertake this public responsibility by providing the market with impartial and independent credit-rating information.

The contradiction between production and credit and the contradiction between credit and rating are the driving force for the development of a credit-based economy.

The first pair of contradictions in essence demand infinite expansion of credit to satisfy the growth of production, making it a driving force for the pro-cyclicality of a credit-based economy. The second pair of contradictions demand control of credit expansion risks, making it a driving force for the counter-cyclicality of a credit-based economy.

Therefore, credit rating agencies should aim to prevent the exponential expansion of credit size through disclosing the risk of sources of repayment in covering debts.

The credit rating theory of China's Dagong Global Credit Rating takes the probability of wealth creation as the basis for credit ratings. It also takes into consideration factors such as political stability, credit environment, economic conditions, maximum debt of a debtor, the outstanding debts of the debtor and degree of deviation between the sources of repayment and wealth creation capacity.

The biggest theoretical innovation of Dagong lies in the degree of deviation between repayment sources and wealth creation capacity. The degree of deviation is in direct proportion to the debtor's solvency risk.

In reality there are various ways of repaying debt, and each source of repayment varies in its impact on solvency risk.

For instance, one debtor may repay debt with their profit while another debtor may repay debt by printing more bank notes. In each scenario, the debt is repaid; the decisive factor to differentiate the security degree of their repayment capabilities is the distance between the source of repayment and wealth creation capability, namely the degree of deviation.

The author is the Chairman of Dagong Global Credit Rating Co. Ltd., a credit ratings agency based in Beijing

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