Dagong is a credit rating agency based in China, its business growing with the country’s multi-layer financial market and global expansion of business ties. But company also has a philosophical tradition. Part of its “business” is to reflect on the dialectic of credit relations and credit rating, and the theoretic implication of society-wide credit proliferations.
A more intent effort has been led by Mr Guan Jianzhong, its Chairman, since the Wall Street meltdown and outbreak of a global crisis in 2008. Doing so was prompted by a conviction that the crisis was in part induced by inadequacies in the traditional credit rating approach, and that raters must change their work philosophy to be more responsible for the general state of the global economy.
What Dagong thinks about credit rating? What its role essentially means to a financial system? And what it can do to guarantee a higher quality of its service? In a recent speech, Mr Guan gave a comprehensive summary of his views on these very basic issues.
For Dagong’s clients and partners, the speech can be a good presentation of our values. Its full translation follows:
Redefining Role of Credit Rating in Financial system
Aug 31, 2017
IT HAS BECOME a reality that financial risks are nowadays lurking in our everyday life, in almost every corner of society, and every part of the world. And more frequently, these risks seem to deteriorate into a sweeping financial crisis, bringing sufferings society-wide, and worldwide. Unfortunately, what people can do about these risks, in theory and in method, as well as in managerial model, is showing a widening gap from their evolving logic. Erroneous understanding and application of credit ratings are feeding the damaging power of a crisis. It is imperative, therefore, for people to learn about the workings of a credit economy and reconsider what is meant by finance, financial system, and credit rating, so that we can correct the errors and find a really workable solution to the financial risks in our times.
I. PRODUCTION AND CREDIT; CREDIT AND CREDIT RATING
1. These two sets of contradictions interact to shape up the credit economy.
IN THE TRADITIONAL economy, expansion in production and consumption are made possible by the creation of material wealth at a given time. The real wealth creation ability serves as the anchor for equilibrium of production and consumption. Such equilibrium does not leave much room for capital to seek its incremental value. To seek a new model to realize capital’s expansive nature, production must break through the limits from the consumption ability based solely on the real wealth creation. Hence the credit-based consumption ability. Loans come into being where a creditor-debtor relationship is formed. Loans are a kind of credit capital conditioned on the debtor’s later repayment. Once such credit capital grows into a society’s main origin of consumption ability and main part of liquidity for reinvestment, the contradiction between production and consumption will take a new form, namely the contradiction between production and credit ― or consumption ability built on a credit relationship. In this relationship, credit capital is channeled from the creditor to the debtor through the medium of credit rating, based on the information the rater provides about the risks in debt repayment. Hence the second set of contradiction, namely the contradiction between credit and credit rating. On the side of production, credit is needed to continuously expand the consumption ability, and in due course, to generate returns of capital. The interactions between production and credit thus lead an essentially pro-cyclical force in a credit economy. But to provide the necessary condition for establishing a creditor-debtor relationship, a credit rater is needed to mark out clearly the security limit of the debtor’s indebtedness. So, essentially, interactions between credit and credit rating yield a counter-cyclical force in a credit economy. These two sets of contradictions are characteristic of a mature credit economy.
2. Interactions between the two sets of contradictions represent the inherent logics of credit economy.
The contradiction between production and credit provides driving force for the credit economy by leveraging on the real wealth creation ability. Although production requires a continuous credit expansion to generate new consumption ability and returns of capital, it cannot generate unlimited driving forces, because it needs to be based on the real wealth creation ability. A surplus of credit supply, should it exist, will in part translate into the driving force for pro-cyclical expansion. But the rest of it will jack up the price of capital. Credit expansion, once in excess of its base of the real wealth creation ability, will result in a crisis to corrupt the whole system of the debt chain, causing widespread defaults. And the market will not return to equilibrium until it has been through with a credit crisis in an economic turmoil.
The contradiction between credit and credit rating reflects the principle that, in a given time, to ascertain the debtor’s security limit for indebtedness is the prerequisite for the creditor’s decision as to whether to establish a credit relationship with the debtor. Without defining in quantitative terms the debtor’s security limit for indebtedness, the credit rating industry will not only fail to protect credit relations; it will fail to forestall an unbridled credit expansion just as well. In consequence, the raters will misguide credit relationships and capital flow to such an extent as to further deviate from credit relations’ inherent logic. Doing so can only result in a crisis and the breakdown of more credit relationships following a radical downgrading. Profit is the main source of debt repayment. It holds the bottom line of a credit relationship by generating the ability of debt servicing. If the rater, in any circumstance, fails to follow this rule in credit relation building, it will not be able to play a responsible, counter-cyclical role as required by the inherent logic of the credit relationship. It can only be seen as manipulative trouble-maker in the financial market.
Interactions of the two sets of contradictions (that between production and credit, and that between credit and credit rating) follow such a process: As the first set of contradiction results in so much increase in credit as to exceed the limitation of credit relations, the second set of contradiction will react by preventing credit from exceeding the security limit of debt. That is when the former demonstrates an unlimited demand for credit, the latter represents a restricted supply of credit resources. In the more important set of contradiction, or that between credit and credit rating, rating is the determinant factor thanks to its function to reveal the risks in debt repayment. The nature of these two contradictions is the contradiction between credit supply and demand, and a place for interactions among credit rating, credit, and production. Among them, rating is the mechanism for distributing credit resources, while credit resources translate into credit consumption, which in turn provides a strong driving force in production. In the medium of establishing credit relationship, credit rating plays a role in allocating credit resources. By adjusting the volume of credit supply, it determines the direction and volume of credit resources in production.
II. CREDIT RELATIONSHIPS AND CREDIT CHAIN
1. Creditor-and-debtor relationship is a form of capital formation.
CREDIT RELATIONSHIP IS a form of capital formation that involves one side as the creditor and the other side as the debtor. It is a basic form of the relationships in an economy and a driving force to sustain the consumption demand in a society. The state of credit relationship determines a society’s reinvestment in production and demand of consumption.
In today’s China, creditor-debtor relationships are also the very basic economic relationships in its society. Members of its society build creditor-debtor relationships among themselves and in each case one depends on the other’s creditworthiness to keep up their relationship. Whether or not the debtor, as the main player in such a relationship, can honor its commitment of credit has great bearing on the stability of society’s credit chain. Society-wide development of credit relations is form of national debt. Its size is determined by the nation’s wealth creation ability — its basic source of debt repayment and source of credit. Thus we can see the logic running through credit relations, credit resources, national debt, national consumption, and then to national economy. Their proportionate relationships are the key relationships in Chinese economy, and are constructs of China’s new economic foundation. Only the development program based on the national credit resources can be attainable.
The supply of credit depends heavily on credit relations where they are an increasingly widespread social phenomenon. So the aimlessness and fragility in credit relations will result in the uncertainty in the overall credit supply. This being the case, for the creditor, the risk in the credit environment is of the most threatening kind. Credit rating services will help reveal the creditor’s risks by quantifying the mutual influence of the above two factors.
2. Credit chain is the aggregation of relations of all creditors and debtors interconnected by the rating system.
Credit chain is the aggregation of relations of all creditors and debtors interconnected by the rating system. And all credit chains interconnect to constitute a society’s credit system, or the system of capital flow.
A credit system made of stable credit chains can stay away from a major crisis. It can protect debtors from the external impact on their credit, so that their debt assets can continue to enjoy security and liquidity and produce a positive effect on the creation of wealth and debt repayment sources. By a contrast, a credit system made of credit chains of potential risks are vulnerable for a credit crisis which may be caused, in part or in entirety, by a series of debt defaults. Debtors would see a devastating collapse in their credit relations, followed by a halt in credit supply to affect negatively their creation of wealth and debt repayment sources.
3. Credit relations and credit chain are related and differentiated from one another.
They are interrelated and differentiated from one another in that, firstly, the credit relationship formed by the creditor and debtor is only part of a credit chain, and the stability of every credit relationship will affect the stability of a credit chain, which will in turn contribute to the stability of a credit system.
Secondly, a credit system, as integration of a given number of credit chains, will have a counteraction on every credit relationship within. The potential crisis of a credit chain will affect every creditor or debtor it has connected, and affect the stability of every creditor-debtor relationship in due course.
III FINANCE AS UNITY OF CREDIT AND RATING
1. Credit and rating – what make a modern financial system complete.
FINANCE IS A credit relationship between the creditor and the debtor on the condition of debt repayment. The spread of credit relations in society is made possible by credit rating. Stable credit relations and capital flow require a free distribution of rating information, processed according to universal standards and good for comparable studies. It is in this sense that we can see finance as a unity of credit and credit rating.
The world has already stepped over the threshold of credit economy, in which credit, or creditor-debtor relations, lay the very foundation of our economy, and chains of credit, linked up by many credit relations, form the distribution system to support a society’s all other pursuits.
Credit and rating essentially require control of credit expansion, representing a counter-cyclical force. This counter-cyclical nature determines the role of credit rating in a society’s progress, in which a society’s all credit relations work with the help from the intermediary of credit ratings. Rating can provide the creditor with a quantitative description, with three indexes, of the debt security limit that it faces. And by doing so, it serves as de facto deterrence to unbridled expansion of debt financing. It must be pointed out here that only when standard and comparable rating information is widely available can rating’s counter-cyclical function be realized. This requires a language system in which the same standard is applied to different issuers with the same rating, and comparable standards for different ratings.
A national financial system is the aggregation of all credit relations, connected by all credit chains. It consists of three types of credit, namely the credit that is based on the creation of real wealth as the debt repayment source; the credit that is based on some wealth likely to be created in the future as the debt repayment source; and the credit based on the structured formation of certain future credit relations, which is on offer to re-enter the market for transactions. Society-wide credit relations are the main vehicle of consumption ability. Limited debt repayment sources from the creation of wealth and unlimited tendency for credit expansion are generating new forms of credit relations. Once the third type of credit relations begin to count for a noticeable share in the national financial system, the status in credit rating will affect the national financial security in every possible way one can think of.
2. Financial innovation: More effective integration of credit and rating.
The goal of internet finance is to improve the connectivity in capital flow. Just as in the case of any creditor and debtor relationship, the prerequisite for cross-border capital flow is the cross-border flow of credit information. So credit rating is an intermediary service for investors. Independent rating of credit risks is necessary for making a credit relationship possible.
The cross-border flow of credit information requires a consistent and impartial set of rating standards. To have a rating agency representative of the common global interests of all nations, such as to serve the Belt and Road Initiative proposed by China, may be the first step to establish such standards. But the reality of the credit rating industry in today’s world is incompetent to play the part. The three large Western rating agencies, with divisions in many countries, continue to dominate the industry, while most other rating agencies only work in local markets and do not have shared standards. It is difficult to apply their rating results across the national border.
As the financial market evolves, investment products multiply, credit chains become more complex, and credit risks seem increasingly threatening. Credit rating agencies participate in the market no longer as its media, but at times hold direct influence on investment decision-making. They play an important role in raising alarms about financial risks. Dagong’s creation of credit engineering, which combines the approaches of engineering and credit rating, can produce rating results through simulation tests, and enormous modeling and computing operations. Just as financial engineering meets the need for credit expansion, what credit engineering does is to ascertain the boundary of debt security in a given situation. By applying credit engineering and other cutting-edge technologies, Dagong can perform the more rigorous tasks for credit raters in the time of financial innovations.
IV. SOVEREIGN RATING AND GLOBAL RATING SYSTEM
1. Credit system is the foundation of a nation’s financial system. And a national credit system is part of the international credit system. National credit rating standards are important for global economic development.
A FINANCIAL SYSTEM is by nature a complex of interconnected creditor-debtor relations. The quality of such relations is determined by credit rating. A national credit system is foundational to its entire financial system, and is part of the international credit system. And national credit rating standards may affect many things ranging from its state performance, cross-border capital flow, rational allocation of national wealth, to its international credit standing. This is all the more the case for a national as a global or regional financial center.
2. Existing national credit rating standards are harmful to the global credit relations. New standards are needed.
In many ways, the prevalent rating standards national rating standards do more harm than good to the global credit relationship: First, they fail to reflect the fact that in some of the most indebted nations, debt has surpassed GDP by growth and cannot be repaid through wealth creation. They even follow a pro-cyclical approach by keeping up those nations’ ratings. Second, they fail to duly appreciate the extraordinary solvency of creditor nations in use of export revenues as loans to the developed debtor nations. Third, they create an imbalance in the distribution of credit resources. Data of 2008 show that over 90 percent of the world’s capital flow arrived in the developed economies, and along with it, almost countless investment projects. Such polarization in the distribution of credit resources is a main explanation of the imbalance in global economic development. Fourth, by according the highest credit standing to some biggest debtor nations, the existing rating standards help them attract global capital at a low cost. Among those nations, the issuers of international currencies can at the same time shift part of their debt burden onto other countries through currency devaluation. That some deeply indebted nations can continue to earn an influx of wealth further exacerbates the inequality in economic competitiveness in the world. And fifth, almost unavoidably, the deep-seated flaw in the prevalent rating standards will only generate biased credit information. But such information is so important as to influence, directly and indirectly, different countries’ macroeconomic policies and investment decisions, which will in turn affect the state of the world economy and overall credit relationship.
National credit plays a dominant part in the global credit system. Its state of being directs the flow of international capital and national interests, and therefore has important baring on the stability of global credit relations. For too long, however, the most indebted economies have been suffering from a drain on their internal driving power for growth. Once their borrowing attempts run aground, they will almost for certain trigger a domino effect leading to a catastrophic event in the global credit system. The risk is genuine but is not unmasked by the prevalent standards. Over the past 15 years, the world has already witnessed as many as some 60 financial crises, the worst being the global crisis led by the US subprime debt collapse.
3. International credit system is a part of the global financial system. And international credit rating is important for its security.
The international credit system determines the state of the global financial system and its security. International ratings can influence the working of the global financial system by revealing the debtors’ risks to the international creditors. One nation’s agenda-setting influence on the international credit rating market can benefit its sovereign power and financial security, especially to help itself resist the possible impact from unjust external rating attempts. At the same time, the reliability of a nation’s rating system serves to not only support the stability of its own system, but also support the global financial system by contributing directly to all member nations’ stability.
4. The existing international credit rating system is yet to match the global financial system’s development. New ideas are needed for building a new rating system.
The existing international credit rating system is dominated by the United States and is plagued by a few quite noticeable problems: First, wherever national interests are involved, the US rating agencies tend to rate another nation’s credit risks in such a way as to protect their nation’s core interests. Second, applying one nation’s rating standards to another nation is neither fair nor practical to obtain useful rating information for the market. Doing so can only distort the prices of global credit products. Third, poor regulation over the global providers of credit information has reduced the international rating system to be only instrumental for certain small groups to hijack the interests of investors all over the world. By taking advantage of its political influence and the world’s dependency on rating information, a largest debtor nation has gone so far as to assign higher ratings to debtor nations and lower ratings to creditor nations. It is in effect to help debtor nations exploit creditor nations, and amounts to a destruction of the global credit relationship and economic imbalance.
In a time of the global spread of credit relations, what we need is an international credit rating system that is able to fully reveal the debtor’s credit risks. Such a system requires: First, there should be, as required by the nature of international credit rating, an international rating organization independent of any national interests. Second, there should a global system of standards, or a set of standards that are capable of revealing the credit risks in different nations just as well as universally applicable. Third, there should be a global regulatory agency, or an authority to apply universal regulations to international credit ratings.
V. FLAWED METHODOLOGY
THE GLOBAL CREDIT CRISIS was rooted in the erroneous Western credit rating methodology. Errors in ideology feed the errors in its credit reporting, and the poor quality of its supply of information in turn results in difficult credit relations. Such credit relations are more often than not fragile, with no security from collaterals of real worth. They will in the end break down a society’s credit chain and give rise to a general crisis.
The Western rating methodology is erroneous in four large aspects:
1. Mixing ideology with the professional practice of credit rating, and unable to reveal where credit risks reside.
The Western rating methodology boils down to the insistence that the ranking of sovereign credit risks must follow an order defined by Western democracy, and that the institutional environment, especially the regulatory and legal environment, is the most important factor to measure any issuer’s credit quality.
However, no one can say there is a political and economic system in the world with a universally recognized advantage, or that any particular system is better equipped than all other systems in honoring its debt obligations. A rating agency will inevitably come to a wrong conclusion if it takes the Western ideology as a measurement of credit. An excessive emphasis on institutional and sovereign factors has led the Western credit rating system to a wrong path, if not an all-round failure.
2. Default statistics are abused, so much so that they become a pseudo science.
The Western rating methodology uses default rate as the key reference for determining a debtor’s default probability. Doing so, it sets the default probability of for each credit level on its historical default data. That is to converts the historical statistics, which are good only for verifying an issuer’s credit record, directly into its credit rating.
Replacing rating with historical data is in itself is anti-rating by nature. It is because what rating stands for is a forecast of future risks rather than a statistical exercise about past records. The historical default rate represents only what has already happened, not the present or future default probability.
3. Showing neither standards nor understanding of the real risks by capping all issuers under their national rating.
The sovereign ceiling is an important part of the Western rating practice, which requires setting a nation’s sovereign credit rating as the maximum level for all local issuers can possibly obtain when they raise foreign currency debt.
Such practice in effect substitutes an ideology for a rating agency’s independent assessment of credit risks, and substitutes the sovereign credit standing for the rating of all other debtors. Not only does it render credit rating devoid of use, but it also allows the already highly politicized sovereign standards to contaminate the entire system of Western credit rating. But a nation’s central government does not necessarily hold an influence on the credit risks of the nation’s economic entities, and the national ceiling practice simply does not have sufficient realistic ground.
4. Neglecting the accumulative credit risks in a pro-cyclical economic process, unable to play a counter-cyclical role as creditors should.
Two sets of contradiction exist in a credit economy, namely that between production and credit, and between credit and rating. The first contradiction represents a pro-cyclical force in that credit is needed to continuously expand the consumption ability, and through the process, to allow capital to seek incremental returns. The second contradiction represents a counter-cyclical force, by contrast, in that a credit relationship cannot be built to generate the expected returns of capital unless the debtor’s security limit for indebtedness is marked out by credit rating.
With its analysis based invariably on the debtor’s present financial state, the Western rating methodology is pro-cyclical by nature, and cannot function in a counter-cyclical way. It can do nothing, as proven by history, to produce advance warnings about prospective deterioration of the debtor’s credit risks. All it can do, instead, is to drastically downgrade debtors after a general credit crisis has already broken out.
VI. A CORRECT CREDIT RATING METHODOLOGY
DAGONG’S MISSION IS to be an architect of a new rating theory, based on its research of credit economics and logics of credit rating. This was officially established as Dagong’s value preposition as the global credit crisis was doing unprecedented damages to the global economy, after it was induced by the flawed Western rating methodology.
1. Dialectical materialism as Dagong’s guidance.
Factors contributing to credit risks are all interrelated. From the way they work on one another, we discover the underlining their evolving logics and patterns. Dialectical materialism has enabled Dagong to dig into the core of credit risks and define how they come into being.
2. Dagong follows a counter-cyclical line, to use rating as a credit risk warning.
Credit relations proliferate in society through the medium of credit rating. In the process, the rater is expected by the creditor to answer basically three questions about the debtor: First, what is the security limit for its indebtedness? Second, whether it can pay back the outstanding debt in time? And third, whether there is any room for incremental debt? By explaining the above three debt security concerns in clear, quantitatively measurable ways, the rater plays a de facto counter-cyclical role in obstructing reckless debt financing.
Following a counter-cyclical principle, Dagong can provide credit risk warning through applies simulation modeling. It believes a credit rater’s job is none other than forecasting credit risks, a function of it being to continuously size up debt risks. The rating report that it comes up with must integrate all basic single-factor rating forecasts into a comprehensive evaluation. It therefore needs a scientific methodology, protected by the right examination and adjustment mechanisms. Abilities in credit risk forecasting and early warning can help credit raters do a much better job in their service to the market.
3. The institutional factor is important, but not so much as to warrant a “national ceiling”.
Events such as regime changes are important. The institutional environment does affect the debtor’s wealth creation ability and debt repayment sources, which in turn determine the debtor’s solvency.
Dagong does think highly of the influence from the institutional environment on solvency. What it doesn’t agree with is to set a national ceiling to indiscriminately cap the ratings of all the bond issuers in the nation.
4. Dagong believes wealth creation is key to the debtor’s solvency.
Wealth creation ability and debt repayment ability are by nature closely related. Four basic scenarios exist in the realistic world: First, profit earning is enough to cover the full amount of debt and interest obligations. Second, profit can repay part of the debt and its interest. Third, profit can only cover the interest payment. And fourth, profit is so meager it cannot even cover the interest. The only correct way of credit rating is by attaching a primary value to wealth creation, and by looking at to what extent wealth creation ability can contribute to the debt repayment ability.
5. The Dagong concept of deviation, not past default records, better reveals the growth of credit risks.
At the core of Dagong’s credit rating methodology is the concept of deviation, derived from the knowledge that wealth creation ability, although important, does not make up the entirety of debt repayment resources. Of all types of debt repayment resources, the depletion of one tends to motivate the use of another, and almost naturally, doing so will give rise to a sequence of debt repayment resources that extends increasingly distant from the wealth creation ability, reflecting various degrees of risk. Measuring the deviation of various debt repayment resources from the wealth creation ability, after adjusted by the risk factor, betrays clearly their different levels of security.
Default records, as the very basics of the Western rating methodology, and deviation, as Dagong proposes for its own methodology, represent two different values and perspectives. By emphasizing default records, what Western methodology does is to use the past data as the guide for the future. By emphasizing deviation, however, Dagong infers its forecast from a study of the inner workings of all the factors contributing to credit risks. The two rating methodologies are opposite to each other in logic, and in what they can actually bring about to the global economy.
6. Dagong conducts rating rating to the degree of deviation, a measure good for consistent and comparable application to all debtors.
The language for credit rating must consistency for debtors in the same credit level, and comparability for debtors in different credit levels. Society-wide flow of capital requires by its nature the smooth, unhampered flow of rating information, and only the consistent and comparable rating information can play its part to facilitate society-wide capital flow. And only in such a process can the counter-cyclical function of credit rating be be realized.
VII. THE WORLD MUST REBUILD ITS INTERNATIONAL RATING SYSTEM TO MASTER A CREDIT ECONOMY.
OUR EFFORT TO REBUILD the international credit rating system, to begin with, should emphasize the central importance of wealth creation ability, and the actual solvency as the basic factor to sustain a credit relationship. By employing a new credit rating concept and methodology to balance the supply and demand of credit resources, the system should be able to send out alarms about the risks arising from the pro-cyclical chase for unlimited expansion on the production side. This system should live up to its responsibility for the world. It should actually work as a global credit risk defense system.
The new rating system should consist of three key components — an international rating regulatory body, rating organizations, and the international rating standards. It should embody such principles as global coverage, consistence, independence, and global supervision and regulation, to enable a fair and just mechanism to expose the risks in every creditor-relationship. This is the way to rebuild global credit and to have the global economic recovery — to have a credit rating system with a major upgrade in risk warning capabilities and able to prevent us from a reprise of worldwide credit crisis. (END)