Given the economic tumult in China, we thought it would be worthwhile to get some perspective from that nation’s largest independent credit rating agency – Dagong. A check of its website shows that Dagong assigns a local currency rating of AA+ and a foreign currency rating of AAA to the People’s Republic with a stable outlook (at least as of March 20, 2014, the date of the most recent rating report). These ratings sharply contrast with Dagong’s US sovereign rating of A-.
Dagong has portrayed itself as an innovative upstart endeavoring to shake up the sleepy and deeply conflicted world of credit ratings but a close examination of its sovereign rating methodology and accompanying analysis suggests otherwise. Its rating methodology is structurally the same as that of the Big Three, which is not surprising given that many former Big Three rating analysts occupy key analytical positions at Dagong. For instance, Dagong methodology neither tracks the changes in credit profiles of banks and other issuers that result from their being party to derivative contracts nor the contingent liabilities of sovereigns that may have to bailout counterparties to derivative contracts. Likewise, Dagong’s analytical processes embed the same self-imposed limitations that corrode rating analysis by the Big Three. Dagong commentary indicates that it is subject to home country bias, while its failure to thoroughly embrace quantitative methods allows its ratings to become stale – as epitomized by the AAA China sovereign rating.
Our examination starts with the basic premise of credit ratings: that credit ratings convey incremental probabilistic information on default risks (breaches of contractual obligations), that contractual subordination provides a binding notching relationship among different classes of creditors for asset recovery upon bankruptcy, that default risks are rated to bankruptcy (or an analogous credit terminal event for sovereigns and other entities that don’t have access to the bankruptcy process). This is the fundamental credit rating theory that has guided credit ratings and pricing in capital markets for decades. Dagong’s criticism that western credit rating practices are without any theoretical foundation is more of a savvy commercial move than a critical analytical view and is disingenuous – it simply suggests that Dagong either has not thoroughly studied the nature of credit ratings or is not interested in a good faith effort to truly understand credit ratings as they should be.
It is true that the current generation of credit rating methodologies is not perfect in that the incremental probabilistic credit information is not derived from credit causalities but from historical default statistics. However, where credit ratings lacked in forward-looking relevance (timely credit information), it has provided reliability in credit reporting given decades of accumulations of historical default statistics.
Dagong’s main criticism of the western credit rating methodology is actually what Dagong itself lacks – a body of fully seasoned historical default statistics. Hence Dagong’s credit rating methodology is driven by what is called “wealth creation capacity” instead of default risks – if wealth creation fell short of debt obligations, a credit event would occur. Dagong claims that its ratings provide more relevant (timely) credit information because wealth creation capacity is forward-looking. On that basis, Dagong assigned an AAA rating to China because of strong economic performance (wealth creation) and an A- to the US because of quantitative easing (currency debasement) which is akin to debt cancellation.
The problem with this approach is that national wealth creation is neither a contractual obligation nor a contractual performance measure. In addition, allocations of wealth creation is subject to stakeholder conflicts, hence wealth creation would not necessarily drive the credit performance of its sovereign and other borrowers in the absence of mature legal and public/corporate governance systems. If, for example, the sovereign chose to use its vast resources to prop up equity prices or bail out insolvent municipalities, less wealth would be available to the sovereign creditors. In a mature economy where investors have access to legal representation (litigation) to enforce their rights in the court of law, public/corporate governance regime would inherently resolve the stakeholder conflicts. But in an evolving economy, stakeholder conflicts in allocation of economic resources in the absence of legal and constitutional representation are not just a credit issue but political and societal issues as well.
Furthermore, quantitative easing (“QE”) is not a credit event because it breaches no contractual obligations, but even if it did, shouldn’t Dagong subject the Chinese government to the same standard? The Chinese government launched one of the most massive and sustained QE in monetary history that drove the Yuan (RMB) exchange rate from 1.5 in 1980 to as low as 8.3 in the period between 1994 and 2006. It also injected another 4 trillion Yuan in the wake of the 2008 financial crisis. Given the relatively small amount of Chinese sovereign debt, shouldn’t the effect of debt cancellation via currency debasement be a bigger rating factor in China’s sovereign rating? Moreover, the wealth creation capacity is basically a weighted average of a bunch of backward-looking metrics, such as GDP, so what forward-looking credit information exactly do Dagong’s credit ratings convey?
Double standard aside, Dagong has not thoroughly analyzed the enormous level of uncertainties as China migrates toward a Citizen Society, which brings unprecedented challenges from a credit analytical perspective as follows:
- A new social contract is urgently needed to foster fair allocations of the benefits of economic growth between vested interest groups and average citizen, including anti-corruption, environmental, new considerations in human rights (shareholder rights, creditor rights, property owner rights, rights to have legal and constitutional representation for enforcement of citizen/investor rights, etc.)
- Slowdown in government investment driven economic growth could potentially trigger massive unemployment.
- A new national development model that involves delicate balancing acts between fiscal and monetary policies. Until recently, China had historically followed a relatively simple national development model by pegging to USD in monetary policy while pursuing an aggressive fiscal policy. Going forward, however, the economic growth (wealth creation capacity) on the new path will likely be fraught with uncertainties.
In conclusion, Dagong’s credit ratings can be summarized as follows:
- Illogical credit risk definition: The ability to pay debts is rated to an open-ended economic measure (wealth creation capacity) without a credit terminal event (such as bankruptcy).
- Lack of a credit terminal event: As an economic risk, wealth creation obviously would not end in bankruptcy. But where would it end and how would it be resolved among creditors upon the terminal event?
- Lack of a binding notching relationship among different classes of investors for asset recoveries upon bankruptcy: As an economic measure, wealth creation capacity is simply unable to define a contractually binding notching relationship to differentiate junior and senior credit obligations.
- Without the three essential features mentioned above, Dagong’s so-called credit ratings are simply economic performance rankings disguised as credit assessments – As such, they do not convey any probabilistic credit information on rated debts. Moreover, they are economic performance rankings that ignore dislocations caused by the over-use of derivative contracts, the proliferation of shadow banking, and contingent liabilities of quasi-state entities, that are often seeds of financial crises.
As the current generation of credit rating methodologies is coming under increasing investor criticism for not conveying critical information on a timely basis, Dagong had a historical opportunity to present an innovative, alternative rating methodology to challenge the incumbent Big Three rating agencies, but its performance so far is truly disappointing. Dagong is missing the chance to build a genuinely better product for determining ratings which could improve credit assessments worldwide. Instead, by portraying an overly rosy view of Chinese credits, Dagong risks abetting a financial crisis in China in strikingly similar fashion to the financial crisis precipitated in part by the Big Three rating agencies. As Dagong is poised to expand its rating services in the European capital markets and the one-belt-one-road markets at the heel of the AIIB, would investors be wise to place their confidence in Dagong? Be skeptical, at least for now.
This article is contributed by Simon Hu and Marc Joffe with a special thank to Bill Harrington.