Reform International Rating System to Promote Global Economic Recovery

1. Reform International Rating System to Promote Global Economic Recovery Guan Jianzhong 8 November, 2011 Lisbon

2. Contents I. The existing international rating system led to the global credit crisis II. Building a new international rating system is the prerequisite for the global economic recovery III. Roadmap of international rating system reform

3. The Basics of Credit Economy The root cause which makes the world economy difficult to recover is that the ongoing crisis bail-out approach goes against the law of the credit economy.

4. 1. The credit relationship between the creditor and the debtor has been socialized and woven into the entire process of social reproduction; the status of the modern credit relationship plays a decisive role to the development of social reproduction. 2. Establishing and maintaining the credit relationship are highly dependent on credit rating information. The quality of credit rating determines the state of the credit relationship. 3. The aggregate credit relationships constitute the international credit system which is the foundation of the modern global economy, and international credit rating system is the basis to build global credit system. The Basics of Credit Economy

5. 4. The inherent link between the world economy and the global credit system and international credit rating system increasingly makes credit rating dominant of the world economy. 5. The fundamental error of the existing international rating system has destroyed the international credit system upon which the existence and development of the global economy is desperately dependent. In order to promote the global economic recovery, we must build a new international credit system and reconstruct the international rating system. The Basics of Credit Economy

6. I. The existing international rating system led to the global credit crisis Essentially, the credit crisis is that the global relationship between the creditor and the debtor has broken. Modern international credit relations are built on the western credit rating information. Wrong rating information makes the international credit system full of default risks.

7. I. The existing international rating system led to the global credit crisis 1. The world credit revolution accelerated the formation of the global credit system The contradiction between production and consumption in the western developed countries has promoted a credit revolution in the human society. The world credit revolution means that the existing credit model is changed across the world characterized by continuous expanding consumption demand by borrowing and loading beyond the real wealth creation capability, integrating the credit relations into the entire process of social reproduction, which makes the credit relations the basis of economic foundation of modern society, exerting overall influence to human economic and social activities.

8. I. The existing international rating system led to the global credit crisis The revolution has gone through four stages of development: (1) The stage that the world currency becomes unified In this stage, human has ended the thousands of years of history that there was no a unified world currency for cross-border economic activities and chosen a currency as the world currency, which is the starting point of changing human credit activities.

9. (2) The stage that the state creates credit needs In this stage, the signatory states of the Bretton Woods System were no longer restrained by real wealth-creating capacity and able to regulate the total size of market credit to meet fund needs of production and consumption by changing money supply, interest rates and exchange rates on their own. As no state can increase money supply unlimitedly ignoring real wealth, the stage is characterized by utilization of the real-life credit resources. I. The existing international rating system led to the global credit crisis

10. (3) The stage that the market creates credit needs Different from the last stage, social credit needs are created by the market based on the value that economies may create in the future through a series of financing facilities enabling debtors to raise funds from creditors. It is characterized by using future credit resources as the stage is based on the future value. I. The existing international rating system led to the global credit crisis

11. (4) The stage of virtual credit needs In this stage, the virtual credit needs lack of support from reality and future value creating capability and, in essence, is the credit bubble. They come forth as the western developed countries encouraged low-income groups without actual solvency to borrow money, redeveloped the existing lending relationships, and developed new credit derivatives and artificially designed credit needs. Without any real wealth foundation, this stage is employing the credit resources that do not exist utterly. I. The existing international rating system led to the global credit crisis

12. (4) The stage of virtual credit needs According to the statistics, the total contract amount of financial derivatives traded in open markets world-wide, including foreign exchange, interest rate and credit derivatives, was USD80.31 trillion in 1998. By 2009, the figure was over seven times as much as that in 1998, reaching USD603.9 trillion, and 10 times of the world GDP of the year. The derivatives of the U.S. account for 30-40% of the world total in terms of both type number and transaction size. I. The existing international rating system led to the global credit crisis

13. 2. Inherently international credit system calls for a fair international rating system Each credit relation is conditionally built based on the judgment of the solvency of the debtor. When debtors’ credit risk factors are increasingly socialized, identifying their default risks has become a complex professional research process. It is very difficult for both creditors and debtors to have such ongoing research capacity, and particularly, information from a third-party independent of creditors and debtors is more easily recognized when pricing credit transactions. Therefore, due to the credit socialization, professional rating agencies are chosen and assigned the responsibility and power to independently judge debtors’ credit risks. I. The existing international rating system led to the global credit crisis

14. 3. The existing international rating system can hardly assume the responsibility of rating the world The major problems with the existing international rating system include: (1) The clear position of protecting the interests of the largest debtor makes the ratings offered by the system short of independence and objectivity, committing a very serious moral mistake to the entire human society. I. The existing international rating system led to the global credit crisis

15. 3. The existing international rating system can hardly assume the responsibility of rating the world (2) Based on seriously political and ideological rating criteria, the ratings reflected some countries' political and economic concepts, but not objective connections between the underlying credit risk factors. Due to the distorted rating information, the international capital has flowed to countries with poor solvency and the western developed economies have raised excessive amount of debts, suffered from serious debt crisis and dragged down the world economy. I. The existing international rating system led to the global credit crisis

16. 3. The existing international rating system can hardly assume the responsibility of rating the world (3) The international community does not have regulatory power over the international rating system that is responsible for security of the world financial system and dominated by a sovereign rating agency, neither does the relevant government perform its due management responsibility. Lack of supervision enables the international rating system with wrong morality and criteria to have super power and to cause consequences that the world has to assume. I. The existing international rating system led to the global credit crisis

17. 3. The existing international rating system can hardly assume the responsibility of rating the world (4) With competition mechanism, rating agencies tend to assign similar or identical ratings to protect their own interests and their abilities to reveal risks are weakening. Consequently, it is difficult for the existing international rating system to assume responsibility of rating the world. I. The existing international rating system led to the global credit crisis

18. 3. The existing international rating system can hardly assume the responsibility of rating the world (5) Violating the rationale of credit-debt relationship and basic credit rating principles, the world's largest debtor country controls the say in international rating, develops rating criteria favorable for debtor countries, over-estimates the credit worthiness of those countries with declining actual solvency and under-estimates the credit worthiness of those creditor countries with value-creating ability, which results in ongoing unbalance in allocation of international credit resources and economic development. I. The existing international rating system led to the global credit crisis

19. 3. The existing international rating system can hardly assume the responsibility of rating the world (6) The fundamental errors of rating concepts have exacerbated asymmetry of information on the international credit risks. ① Test ratings with default rates; ② Set sovereign rating as the ceiling of credit rating of an economy; ③ Emphasizing refinancing capability while ignoring the fundamental role of wealth creation capacity to solvency; ④ Believing a country with the right to issue international reserve currency will never default and can repay the debt by printing money when in debt crisis I. The existing international rating system led to the global credit crisis

20. I. The existing international rating system led to the global credit crisis Comparison of Rating Concepts between Dagong and Three Rating Agencies

21. I. The existing international rating system led to the global credit crisis Converged Rating Changes of the Three US-based Rating Agencies after Dagong Released Ratings

22. 4. Evolving trend of global credit crisis The global credit crisis will undergo four stages based on the internal logic of development: Debt crisis -- Debt crisis is a systematic destruction event causing the credit system to fail to work properly as credit relations are broken continuously due to defaults of debtors. Economic crisis-- Economic crisis is a big recession of real economy caused by damage of debt crisis on the credit system. When debt crisis has shaken the economic foundation formed by credit relations, consumption bereft of debt support is in continued downturn, resulting in sharp decline of wealth creating capability of the real economy. Sovereign debt crisis is the concentrated expression of the combined effects of economic crisis. If left alone, the credit crisis evolves into the third stage. I. The existing international rating system led to the global credit crisis

23. 4. Evolving trend of global credit crisis The global credit crisis will undergo four stages based on the internal logic of development: (3) Currency crisis --Currency crisis is an extreme government-led economic behavior that happens when a debtor country losing solvency and entitled to issue the international reserve currency lets its currency depreciate to bail itself out from the sovereign debt crisis and export debt. No doubt, the continued depreciation of international reserve currency will lead to the world currency war and fourth stage of credit crisis. (4) Overall crisis – Overall crisis is the world economic system crisis caused by overwhelming destruction to the international monetary system as international reserve currency issuers starts continued currency depreciation. The turning point of the global credit crisis will also be a turn of realizing the world economy recovery. The crisis will test the perceptive level and command ability of human society on crisis evolving pattern. I. The existing international rating system led to the global credit crisis

24. II. Building a new international rating system is the prerequisite for the global economic recovery 1. Credit crisis is the adjustment process of credit system. Credit crisis happens because the western developed countries have been violating credit economic law for long time and the international credit system developed on the basis of wrong ratings makes capital unable to flow normally due to systematic default of debtors. It is a process that unreasonable credit relations give way to correct credit relations. The international credit system will take more than a decade to finish the adjustment process.

25. II. Building a new international rating system is the prerequisite for the global economic recovery 2. Conventional approaches cannot save the world economy. (1) Contradiction between stimulating economic growth and shortage of credit resources (2) Contradiction between increasing revenue, reducing expenditure, developing economy and maintaining social stability (3) Contradiction between currency depreciation and national long-term interests

26. II. Building a new international rating system is the prerequisite for the global economic recovery 3. Rebuilding the two systems is the only way to the global economic recovery (1) The irrational international rating system produced a crisis-ridden international credit system. (2) All the bail-out measures that the international community has taken cannot substitute the credit system. (3) Setting up a new international credit system is the only way to form the force to push the world’s economic recovery. (4) Reconstructing the international rating system is the guarantee to establish a new international credit system.

27. III. Roadmap of international rating system reform 1. Now is the best time to reform international rating system. First, the evolvement of the crisis and failure of the bail-out action further raise awareness of reform of the international community. The reform ideas are brought together into thoughts and actions of reform. Second, the theoretical preparation for the international rating system reform has been completed.

28. III. Roadmap of international rating system reform 2. New international credit rating system model The new international credit rating system model is made up of three major parts - an international credit rating regulatory organization, an international credit rating agency and international credit rating criteria. (1) International credit rating regulatory organization--The non-sovereign organization consists of rating regulatory bodies of countries and is responsible for planning development of the international rating system, developing the international rating regulatory rules, guiding countries to build their own rating systems, regulating rating agencies' behaviors and promoting credit rating criteria to upgrade.

29. III. Roadmap of international rating system reform 2. New international credit rating system model (2) International credit rating agency--The non-sovereign organization is a professional credit information service agency consisting of the domestic credit rating agencies in each country. It should develop a unified international rating standard, conduct rating on multinational organizations, involve in rating of each sovereign state, form dual-rating system of each country and counter balance and prevent from rating risks.

30. III. Roadmap of international rating system reform 2. New international credit rating system model (3) International credit rating criteria--The international credit rating regulatory organization can develop rating criteria development planning and encourage rating agencies to carry out and keep improving the criteria. The organization should focus on development and enhancement of the criteria and ensure its objectivity through mechanisms.

31. III. Roadmap of international rating system reform 3. Guidelines for reforming international credit rating system (1) Global Principle: Ensure to conduct rating and follow up risks to each economy by using the same criteria to make each rating comparable; (2) Independent Principle: ①Supra-sovereign; ②Non-profit-oriented; ③Non- political; ④Non-competitive; ⑤Impartial; (3) Consistent Principle: Use the consistent rating criteria to measure economies’ credit risks to ensure the objectivity of ratings; (4) International Regulatory Principle: Use the consistent international rating regulatory criteria to supervise all of the rating behaviors of rating agencies;

32. III. Roadmap of international rating system reform 4. Three reform stages of the existing international rating system The reform should be divided into three stages. The overall objective is to build a rating system which can fully reveal credit risks of each credit relation world-wide to guarantee security of the international credit system. It will take six years in three stages to fulfill this objective.

33. III. Roadmap of international rating system reform 4. Three reform stages of the existing international rating system In the first stage of 2012-13, the main task is to initially shape a framework of the new international rating system with basic operational conditions. In the period of 2014-15，the second stage is committed to testing and improving the new system during running to basically enable it to provide rating information service. The third stage is 2016-17 during which the major task is to make the rating system coordinated with the credit system on the macro level; to fully build the new international credit system with support from the new international rating system and to realize the economic recovery by using the two systems to push the world economy step out of the crisis.

34. III. Roadmap of international rating system reform 5. It is essential to pool together more resources to reform the existing international credit rating system (1) First and foremost it is imperative to raise awareness -- The world media resources should fully report and communicate the international rating system reform to make the international community understand, support and participate in the reform in breadth and depth. (2) Governments should support -- Governments should recognize from the crisis that consistent with their economic and social management responsibilities, supporting the reform is improving their management.

35. III. Roadmap of international rating system reform 5. It is essential to pool together more resources to reform the existing international credit rating system (3) Creditor countries are major force driving the reform. Those countries more concerned about the safety of their assets naturally want to promote the reform and they should take the lead in reforming and engage debtor countries to participate in the reform. (4) Rating agencies of the whole world, as major players implementing the reform, should join hands to undertake the historic mission to achieve the objectives of the reform.

36. III. Roadmap of international rating system reform Objectively, the global credit crisis calls for a reform in terms of economic and social management model. Proposing the task to reform the existing international rating system is responding to the historical call, and completing the great reform needs human wisdom, consensus and action.

37. Thank you