Should Sovereign Credit Rating Be Outsourced to China? Not So Fast …

China’s Dagong Global Credit Rating Co. recently announced plans to create a so-called super-sovereign credit rating firm. In part, this is because the Big Three U.S. ratings agencies — Moody’s, Standard & Poor’s and Fitch — are believed to be too closely tied to Wall Street. Will Dagong succeed? In this opinion piece, Anastasia V. Kartasheva, a professor of business and public policy at Wharton, argues that Dagong will face an uphill task in establishing credibility. She also explains that the downgrade of a country’s credit rating can have major consequences throughout the economy.

While America’s leaders debate — and sometimes squabble over — how to create jobs and whether outsourcing work to emerging markets helps or harms the economic recovery, another industry is at risk of moving to China: credit rating. That, at least, is the intent of China’s Dagong Global Credit Rating Co.

The Beijing-based company, founded in 1994, has come up with a plan to create a so-called super-sovereign rating firm in partnership with rating organizations in Europe, the U.S. and the BRICS nations (Brazil, Russia, India, China and South Africa). “The idea is good and desirable [because] the Big Three ratings agencies [Standard & Poor's, Moody's Investor Service and Fitch Ratings] are believed to represent the interests of Wall Street,” noted Pi Kyung Won, planning department general manager at NICE, a unit of South Korea’s National Information and Credit Evaluation Holdings, in an interview with Bloomberg in September, soon after Dagong announced its intentions.

Some early signs have begun to emerge that countries that feel discriminated against by the Big Three may turn to Dagong. On November 8, economically strapped Belarus decided it was so fed up with being repeatedly downgraded by Western credit rating agencies that it signed a deal with Dagong to seek a “more generous assessment of its sovereign debt.”

Is forming such an agency a good idea? Emerging markets and investors undoubtedly could benefit from new information, especially if the agency provides credit risk assessment of sectors that the Big Three do not cover. However, the new agency will need to build its credibility and reputation to establish that its ratings are designed to provide objective and unbiased information.

Dagong, though, may have something else in mind. In a report published last year, the agency announced it wanted to give a different perspective on sovereign ratings from the Big Three, correcting some of the incumbents’ “cultural biases.” At the same time, it created two lists of countries that would receive “unanimously higher” and “unanimously lower” ratings. The “better countries” include China, Hong Kong, Macau, Russia, Brazil, India, Indonesia, Venezuela, Nigeria and Argentina. The “not-so-good ones” are most Western developed economies and also Thailand and the Philippines. In practical terms, this means an investor who decides between buying debt securities in Russia and Thailand needs to know how much prettier Russia is relative to Thailand in Dagong’s eyes.

Concerns are often raised about the credibility of ratings for Chinese enterprises. Chinese ratings agencies tend to assign AAA ratings to many state-owned enterprises and local governments. For example, the Ministry of Railways has a Triple-A rating. According to the agency, these entities have enough guarantees to secure high credit quality. Still, arrangements to improve the rating by buying credit insurance may be misleading.

Downgrading U.S. Debt

In August, Dagong downgraded its sovereign rating of the U.S. by one point to A, bringing it on a par with Russia and South Africa. This downgrade was more severe than that of Standard & Poor’s or other U.S. rating agencies. Will this help Dagong expand its presence in the sovereign debt ratings business?

Clearly, the move helped generate publicity. The role of the Big Three ratings agencies in the U.S. economy has been in the spotlight in recent months, especially over the fact that the U.S. could lose its AAA rating. S&P has downgraded its U.S. rating to AA+, while Moody’s and Fitch have confirmed a Triple-A rating but with a negative outlook. This is the first time in U.S. history that the country’s debt has been downgraded.

Let us be clear about one thing, though: A debt downgrade does not equal a default. Even the worst imaginable scenario — a AA rating from the Big Three — is assigned to a country that “has very strong capacity to meet its financial commitments. It differs from the highest-rated AAA obligors only to a small degree,” according to S&P’s rating definition. Does that really matter to the U.S. economy? Should not America’s leaders focus on more immediate tasks such as creating jobs and boosting economic growth?

Rating Ceiling

Perhaps so, except for the fact that the downgrade of a country’s rating has a greater impact on its economy and residents than many people realize. The Big Three ratings agencies have a common practice known as country ceiling. This means the rating assigned to an issuer or corporate entity cannot exceed the rating of the country in which it operates. For example, S&P’s sovereign rating for Brazil is BBB-. This implies that no Brazilian bank, insurance firm or firm can obtain a rating substantially higher than BBB, regardless of its efforts to sustain high credit quality. The rationale for this rule is that the country’s macroeconomic conditions affect the health of its financial and industrial sectors. The presence of a sovereign crisis in emerging markets on average raises corporate default rates two-and-a-half times — from 10% to 24%.

So what does the downgrade of U.S. debt mean for 340 million Americans in their daily lives? The impact is significant, for the simple reason that government debt securities play a vital role in the economy. They facilitate interactions among financial institutions such as banks, insurance companies and the still-recovering mortgage lenders. A debt downgrade pushes up the cost of borrowing across the economy.

Credit cards and consumer loans, including college loans and auto loans, will have higher costs, which means that we should be prepared to pay higher credit card bills in the coming months. Though credit card companies have to notify their customers at least 45 days before increasing their rates, higher rates are unavoidable in the medium term.

In addition, mortgage rates are affected almost immediately — home owners can expect to see their payments go up. Moreover, the loss of a AAA rating would lead to the downgrade of Fannie Mae and Freddie Mac, government-sponsored enterprises that benefit from the explicit federal government guarantee. They, in turn, securitize mortgages for more than half the U.S. housing market, which is still struggling to recover from the crisis. Higher debt costs could increase the securitization costs and slow the recovery.

More bad news could follow. AAA-rated financial institutions, such as U.S. insurance providers, could possibly lose their gold standard stamp. Insurers hold significant amounts of U.S. debt on their balance sheets. Deteriorating macroeconomic factors are likely to decrease the value of their assets even further. This means that insurance premiums could go up. Insurers also play another important role in our daily life. They invest billions of dollars in municipal bonds that enable communities to undertake critical projects including building schools, community colleges, health-care facilities, and urban development projects. The costs of financing these projects could increase and the number of implemented projects could go down.

The downgrade could also affect the ratings of the state and local governments, especially those that have greater relative economic volatility and heavily rely on federal spending and capital markets. In the short run, this could lead to downsizing of public sector employment and budget cuts.

Are Ratings Agencies to Blame?

Not this time. The possibility of the rating downgrade indicates deteriorating economic conditions in the U.S. economy. As soon as the Obama administration builds a solid fiscal consolidation plan and the economy shows signs of recovery, the rating may be upgraded back to AAA. This means that U.S. political leaders — both Democrats and Republicans — should focus on policies that enhance America’s competitive position in the world economy and boost economic growth. Short-term bickering for political mileage will get us nowhere.

The same principle applies to China’s Dagong. The ratings agency has a unique opportunity to provide valuable information to emerging economies where such information is scarce. In its case, too, making political statements will only diminish its potential.

Editor’s note:
Anastasia V. Kartasheva is a member of the Wharton Risk Center. She is the author of several academic articles on the role of credit rating agencies in the U.S. and global economy.

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