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2011 Sovereign Credit Risk Outlook

Dagong Global Credit Rating Co., LTD

(January 27, 2011)

Solvency of the central government is the embodiment of a country's

overall economic strength; sovereign credit determines the trend of international

credit relations1. Whether international credit relations are stable or not has a

direct impact on the healthy development of the world economy. Since 2007, the

evolution of the global credit crisis proved that the sovereign credit risk is the

continuation of debt crisis in the financial and economic fields and that the

sovereign debt crisis is the inevitable response of national economic recession

and an advanced form of the credit crisis. Scientific forecast of the sovereign

credit risk in 2011 is conducive to human society to grasp the law of development

of international credit relations, and respond to the challenges of the sovereign

debt crisis.

Review of Sovereign Credit Risk in 2010

The sovereign debt crisis of the United States and Europe in 2010 was the

world's most significant sovereign credit risk event. To get rid of the sovereign

debt crisis, the United States continued to implement quantitative easingmonetary policy, which led to the violent shock of the international monetary and

credit systems, resulting in the complete out-break of a world credit warfare. The

drawing effect of strong economic growth in emerging creditor countries to the

global economy and their continued buying of the treasury bonds of big debtor

countries has prevented the sovereign debt crisis in developed debtor economies

from getting into collapse. Emerging creditor countries were able to effectively

stabilize the international credit relations and laid the credit foundation for the

recovery growth of the world economy.

_________________________________________________________________________

1International credit relations mean the credit and debt relations between different countries,

with the subject of the relations including not only natural persons, and legal persons, but

also government agencies.

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Looking back at 2010, the state of credit risk development in the world

shows the following five basic characteristics:

1. The basic layout of worldwide system of sovereign credit and debt is

mainly comprised of the debt system of the developed countries and the

credit system of the emerging countries

The debt system of developed countries is made up of developed debtor

countries. Developed debtor countries refer to the countries that has a relatively

high level of government debt and net debt in both the absolute volume and

relative volume (the ratio of total debt volume to gross domestic product),

including: the United States, Japan, Germany, France, Britain, Italy, Spain,

Austria, Belgium, Portugal, Ireland, Greece, Iceland, Canada and the

Netherlands, the total size of all levels of government debt was about 39.5 trillion

USD. The credit system of emerging economies is comprised of emergingcreditor countries and regions. Emerging creditor countries and regions refer to

the emerging countries and regions that have become the official creditors of the

government debt of developed debtor countries due to the rapid increase in their

foreign exchange reserves since the 1980s and 1990s, which are mainly in Asia

and Latin America, including: China, Russia, Saudi Arabia, China Taiwan, China

Hong Kong, India, South Korea, Brazil, Thailand, Indonesia, Singapore, Malaysia,

Argentina and other countries and regions, which constitute the system of

emerging economies credit system. These emerging countries and regions are

the major big export countries characterized by the export-orientedmanufacturing, energy and raw materials sectors. Embodied in the sovereign

credit and debt layout is the situation as follows: the decline in the endogenic

solvency of the developed debtor economies led to the increased demand for

government debt. Whereas the growth of the economic strength of the emerging

creditor economies made them the key external provider of government debt

revenues for the developed debtor countries. Therefore the debt system of the

developed countries is the main source of the global sovereign credit risk.

2. In the developed countries the financial crisis turned into a sovereigndebt crisis, as the solvency of key debtor countries declined sharply

This year risks in the financial sector still remained in developed debtor

countries, but the crisis has become calm; and the governments have

experienced 2-3 years of massive financial bailouts and economic stimulus,

which caused the sovereign credit risk to significantly increase from before the

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crisis. The developed debtor countries experienced gradual economic recovery in

2010, but the growth rate was very low, the nominal economic growth rate

averaged only 2.7%, while the debt growth rate was high, reaching 10.9%, this is

the third consecutive year that economic growth and debt growth are seriously

out of line, this has led the governments to rely more heavily on financing incometo maintain the financial operation, which will result in a further decline in

solvency. In mid-2010 as well as at the end of the year two sovereign debt crises,

happened in the eurozone, which resulted in Greece and Ireland being in need of

official assistance; besides , they set Portugal and Spain, two other highly-

indebted eurozone members exposed to even greater financing risks. The

European Union temporary aid mechanism established for the purpose of

assisting euro member states, although provided provisional relief from the crisis,

yet due to deterioration and no significant improvement in macroeconomic

fundamentals, the future sovereign credit risks of the eurozone countries will stillbe very fragile.

3. The United States, the world's largest debtor country used the US Dollar

to distribute the output of debt, and waged a global credit warfare.

After the United States indicated in August 2010 that it would launch a new

round of quantitative easing monetary policy, capital accelerated the outflow from

the United States, and transferred to emerging market countries, causing a new

round of depreciation of the US dollar. Trends such as this had a strong impact

on emerging market countries, large-scale international capital flows and

international commodity prices rise led to currency appreciation, rising inflation

pressure and asset prices in emerging market countries. The World Bank

estimated that in 2010 the net flows of international capital into the stock market

and bond market of developing countries increased by 42% and 30%

respectively. The continuous devaluation caused by excess issuance of US

dollars eroded the legitimacy of the global monetary system that takes the US

dollar as the key reserve currency, bringing the US dollars credit-worthiness to a

vulnerable position. The excess issuance of the US currency and the emerging

market countries fighting in an effort to resist massive short-term international

capital inflows and imported inflation are the signs of a global credit war. Credit

war is the result of development of the debt crisis of an economic subject into the

sovereign debt crisis phase; and it is waged by a country that issues international

reserve currency; it aims at encroach on other countries interests through

continuous depreciating the actual value of the currency; and it arouses all the

countries in the world to take various credit resources as a financial weapon to

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safeguard the national interests.

4. The emerging creditor countries powerful capability to create wealth was

the catalyst to the stabilization of international credit relations

In 2010, emerging creditor countries continued to lead the growth of the

global economy, while exports continued to grow, the expansion of domesticdemand led imports to rise faster, while the main emerging creditor countries

such as China, Brazil and India, were the main source of growth in global trade

and foreign direct investment, which contributed to the recovery of the global

economy from the crisis as soon as possible, and getting it back to a steady

growth path; at the same time that the subject of institutional investors in

international sovereign bond markets emerging creditor countries continued to

hold the treasury bonds of developed debtor countries in 2010 prevented the

sovereign debt crisis in developed debtor economies from getting into collapse,

thus stabilizing the international credit relations and laying the credit foundationfor the recovery growth of the world economy.

5. The credit risk of developed debtor countries damaged the healthy

development of the world economy.

The expansionary fiscal policy generally implemented in developed debtor

countries during the financial crisis has played a positive role in stabilizing the

financial system and preventing the economy from large-scale recession;

however, as the government debt ratio increased significantly, and economic

weakness became a normal state in the developed countries, sovereign credit

risk become a destructive force to the national and global economy in 2010.First of all, the increasingly rising sovereign credit risk forced some developed

countries to shrink the scale of fiscal expenditure in the second half of 2010;

when it was difficult to improve the situation of private consumption and there

was a decline in public spending for economic recovery, therefore the drawing

capability of developed countries to global economic growth seemed less than

before the crisis. Secondly, the quantitative easing monetary policy adopted by

major developed debtor countries to sustain the economic recovery and ease

credit risk gradually resulted in the following adverse trends in 2010: a rise in

global inflation, rapid currency appreciation in emerging market countries andsome developed countries alike, and appearance of asset price bubbles; and

these tendencies were extremely detrimental to the healthy recovery and

development of the global economy .

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Outlook of Sovereign Credit Risk in 2011

In 2011, there is a large uncertainty in the sovereign credit risk of developed

countries, and the overall debt servicing capacity of developed debtor countries

is very vulnerable as there lack of fundamental measure for restoring economic

growth in the debt system of the developed countries. The United States is the

biggest sovereign debt crisis country, the declining trend of the national debt

repayment intention triggered by the collapse of the United States actual debt

solvency will not change, it will inevitably continue its quantitative easing

monetary policy, which would escalate the world credit war, and the consequent

global inflation and liquidity risk will exert noticeable impact to countries that

depend heavily on external factors and have economic vulnerability. Debt crisis

may occur to the developed economies that have the weakest solvency, such as

Portugal and Spain. The debt situation of expenditure over income in developed

debtor countries can be bound to drag down the world economys sustainable

development. The strong wealth creation capability of emerging creditor countries

and regions make creditor countries the important providers of financing income

for developed debtor countries. They are bound to be the mainstay in stabilizing

and reforming international credit relations.

1. The financing needs of the developed debtor countries will continue

to rise, and debt income will remain the basis for stabilizing the credit

relations of these countries

In 2011, the financing needs of developed debtor countries will continue an

upward trend. Dagong estimates that the total debt financing needs for

developed countries will be over 26.5% of GDP, slightly higher than 26.2% in

2010 (see Table 1). Most of the debt financing needs of major debtor countries

will exceed 20% of GDP of the year; the highest financing needs in Japan will be

57.8%. In 2011, the rise in the total financing needs of these developed debtor

countries has increased their reliance on debt income in order to maintain

financial sustainability and stability of the sovereign credit relationship.

The key reason for the increased debt financing needs for developed debtorcountries in 2011 is the increase in the debt maturity scale. After a peak in bonds

for three consecutive years, the size of the debt due for major developed debtor

countries will continue a higher trend after 2011. Major financing powers such as

Japan, the United States, Germany and Spain have a large size of debt due in

2011 which is greater than 2010. Due to the fact that matured debt accounts for

about two-thirds of the total debt financing needs of developed debtor countries,

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which is the main factor in the increase of debt financing needs.

The second reason for the increased debt financing needs for developed

debtor countries in 2011 is that they generally proceed with fiscal policy

adjustment in 2011, but different fiscal adjustment has resulted in the overall

decline to be small. For developed countries, the average size of the deficit in2011 is expected to fall from 8.0% (ratio of deficit to GDP of the year) in 2010 to

6.9% (see Table 2). The degree of deficit reduction in developed countries reflect

the difference among different countries in the rate of increase in debt, financing

conditions, the macroeconomic outlook and the difficulty of the deficit

compression. After the outbreak of the financial crisis, the large-scale rescue of

the banking sector leads to the significant deterioration in the economic situation,

big and extended economic contraction for countries with fast increase in

government debt such as Ireland, Spain, Britain, Iceland and other countries, and

there will be more substantial fiscal adjustment in 2011. In addition, countries likeGreece, Portugal, France and other countries have long been in a situation with

high debt and weak economic growth, facing the pressure of deteriorating market

financing conditions; they will also make significant fiscal adjustment. Except

Greece that focused its adjustment in 2010, adjustments in other countries in

2011 will be 2% and above. For big debtor countries whose financing conditions

are still fairly relaxed, the government is insufficiently motivated to cut deficit

sharplyand the adjustment will be small, taking into account the importance of

maintaining economic growth momentum and confidence in the ability of national

financing, as in the United States; or takes uniform minor adjustments topractices, such as Japan and Germany. Meanwhile there are many countries that

due to their structural deficit throughout the years, resulted in a higher scale of

national government debt, although there was little increase in the temporary

deficit after the erupt of the financial crisis, yet it is very difficult to decrease the

structural deficit, so there is a slight decline in the deficit, such as in Italy, Belgium

and Austria.

In contrast, the debt requirement of developing countries is steadily

declining. Except Central and Eastern Europe and CIS countries, developing

countries gradually got rid of the negative impact of the financial crisis in 2010,economic growth contributed to improved financial situations. Most developing

countries have made it clear that in 2011 there will be withdrawal of stimulatory

fiscal policy, only to different degrees. Especially in emerging market countries,

rapid capital inflows and inflation pressure will cause the expansionary fiscal

policy to be withdrawn in great extent in 2011. In developing countries the

average deficit is expected to decrease from 3.1% (ratio of deficit to GDP) in

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2010 to 2.4% (see Table 2). According to the forecast of International Monetary

Fund on 52 emerging economies, the needs of their government financing will

drop from 9.75% of GDP in 2010 to 9% in 2011.

Table 1 2010-2011 Debt Financing Needs of Governments in Developed Debtor Countries Unit:%

2010e 2011p

Debt

Maturity

Fiscal

Balance

Financing

Needs

Debt

Maturity

Fiscal

Balance

Financing

Needs

Austria 5.2 -4.6 9.6 2.6 -4.0 6.6

Belgium 21.9 -3.2 24.1 18.5 -2.4 20.9

Canada 16.3 -2.5 18.8 13.2 -2.1 15.3

France 14.7 -8.0 23.5 16.0 -6.0 22.0

Germany 9.4 -4.5 13.9 9.3 -3.7 13.0

Greece 12.9 -9.6 23.8 18.8 -7.4 25.5

Iceland 11.2 -10.9 22.1 21.2 -6.8 28.0

Ireland 6.5 -30.7 37.2 6.2 -14.7 20.9

Italy 20.3 -5.1 25.4 18.2 -4.3 22.5

Japan 43.4 -9.6 53.0 48.9 -9.2 57.8

Holland 14.1 -6.0 19.8 13 -5.3 18.3

Portugal 15.4 -7.3 22.7 16.2 -4.6 20.8

Spain 11.7 -9.3 21.0 14.0 -7.0 21Britain 5.3 -10.1 15.4 7.5 -7.5 15.0

USA 15.2 -10.6 25.8 18.3 -9.3 27.6

Total

Financing

Needs

17.6 8.6 26.2 19.6 6.9 26.5

Source: IMF, Countries Ministry of Finance, Dagong

Note 1: all the data are the percentage of absolute value to GDP, the total financing needs are the

weighted average of the percentage value of all countries.. 2, e means the estimated value, p the

predicted value.

Table 2 The Worlds Major Financial Data UnitTrillion USD %

2011p 2010e 2009 2008 2007

Global Financial Revenue 21.5 20.2 19.5 20.6 19.3

Global Financial Expenditure 25.1 24.1 23.4 21.9 19.5

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Global Average Fiscal Deficit/GDP -5.7 -6.3 -6.6 -2.2 -4.2

Developed Countries Average Deficit/GDP -6.9 -8.0 -8.1 -3.6 -1.4

Developing Countries Average Deficit/GDP -2.4 -3.1 -3.2 0.8 2.0

SourcesIMFOECDAfrican UnionCountries Ministry of FinanceDagong

Notes1, Estimated according to data from 150 countries. Includes: 30 countries in the Middle East,44 countries in Africa, 32 countries in Latin America, 28 OECD countries, 6 countries in East and

South Asia, 4 countries in Central and Eastern Europe. 2, e means the estimated value, p the

predicted value. 3, the deficit rate is weighted average. 4, Developed and developing countries are

defined by the same method adopted by the International Monetary Fund.

2. In 2011 the developed debtor countries, constrained by the

macroeconomic environment of the debt system, lack of the basic

conditions to improve their solvency, their actual solvency will be in an

unstable stateIn 2011 global government debt levels will continue the trend of significant

increase, but the growth rate will slow down compared with 2008-09. Dagong

expects the global total size of government debt to GDP ratio to increase from

76.3% in 2010 to 79.6% in 2011, and debt growth rate to slow from 10.9% to

8.5% (see Table 3). The developed debtor countries that account for more than

90% of the global government debt are the driving force for debt increase.

Government debt in develop countries is expected to increase from 94.9% of

GDP in 2010 to 100.5% in 2011 while the level of government debt in developingcountries begins to decline or remains relatively stable.

It is difficult for developed debtor countries to reduce the deficit level,

meanwhile, with the weak economic recovery the debt ratio will not be stable in

the near future. The debt rolling pressure inflicted by high debt erodes a country's

debt-enduring space, the actual solvency of the developed debtor countries will

be in an unstable state. The main factors influencing its deficit and debt reduction

process are:

First, weak economic growth. In developed countries ever since the 1980s,financial liberalization policies have given rise to the continuous expansion of the

scale of borrowing; the ever-increasing debt scale in government, financial

institutions and the general public resulted in the over-expansion of the virtual

economy. The outbreak of the financial crisis indicates that economic laws are

playing their role in forcing developed countries to adjust the ratio between the

real economy the virtual economy, so that a concordance can be regained

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between the two; the whole process of deleveraging the economy is bound to

reduce the domestic demand in the private sector, resulting in the correction of

the abnormal economic expansion in the past. In this process, sluggish

consumption and investment will become the norm, while the economy will

experience a long period of low growth. In 2011, developed countriesgovernment expenditures will show an overall declining trend, the increase in the

scale of investment by corporations is not sufficient to absorb the large number of

the unemployed, private consumption is difficult to significantly rebound and the

level of economic growth will be slightly lower than in 2010 at an expected rate of

2.2%. Sluggish economy will lead to decreased fiscal revenues, while high

unemployment rate will result in increased social security spending, therefore,

the deficit size will be increased even if no additional expansionary fiscal policy is

adopted by the government.

Second, financial aid is still needed. After 2010 there were less cases of

direct capital injection into the financial sector by governments of developed

countries . However, financial institutions still face the serious challenge of two

types of risks. One is that the increased bad debts caused by the weak economic

recovery challenges the bank's balance sheet; although the banking industry has

been generally strengthened, the capital adequacy ratio is still insufficient. The

US banking industry experienced a high rate of bankruptcy in 2010, while the

possibility of a double-dip recession in the US real estate industry cannot be

ruled out in 2011, and continued high unemployment makes it difficult for the

bank failure to effectively decrease in the future. In the United States Freddie

Mac, Fannie Mae and the Federal Deposit Insurance Corporation and other

government-sponsored enterprises (GSEs) also need the support of the

government's strong capital injection to survive. Another risk is that banks are

facing impending financing pressures. The International Monetary Fund forecasts

in the "Global Financial Stability Report" in October 2010 that in the next 24

months, the banking industry in developed countries needs to finance for 4 trillion

USD worth of matured debts. The banking sector in developed countries rely on

wholesale funding, especially European banks, wholesale financing (including

loans from the European Central Bank) account for more than 40% of the total

debt in the eurozone banking system; the structural weakness creates a greater

liquidity risk for banks in the eurozone than those in the U.S., Japan and the

United Kingdom. Ireland, Spain, Greece and other countries rely more instead of

less on the liquidity support measures of European Central Bank. The prominent

liquidity risk of the banking sector makes the government need to provide

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guarantees on bank debts. For the foresaid reasons, the government can not

withdraw from the financial relief measures; and the financial aid will still affect

the size of government deficits and debts.

Third, it is difficult to cut the structural deficits. During the process of

implementing neo-liberalistic reform in the developed countries, tax revenue

reduced significantly, but it is hard to effectively cut the expenditures on social

welfare due to the pressures from various interest groups, resulting in

longstanding structural deficits that became even worse and intractable after the

drop of economic growth. In view of the existing high rate of tax burden, different

countries currently tend to take one-off measurescutting salaries of the public

sectors and expenditures on social services instead of public investment and

social security - to solve the issues regarding structural deficits, in an effort to

reduce the adverse impact of fiscal adjustment on the economy to the minimum

and reduce the resistance to the decision. Although many countries have initiated

reform on pension fund system, there is still a long way to go to implement the

overall reform of the social security system. According to IMF, it is estimated that

the pension fund system reform already performed in the developed countries

will make the predicted average expenditures on pension funds in those

countries increase 1% of GDP in the coming 2 decades, rather than 3% before

the reform. Nevertheless, the predicted growth in expenditures is still

considerable, which requires further reform. Almost no country has made

progress in medical system reform because it involves a wider range of interest

groups and more difficulties exist during the reform process. In 2010, pension

fund system reform was conducted in three countries, Greece, France and Spain

where massive protests broke out from the public, giving a sign of difficulties in

the reform.

Given the foregoing reasons, the total liabilities of the developed countries

will continue to rise in the coming 5 years, and consequently the solvency of

those developed debtor countries will not be stabilized. The vulnerability of credit

risks in the developed countries lies in the interest rate rise risk and financing risk,

wherein the former comes before rupture of financing. The pressure on rising ofinterest rate in the major developed debtor countries is accumulating. An obvious

sign for this is since December 2010, the yield of treasury bonds in major debtor

countries such as the United States, Japan and Germany has shown an upward

trend, reflecting an increasing concern of the market on the solvency of central

government of those countries though the figure is still low, and the governments

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pressure on debt repayment will increase rapidly in case of inflation, reverse

economic recovery or dumping of bonds.

Table 3 Global Governments Debt Data Unit: trillion US Dollar %

2011p 2010e 2009 2008 2007

Global Governments Total Debt 50.3 46.4 41.8 38.6 34.1

Global Governments Total Debt /GDP 79.6 76.3 71.9 63.9 62.4

Global Governments Debt Growth Rate 8.5 10.9 12.9 7.7 6.9

Developed Countries Governments

Debt /GDP

100.5 94.9 89.0 81.2 75.7

Developed Countries Governments

Debt Growth Rate

8.8 10.9 13.8 7.0 7.2

Developing Countries Governments

Debt /GDP

33.4 33.6 32.0 28.4 25.8

Developing Countries Governments

Debt Growth Rate

6.1 9.9 10.9 7.0 6.4

Sources: IMF, OECD, African Union, Ministry of Finance of All Related Countries, Dagong

Note: i) the figures in table 3 are calculated according to data of 125 countries, including 30

countries in the Middle East, 28 countries in the OECD, 20 countries in Africa, 32 countries in Latin

America, 8 countries in East Asia and South Asia and 7 countries in Central and Eastern Europe and

Commonwealth of Independent States; ii) e means estimated number and p means predicated

number; and iii) debt burden rate is the weighted average value.

Table 4 2010-11 Economic Growth and Debt Data in Developed Debtor Countries Unit: %

2010e 2011p

Economic

Growth Rate

Debt/GDP Net

Debt/GDP

Economic

Growth Rate

Debt/GDP Net

Debt/GDP

Austria 1.5 74.9 41.7 1.4 78.4 43.2

Belgium 1.6 102.5 82.4 1.4 104.3 84.2

Canada 3.1 84.4 31.4 2.6 85.5 33.7

France 1.7 92.4 57.1 1.6 97.1 61.8

Germany 3.4 78.9 50.5 2.6 80.7 50.3

Greece -4.0 129.6 97.8 -2.8 -138.1 106.5

Iceland -3.1 124.9 45.2 2.5 116.9 45.7

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Ireland -0.2 96.9 70.9 1.5 105.7 75.3

Italy 1.0 131.3 103.3 1.0 132.7 104.7

Japan 2.8 198.4 114.0 1.5 204.2 120.4

Netherlands 1.8 74.6 34.7 1.7 77.6 37.7

Portugal 1.8 83.3 59.0 -1.5 89.6 63.8

Spain -0.3 72.2 43.4 0.7 78.2 49.3

England 1.7 81.3 51.3 2.0 88.6 57.6

America 2.6 94.3 68.8 2.3 99.0 70.9

Sources: OECD, Dagong

Note: i) the economic growth rate refers to the actual number, and the debt data refers to the debt

of governments in different levels; and ii) e means estimated number and p means predicated

number.

3. As the inherent factors affecting the sovereign debt crisis in the

eurozone countries have not been fundamentally changed, sovereign debt

crisis in the eurozone countries will be further intensified in 2011, with

possible downgrade of sovereign credit ratings on Portugal and Spain

Some debt-ridden countries in the eurozone still have fragile credit risks in

2011, including Spain, Portugal, Italy and Belgium. The debt crisis in the

eurozone arisen from the crisis in Ireland might exacerbate again in 2011,

although it was temporarily pacified after November,2010; because first of all,

those countries macro economic situation has not significantly improved, and theeconomy may still be in recession or just realize slight growth in 2011, leading to

slow fiscal revenue growth and difficulty in cutting deficits. Second, the financing

requirements of the government in Greece, Portugal, Spain, Italy and Belgium

will exceed 20% of GDP in the respective country, and their banking industries,

at the same time, have considerable financing requirements. Because the banks

hold a large amount of government debts, a negative feedback loop is formed

between banks and government. Third, the excessively large size of external

debts of those countries will increase the possibility of speculative dumping.

Fourth, the dispute concerning the long-term solution to risks in treasury bonds inthe eurozone countries makes investors worry about highly risky countries losing

their credit guarantee. In case of bad macro economic performance in those

countries, investors continue to buy the treasury bonds of countries such as

Portugal based on their trust in Germany and France, two powerful countries in

the eurozone. However, these two countries recently proposed to implement

European Stability Mechanism (ESM), indicating that creditors might bear part of

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the losses after 2013. This reflects the dilemma for the powerful countries in the

eurozone while facing the conflict of domestic interest and interest in the

eurozone in response to the debt crisis, which will not allow them to help the

countries under crisis with their best efforts. In addition, the European Central

Bank is prudential to conduct Southeast European Project (SEP), showing thatthe European Central Bank is not willing to purchase a large number of the

treasury bonds of the brink counties in the eurozone as the Fed did.

Dagong believes the key risk of the debt-ridden eurozone countries is rising of

interest rate for financing in 2011, but there is still no default risk. The marginal

rate of interest for financing in those countries may rise substantially in 2011, but

given the historical low interest rate, the average interest rate for the government

to repay the debt is still low, reflecting relatively small proportion of interest

expenditure of the fiscal expenditure. In addition, with average long maturity of

the government debt, those governments dont have to repay the due debt in a

concentrated period of time. As for those European countries with large debt, the

international capital market only requires interest rate to be commensurate with

its risk level, and they can still receive some financing support. However, this

doesnt mean those countries do not need the bailout provided by EU and IMF.

On the contrary, more countries, such as Portugal and Spain, will have to ask for

bailout in 2011 for the reasons of preventing debt crisis from spreading and

endangering more countries. Accordingly, Dagong is considering the necessity of

adjusting sovereign credit rating of both local and foreign currency on the

foregoing countries.

According to the current financial bailout package set by EU, the temporary

bailout mechanism, totaling 750 billion euro including EFSF, could help some

small countries under deepened crisis by meeting their financing requirements,

such as Portugal, but can not withstand the potential risk events of countries

systemically influential in the eurozone, for example, exacerbated fiscal status in

Spain. The leading forces, including EU, European Central Bank and core

member countries, need to make even greater effort in collaboration of series of

intervention policies in 2011, to guarantee the fiscal sustainability in the eurozone

countries, avoid spread of debt crisis and seek for effective solution under a more

constructive policy framework, and consequently to maintain the healthy

economic development in the eurozone and the vitality of euro.

4. The United States, as the biggest country involved in sovereign debt

crisis around the world, will continue its quantitative easing policy when

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the country is in danger, and the world credit war will be escalated due to

the overflow of US dollars

The second round quantitative easing policy ongoing in the United States can

not change its weak domestic demand in the short term. In fact, it can only lower

the interest rate of US Treasuries so as to maintain stable interest rate in the

capital market in the long term, playing the indirect role of clearing some

obstacles for a stable recovery. However, the plan of purchasing 600 billion US

dollar Treasury bonds can not realize its predicted goal; and therefore, the United

States will hardly change its predetermined monetary policy in 2011. The

continuous implementation of such unconventional monetary policy in the United

States will lead to the escalation of world credit war and inflict greater losses for

related parties in the world credit system.

First, the trend of long-term depreciation of US dollar will result in haircut of

international creditors debts dominated in US dollar. As the interest rate of US

government debt is lowered due to the quantitative easing policy adopted by the

United States, creditors can not obtain the investment return commensurate with

the risk status of US Treasuries. At the same time, the depreciation will also

cause continuous exchange losses for the international creditors. Since June

2010, the US dollar has significantly depreciated compared with the currencies in

emerging market countries and some developed countries, and the depreciation

is 3.0% against RMB, 12% against Brazilian Real, 14% against South African

Rand, 19.5% against Australian dollar and 11.4% against Korean won. The trend

will continue in 2011, and international creditors will lose all their profits of the US

dollars in exchange for the export income under the gradual depreciation of the

currency. The behavior that the United States ignores international creditors

legitimate interests indicates a dramatic decline of the countrys willingness to

repay the debt.

Second, rapid inflow of capital will cause risks regarding inflation and asset

bubbles in the emerging market countries, which is unfavorable for those

countries to maintain their debt repayment credit. As a result, emerging market

countries, including some developed countries and regions with good economicrecovery, will have to withstand the economic and financial impact arisen from

the inflow of capital in 2011. If the capital inflow exceeded the capacity that the

domestic economic and financial development can absorb, some of the capital

will flow over in the real estate market, capital market such as stocks and bonds

and some commodity market to raise the asset price in the domestic market and

eventually accelerate the inflation. Most of the countries have transferred to

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neutral monetary policies and will speed up the contraction of their monetary

policies; however, due to the viscosity of the currency and imbalance of capital

inflow in different industry, and yet the policies and measures will exert general

restrictive effect on capital in the overall domestic market, the healthy

development of the domestic economy will inevitably be damaged. Some Asiancountries, for the purpose of eliminating the damage to the export in case of rapid

currency appreciation, take some intervention measures, which bring increase of

foreign reserves at a faster speed, and the consequent hedge cost is not

favorable for the inflation control. While the capital retrieves quickly, the fall of

asset prices will impose adverse impact on the robustness of the banks,

domestic consumption and stability of the exchange rate.

Third, the issuance of US dollar encourages numerous speculative capitals

into the global commodity market, leading to an increasing pressure on global

inflation. The quantitative easing policy conducted by the Fed in a continuous

way failed to promote the expansion of domestic credit scale; rather, the liquidity

accumulated inside the financial system, in addition to flowing to foreign markets,

has been used for financial speculative investment, causing surge of prices of

global commodities including energy, raw materials, and foods; and almost all

countries, as a result, have suffered losses arisen from the imported inflation to

different extent. In EU and the eurozone countries where see the slowest

recovery, the annual inflation rate has increased to 2.6% and 2.2% respectively

by December 2010, the figure for countries with serious inflation, such as

Romania, Greece and Hungary, has reached 7.9%, 5.2% and 4.6% respectively.

The anti-inflation measures make the weak economic recovery even worse.

In general, the capital inflow and inflation pressure that emerging market

countries are experiencing will, on one side, directly affect the governments

capacity for repaying local currency debt from the perspective of its influence on

the value of local currency, and on the other side, indirectly and more seriously

threaten the governments credit based on its adverse influence on healthy

development of macro economy and financial security.

Currency system is the carrier of credit system, and therefore, the value of thecurrency determines the quality of credit system. International currency is the

carrier of international credit system, and the instability of the currency value and

the depreciation trend arisen from the over issuance make the function of the US

dollar as the value scale distorted, which make other countries in the world pay

an undeserved cost for their subsistence and development. The strike of short-

term capital dominated in US dollar to the emerging economics has made the

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excess US dollar capital become the destructive factor to the healthy economic

development in different countries. The international credit system established on

the basis of US dollar as the intermediary has been twisted in a way that the

impartiality and reasonable aspect of the current international credit relations

gradually vanish. Different countries, in order to avoid unpredictable losses ontheir own interests, will have to seek for adjustment of international credit

relations, and the global credit war, no doubt, will become the turning point of

reforming international credit relations in 2011.

5. The credit risks of the developed debtor countries become the major

destructive force for the world economic development

The value production in the countries in the global debt system cannot catch

up with the speed of debt growth, not only lacking of the material basis to reduce

the debt, but also consuming the surplus of the creditor countries. Therefore, it is

difficult for the world economy to recover from the crisis as soon as possible. In a

long period after 2011, the credit risks of the developed debtor countries will

constitute the major obstacle to the healthy development of world economy.

From the perspective of the domestic economy in the developed debtor

countries, they will have to adopt fiscal austerity policy under the circumstance of

poor fiscal sustainability since 2011, but the negative growth of public

expenditure thereof will slow down the economic recovery of the developed

countries. Moreover, the indebtedness of the developed debtor countries will

constitute the major obstacle to the development of their domestic economy in arelatively long period in the future. The debt remaining high for a long time will

exacerbate the imbalance of the income allocation that capital owners will earn

more interest income, the part of national income obligated to be allocated to

ordinary citizens further reduces, and consequently weakening the consumption

ability of the public. In order to maintain the sustainability of debt and promote

economic growth, some super low interest rate policy is taken, which accelerate

the outflow of capital and is unable to effectively increase the investment.

Longstanding low interest rate and over issuance of currency will lead to the

undesirable consequence that serious inflation may come before the fulleconomic recovery. The GDP of the developed debtor countries accounts for

59% of global GDP, and the economic downturn in those countries ruins the

ability of developing countries to gain national income from export.

The extremely loose monetary policy taken in the major developed debtor

countries, such as the United States, the eurozone, Japan and Britain, can not be

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substantially changed in 2011, and the global excess liquidity caused thereof is a

potential disaster for the developing countries with weak strength and economic

vulnerability. The financial crisis occurred in Latin America and Southeast Asia in

1990s is tightly connected to the rapid inflow and outflow of short-term capital

from the developed countries, the great damage suffered by countries in Centraland Eastern Europe amid this financial crisis is also attributable to the same

reason. One can reasonably judge that the new round of strike from hot money

and global inflation will, as the less serious consequence, lead to stock turmoil,

fall of housing price and economic slowdown in the emerging market countries

and some developed countries, or as the more serious consequence, cause

sharp depreciation of exchange rate, economic recession or even political crisis,

especially in some countries in Latin America Central and Eastern Europe and

Africa under fragile political and economic status. In addition, although inflation is

not a problem for those developed countries who perform loose monetary policy,the global inflation risk is clear as driven by their monetary policies, and

economic performance of most of the countries will be eroded by inflation in

different degree in 2011.

6. The emerging creditor nations will maintain high economic growth, they

are the backbone to promote the healthy development of international

credit relations amid the unstable global credit system

Emerging creditor countries resumed high economic growth after the financial

crisis, playing an important role in driving the world economy. The emerging

creditor countries are less seriously impacted by the global financial crisis on the

ground that the governments can easily take measures to boost domestic

demands due to relatively high saving rate so as to maintain high economic

growth, which also make them the destination counties of the developed

countries with fastest export growth. Those emerging creditor counties, though,

face pressures on controlling inflation and rising of asset prices in 2011 and are

predicted to realize a slower economic growth than that in 2010; they are still the

countries with the fastest economic growth around the world.

In order to stabilize the international credit relations, it is crucial for theemerging creditor countries to keep or even increase holding the treasury bonds

of the developed debtor countries. The scale of the official foreign exchange

reserves of emerging creditor countries still increased rapidly in 2010. It is

predicted that in 2011, though the surplus of current account will continue to

decrease, the scale of foreign exchange reserves will be enlarged at a relatively

rapid speed because of the large-scale inflow of the capital. The emerging

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creditor countries become the major buyers of the treasury bonds and

government debts of the developed debtor countries by spending most of foreign

exchange reserves on those bonds, which is of great significance to maintaining

the developed debtor countries financing capability and helping them stabilize

their domestic finance and stimulate their economic recovery.

The emerging creditor countries will become the key to facilitate the healthy

development of international credit relations. The situation that developed debtor

countries rely on debt financing income for the operation of the countries will

remain unchanged for a long time in the future; and they, who have vested

interest in the current international credit relations, will not be motivated to

promote its healthy development. However, the emerging creditor countries who

are challenged by three negative factors, including low investment return, gradual

depreciation of US dollar and rapid appreciation of their local currencies, will be

motivated to drive the international credit relations to develop toward a fairer and

more reasonable direction. The emerging creditor countries will make a clearer

and more active effort in pursuing steady reform on international credit system in

2011. First, the continuous expansion of local currency capital markets in the

emerging countries, especially the acceleration of globalization of RMB capital

market, has shown that the emerging market countries are trying to get rid of the

position of immature creditors and transfer to mature ones for bonds

denominated in the local currency. Second, the emerging market countries will

increase their foreign direct investment (FDI). According to the United Nations

Conference on Trade and Development, it is estimated that the global FDI flows

will recover with double-digit growth in 2011-12, among which the emerging

market countries will become the engine for the growth of FDI, especially those in

Asia.