The recent downgrading of the United States’ credit rating brought into focus the fact that sovereign credit rating is today a largely unregulated industry. While a rating is a prime driver of investment decisions and collateral eligibility standards, it is also a potential, though inadvertent, contributor to global financial instability. This author argues for a different way of rating sovereign nations.
A sovereign state is supreme; it can act as it wishes. However, the economic and political potency of a sovereign can be severely diminished if that state’s credit-worthiness or ability to settle debt-triggered liabilities are called into question. Recent histories of sovereigns made humble by unfulfilled debt obligations are still fresh, or at least mostly so. While the example of Ireland may seem blurry for some, , the ongoing difficulties of Greece are very much in focus. Moreover, Portugal and Spain are looming in the not-so-distant background. Even the mighty United States has suffered. In 2010, its credit rating was lowered by Dagong, a Chinese credit-rating agency. The U.S. then had to suffer through the humility of relinquishing its ranking as the most credit-worthy state to the likes of Canada and the Netherlands (according to the same Dagong). The recent downgrading by S&P greatly exacerbated the damage. This is anything but a small feat, as a reduction in sovereign rating could spell out higher interest rates on debt and tighter conditions for access to capital.
What is a sovereign credit rating and who determines it? What are the observed flaws? Could a supra-national framework — in effect, an independent international organization – conduct a relatively flawless and more objective process and outcome?
The following article is an attempt to answer these questions. It starts by delineating the concept and the existing players. This is followed by an analysis of the flaws in the process. The article then proceeds to discuss an alternative — a supra-national organization with a functional focus and political impartiality.
Sovereign credit rating: Today’s how and who
Let us recall that sovereign ratings are assessments of the relative likelihood that a borrower, in this case a government or a state, will default on its obligations. It is a risk assessment assigned by the credit rating agencies to the obligations of a government in question. It rests on an analysis of the sovereign’s competencies, and measures the solidity of its economic, and partly political, foundations. Sovereign credit rating is critical for accessing capital and the cost of capital.
The significance of sovereign credit rating has increased dramatically as a result of the events of the past few years. Governments with greater default risk than is commonly accepted continue to seek capital and financing in the international bond markets. Their credit rating is a capital-market threshold measure. Lending under these conditions has historically been a risky business, since a burst in sovereign lending in the 1920s ended with a wave of defaults during the Great Depression. (Cantor and Packer, 1995). More recent events, in Iceland, Greece and Ireland, underscore this point. The rating agencies have a market impact based on the information that they reveal as well as the level of certification that they extend (IMF, 2010).
The ratings industry
The sovereign-rating industry is dominated by three American firms — Moody’s, Standard and Poor’s, and Fitch. The process is essentially a “one size fit all “process (Bhatia, 2002), at least if one is to go by the criteria established by the American market leaders. Their analysis follows a set of parameters for which a standard or a yardstick is established. These parameters commonly include common macroeconomic performance measures as GDP growth, fiscal balance, monetary policy and the state of the external accounts. They also cover the political as well as the social. They consider the present as well as the future and are as much quantitative as qualitative. A country scorecard is accordingly derived. Among those with a consistently “brilliant” scorecard is the United States, even if one is to include the recent “snub”.
Though the broad reference frameworks of those agencies are identical, there are some differences in the way that individual factors are classified and clustered. Fitch’s clusters include, for example, macroeconomic policies, performance, prospects, structural features of the economy, public finances and external finances. Moody’s includes economic strength, institutional strength, financial strength of the government, and susceptibility to event risk (Moody’s, 2006). Standard & Poor’s includes political risk economic structure, economic growth prospects, fiscal flexibility, general government debt burden, offshore and contingent liabilities, monetary flexibility, external liquidity, and external debt burden (Standard and Poor’s, 2006).
Dagong, the Chinese rating agency, suggested a rating construct that deviates in many ways from those followed by other, namely American agencies. Dagong develops a different cluster of variables and gives them different weights. Its rating standards include management capability, economic strength, financial strength, fiscal strength and the foreign exchange strength. The essence of the approach is the notion that sovereign newly created “social wealth” supports the national funding capacity and constitutes the primary source of debt repayment. “Social wealth” is an expression of sovereign competencies across a wide spectrum going all the way from management capability to economic, financial and fiscal strength (Dagong 2010).
Sovereign rating in 2010 according to the three US agencies and Dagong of China
Dagong’s ratings deviate, sometimes considerably, from those developed by its U.S. counterparts. This applies to nearly all western European countries, as well as Canada and the United States. The United States downgrading, at this point in time, is remarkable, given its long history of prime grading, the reserve currency status of the U.S. dollar and the continued inclination of investors to hold U.S. treasuries (The Economist, April 20,, 2011).
1. High concentration, low regulation
High sovereign-rating industry concentration, or the fact that the combined market share of the three key players is estimated at 80 percent or more of the total global sovereign rating market (Global Times, July 13, 2010), and the little regulation that exists are probably the most critical flaws in the current process. The oligopolistic market structure encourages collusion and precludes the development and adoption of other approaches for rating sovereigns. Very loose regulation of the industry has, moreover, increased the influence of those operators. A Credit Rating Agency Reform Act of 2006 gave the SEC oversight of the agencies and presumed greater competition. But the Act has done little to change the high concentration in the industry.
2. Potentially misleading economic policy trigger
Sovereign ratings are usually the basis for key economic policy decisions at the country level and beyond. Flaws in ratings, even minor ones, could result in flaws in the macroeconomic policies of the country and flaws in decisions taken by many an external body, such as the World Bank. Witness the ratings issued in the context of Iceland, Greece and more recently, Ireland, before the by now well-documented indebtedness triggered the economic implosion of all three countries. To rate the United States, a country with high debt, low savings, unreliable structured financial instruments and institutions as AAA has had serious national and global consequences. It allowed, for example, an unquestioned massive increase in international indebtedness and undermined the U.S. dollar as an international reserve currency.
3. Limited anticipatory function.
Ratings have many applications and one of the most significant is that they influence economic policy making. A sovereign credit rating should, ideally, anticipate economic events and call for adjustment or intervention. Yet sovereign credit ratings of the mid- and late 90’s, for example, failed to anticipate the Asian financial crisis of 1997 and beyond. Early warning signals could have highlighted the serious deviation of the prime exchange rate and capital flow parameters, and drawn the attention of Thailand, Indonesia and Malaysia to the imminent danger. Nothing of this nature took place. Such inaction seems to be the case regardless of the type of crisis (Reinhard, 2002). Even advance rating adjustment warnings have seemed, at times, ill timed and ill formulated. Standard & Poor’s first warning in 70 years that the United States credit rating was in jeopardy because of its public debt was both late and timid (The Economist, April 22, 2011). It should have been strongly and roundly voiced during the days of budget deficit escalation of earlier American administrations.
4. The underlying database
Data underlying the ratings process are collected from the sovereigns themselves, leaving the door wide open to intentional or unintentional self-serving. The quality and reliability of the data are also dependent on the involved sovereign’s quality of record keeping, record updating and record collection (Bhatia, 2002). United States agencies, moreover, include the World Bank Governance Index, a Corruption Index, an Ease of Doing Business Index, the Global Competitiveness Index and the Human Development Index in reference-evaluation measures. Close examination of those indices reveals little relationship to the formulation of the sovereign credit risk. Weights given to rating drivers are also not uniform in their impact (Dagong, 2010). A high weight given to the reserve currency status of a sovereign, for example, could influence the ultimate rating outcome by overshadowing the adverse effects of other criteria that result in a negative valuation.
5. Questionable market response
A high degree of measured judgment is built in to the market response to sovereign credit ratings. Take Japan, for instance. A debt-laden economy, it continues to borrow from the global capital market at low rates. Moody’s stripped it of its AAA rating in 1998 and S&P did so in 2001 (and others followed). Yet this did not discourage loyal investors from continuing to feed the developed world’s heaviest debt burden (The Economist, April 22, 2011).
Is “Supra sovereign “rating the answer?
Sovereign credit rating is today a largely unregulated industry. Yet a rating is a prime driver of investment decisions and collateral eligibility standards. It is also a potential, though inadvertent, contributor to global financial instability.
One way out of this dilemma is to eliminate the tacit involvement of the sovereigns in the ratings process and move the issue beyond the reach of the freewheeling forces of the market. The American rating agencies have, for example, been implicitly allowed by the United States government to fulfill a quasi-regulatory role in the sovereign rating industry. Sovereigns elsewhere provide the prime inputs into the rating process and are able to influence those.
A solution could envisage the creation of an international organization that ignores and transcends national interests, and blends unbiased functional competency with political vision. The organization would conduct an independent analysis, review the results of others’ analysis, and provide advisory support. The independent analysis would be based on objective models, eliminating conceptual and operational bias. The review function would assess and judge the results of ratings done by key agencies operating in the industry. Finally, advisory support would include prescriptive as well as anticipatory advice.
There is no shortage of arguments to support an initiative of this nature. First is the urgent need for a truly authoritative international regulatory body that can express a confident and authoritative view with regards to the credit worthiness of a sovereign. This is not only a question of need but of completeness. The ongoing process of restructuring the international financial system would not be complete without a valid, reliable and trustworthy system of country credit rating. The unique nature and implications of international credit relationships call for the establishment of a competent organization that is able to reveal debtors’ actual risks. The new organization would, as Dagong puts it, blend independence, justice, innovation and, for whatever it may mean, fairness.
Sovereign credit rating is today an unregulated industry. It is too critical an industry to be left to the vagaries of market forces. Setting up an international organization would be a creative solution and one that would open new venues. It would also ensure a professional, functional, independent and yes, “fair” approach.
Larrain G, Reinen H, von Meltzan J, Emerging market risk and sovereign credit rating OECD Development Center, April 1997
Rating agency could break foreign firms’ oligopoly
Source: Global Times, [02:17 July 13 2010
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Sovereign credit ratings before and after the financial crisis
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A guide to Moody’s credit rating, Moody’s, 2006
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IMF, Uses and abuses of Sovereign Credit Rating, 2010
The Economist, “Standard & Poor’s may not have said anything new. That’s no reason for American politicians to ignore it”, Apr 20th 2011
Canor R, Packer F, Determinants and impact of sovereign credit rating, FRBNY Economic Policy Review, Oct 1996
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