tag:theconversation.com,2011:/us/topics/fitch-ratings-2554/articlesFitch Ratings – The Conversation2023-08-10T12:42:10Ztag:theconversation.com,2011:article/2110922023-08-10T12:42:10Z2023-08-10T12:42:10ZUS losing Fitch’s top AAA credit rating may portend future economic weakness<figure><img src="https://images.theconversation.com/files/541770/original/file-20230808-25-a9fldt.jpg?ixlib=rb-1.1.0&rect=132%2C150%2C6139%2C3131&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Money doesn't grow on trees for governments either.</span> <span class="attribution"><a class="source" href="https://www.gettyimages.com/detail/photo/falling-dollar-bills-from-money-tree-royalty-free-image/157593960?adppopup=true">imagedepotpro/E+ via Getty Images</a></span></figcaption></figure><figure class="align-center zoomable">
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<p>The formerly pristine reputation of the U.S. government’s debt lost a little more luster after another prominent rating agency <a href="https://www.vox.com/2023/8/2/23817311/fitch-downgrades-us-credit-rating">demoted Uncle Sam from its AAA perch</a>.</p>
<p>What does a downgrade of U.S. creditworthiness like this actually mean?</p>
<p>While the downgrade is unlikely to have much of an impact in the short term, its implications about the state and size of U.S. indebtedness will likely reverberate on Capitol Hill, where <a href="https://apnews.com/article/congress-spending-bills-shutdown-aea04e44447fcb8a818a01a54854ac12">stalled negotiations over the budget</a> could mark a step toward the Biden administration’s first government shutdown.</p>
<p>Fitch Ratings’ decision on Aug. 1, 2023, led to small declines in the stock and bond markets. But as an economist who <a href="https://scholar.google.com/citations?user=czu6ChoAAAAJ&hl=en&oi=ao">studies the effects of monetary and fiscal policies</a>, I’ve got longer-term concerns about the downgrade’s implications for U.S. economic growth.</p>
<p>To understand why, you have to look at both the reasons for Fitch’s downgrade and what it means for U.S. borrowing going forward.</p>
<h2>Why Fitch downgraded the US</h2>
<p>Just like people, the federal government has to balance the income it takes in and the money it spends for each fiscal year. Most federal income consists of tax revenue.</p>
<p>Since 2001, <a href="https://fiscaldata.treasury.gov/americas-finance-guide/national-deficit/">that revenue has rarely covered enough</a> of the costs of everything the U.S. government pays for, from roadways to wars. When federal income falls short, the government fills the gap by borrowing money from investors. </p>
<p>That gap has gotten a lot bigger in recent years as the U.S. has spent trillions fighting COVID-19, contending with financial crises and funding several wars. As of Aug. 1, the U.S. Treasury <a href="https://fiscaldata.treasury.gov/datasets/debt-to-the-penny/debt-to-the-penny">owed US$32.6 trillion</a>, both to bondholders and other parts of the federal government. </p>
<p><a href="https://www.fitchratings.com/research/sovereigns/fitch-downgrades-united-states-long-term-ratings-to-aa-from-aaa-outlook-stable-01-08-2023">That’s part of the reason</a> that Fitch cut the U.S. government’s long-term creditworthiness by one notch, from AAA – its highest rating – to AA+. Fitch also cited an “erosion of governance,” specifically pointing to <a href="https://theconversation.com/political-compromises-like-the-debt-limit-deal-have-never-been-substitutes-for-lasting-solutions-206964">recent efforts by conservatives</a> to prevent the U.S. from raising its debt ceiling. </p>
<h2>What happened last time</h2>
<p>This was not the first time that a rating agency lowered the credit of the U.S. government. </p>
<p>In 2011, Standard & Poor’s, one of Fitch’s competitors, also <a href="https://www.cnn.com/2023/08/02/investing/premarket-stocks-trading/index.html">downgraded its rating for the U.S.</a> from AAA to AA+. S&P <a href="https://www.washingtonpost.com/business/economy/sandp-considering-first-downgrade-of-us-credit-rating/2011/08/05/gIQAqKeIxI_story.html">similarly blamed governance issues</a> – that downgrade followed a similar debt ceiling standoff – as well as the burden of rising government debt. </p>
<p>At the time, Fitch issued a warning but it didn’t cut the U.S.’s credit rating until now.</p>
<p>The 2011 episode had <a href="https://www.wsj.com/articles/SB10001424127887323984704578203593473607014">no long-term effects on financial markets</a>, including Treasury bonds – meaning investors remained happy to continue lending to the U.S. at favorable rates.</p>
<p>Does that mean Fitch’s downgrade will similarly have little long-term impact? Not necessarily.</p>
<h2>Why things might be different</h2>
<p>Any country seeking to borrow money in perpetuity needs lenders who are happy to lend.</p>
<p>For the U.S., that means it needs a constant supply of <a href="https://theconversation.com/why-the-national-debt-doesnt-matter-or-how-i-learned-to-stop-worrying-and-love-treasuries-38775">buyers for Treasury bonds</a> and the other securities it sells. These <a href="https://www.treasurydirect.gov/auctions/">securities are sold in auctions</a> and then traded on global financial markets.</p>
<p>Investors of all kinds around the world find Treasurys attractive. They’re <a href="https://www.investopedia.com/ask/answers/042215/what-are-risks-associated-investing-treasury-bond.asp">seen as safe</a>, because the U.S. government is considered less likely to default than, say, a company going bankrupt.</p>
<p><a href="https://www.fitchratings.com/">Rating agencies like Fitch</a> assess these risks and periodically adjust their credit rating scores based on their assessment on the ability of the federal government – and other borrowers – to keep up with their debt obligations.</p>
<p>“Repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management,” Fitch said in its announcement, in a reference to recurring <a href="https://theconversation.com/political-compromises-like-the-debt-limit-deal-have-never-been-substitutes-for-lasting-solutions-206964">fights among lawmakers over raising the debt ceiling</a>.</p>
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<span class="caption">Rifts between Republicans and Democrats are making it harder for Congress to pass budgets and get other important work done.</span>
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<p>But if economists and financial analysts deem Treasurys to be growing riskier, then investors may become less interested in buying them. Alternatively, they may demand a higher interest rate in exchange for taking on the risk that the U.S. may default on its debts.</p>
<p>So, however the market reacts, I believe that this downgrade reflects the real deterioration of America’s fiscal standing as well as its ability to safeguard it. </p>
<p>And as economists and financial analysts decide Treasurys are becoming a riskier security to hold – whether because of the size of overall U.S. debt or because <a href="https://theconversation.com/why-america-has-a-debt-ceiling-5-questions-answered-164977">political brinkmanship</a> is making a once-unthinkinkable default more likely – then investors may become less interested in buying them. Or, at least, they may demand the U.S. pay them more to take on the risk, resulting in higher borrowing costs for the government.</p>
<p>Ultimately, this means there will be less money for everything else the U.S. might want to spend money on – or the overall debt load will rise even faster.</p>
<h2>Limited options</h2>
<p>To cover its growing borrowing costs, the federal government has few options – none good.</p>
<p>It can borrow more money, which is seen as riskier – like taking out one loan to pay off another – and could result in an even lower credit rating and a continuous spiral of rising borrowing costs. Or it could hike tax rates or cut spending, both of which have political consequences and could be hard to accomplish given the <a href="https://www.pewresearch.org/short-reads/2022/03/10/the-polarization-in-todays-congress-has-roots-that-go-back-decades/">degree of polarization in Congress</a>.</p>
<p>Furthermore, <a href="https://doi.org/10.1111/rode.12661">research has shown that higher government debt</a> is generally associated with lower long-term economic growth, which reinforces the problem by reducing revenue and thus requiring more debt. </p>
<p>So, while Fitch’s downgrade doesn’t signal an imminent financial crisis, it does serve as a warning as Congress engages in its fiscal fights – including the <a href="https://apnews.com/article/congress-spending-bills-shutdown-aea04e44447fcb8a818a01a54854ac12">one over the budget</a> that will heat up in September.</p><img src="https://counter.theconversation.com/content/211092/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Hakan Yilmazkuday does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The rating agency demoted the US government’s creditworthiness to AA+, its second-highest ranking, on Aug. 1, 2023.Hakan Yilmazkuday, Professor of Economics, Florida International UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1652982021-08-11T12:29:32Z2021-08-11T12:29:32ZCredit ratings are punishing poorer countries for investing more in health care during the pandemic<figure><img src="https://images.theconversation.com/files/415530/original/file-20210810-19-178x8bn.jpg?ixlib=rb-1.1.0&rect=175%2C146%2C4607%2C3105&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Morocco wanted to spend more on health care. As a result, its credit rating was cut. </span> <span class="attribution"><a class="source" href="https://newsroom.ap.org/detail/VirusOutbreakMoroccoVaccination/14a66c3698cb4f118b52942707c17d6a/photo?Query=Morocco%20covid-19&mediaType=photo&sortBy=arrivaldatetime:desc&dateRange=Anytime&totalCount=210&currentItemNo=53">AP Photo/Abdeljalil Bounhar</a></span></figcaption></figure><p>Economic recovery from the COVID-19 pandemic <a href="https://www.un.org/development/desa/dspd/2020/07/recovering-from-covid19/">depends on sustained investment</a> in health care and social services. But while rich countries like the U.S. <a href="https://www.imf.org/en/Topics/imf-and-covid19/Fiscal-Policies-Database-in-Response-to-COVID-19">can borrow and spend relatively easily</a>, low-income nations face a major obstacle: their credit ratings. </p>
<p>A credit rating, like a credit score, <a href="https://theconversation.com/why-credit-ratings-matter-and-why-they-cant-be-ignored-69361">is an assessment of the ability of a borrower</a> – whether it’s a company or a government – to repay its debts. Lower credit ratings drive up the cost of borrowing.</p>
<p>This threat prompted <a href="https://group30.org/publications/detail/4799">some poorer countries to avoid tapping investors</a> for vital financing during the pandemic, while other governments that made plans to spend more on public services <a href="https://www.reuters.com/article/us-ratings-sovereign-idUKKBN2B92OY">were hit with credit ratings downgrades</a> from private companies. </p>
<p>My <a href="https://sase.confex.com/sase/2021/meetingapp.cgi/Paper/17513">forthcoming research</a> shows that when credit ratings fall, countries tend to spend less on health care. This should be a cause for concern as the delta variant of the coronavirus <a href="https://coronavirus.jhu.edu/map.html">drives up case counts across the world</a>. </p>
<h2>Punished for health care spending</h2>
<p>A wide gap has emerged between rich and poor countries in terms of how much they are spending to fight the coronavirus’s impact and shore up their health care infrastructure. </p>
<p>Governments in rich countries <a href="https://www.brookings.edu/opinions/how-to-balance-debt-and-development/">have provided trillions of dollars</a> in direct and indirect support for their economies, on average about 24% of their gross domestic product. Developing economies, on the other hand, have been able to spend only a tiny fraction of that, an average of about 2% of their GDP. </p>
<p>Recent research found that a country’s credit rating <a href="https://www.nber.org/papers/w27461">was the largest factor</a> in how much a government spent on COVID-19 relief. That is, the lower a country’s rating, the less it was able to spend on health care and other social services. </p>
<p>For instance, Ivory Coast and Benin are the only two countries in sub-Saharan Africa that <a href="https://www.brookings.edu/opinions/how-to-balance-debt-and-development/">have been able to borrow in international markets</a> since the pandemic began. Others chose not to borrow, at least in part, it seems, <a href="https://group30.org/images/uploads/publications/G30_Sovereign_Debt_and_Financing_for_Recovery_after_the_COVID-19_Shock-_Preliminary_Report_1.pdf">out of fear of the ratings downgrades</a> that might result. This has prevented them from financing much-needed spending. </p>
<p>The fear is justified. Countries that planned to increase spending, such as Morocco and Ethiopia, were punished for it. Morocco’s credit rating, for example, was downgraded to speculative grade, or “junk,” by <a href="https://www.reuters.com/article/morocco-rating-fitch-idUSL8N2HE5YL">Fitch</a> and <a href="https://www.bloomberg.com/news/articles/2021-04-02/morocco-cut-to-junk-by-s-p-kn0qnt09">Standard & Poor’s</a> because of its plan to spend more on social services. <a href="https://www.worldbank.org/en/news/feature/2016/08/17/analysis-how-do-credit-downgrades-affect-short-term-government-borrowing">The ratings cuts will make it much harder</a>, and more expensive, for it to borrow from international investors.</p>
<p>And Moody’s Investors Service <a href="https://www.reuters.com/article/ethiopia-bonds/update-1-moodys-downgrade-over-g20-common-framework-hits-ethiopian-bonds-idUSL5N2N52KD">slashed Ethiopia’s credit rating</a> after the country sought debt relief from a <a href="https://www.imf.org/en/About/FAQ/sovereign-debt#Section%205">new Group of 20 program</a> so that it <a href="https://www.bloomberg.com/news/articles/2021-07-07/ethiopia-in-negotiations-to-restructure-1-billion-more-of-debt-kqte6iuj?sref=Hjm5biAW">could spend more on supporting</a> its economy and citizens.</p>
<p>Overall, despite spending far less during the pandemic, poorer countries <a href="https://www.reuters.com/article/us-ratings-sovereign-idUKKBN2B92OY">were much more likely than wealthier ones to see their credit ratings cut</a> by Fitch, Standard & Poor’s and Moody’s – the three biggest private credit rating agencies. </p>
<p>Low-income countries are therefore forced to choose between keeping their credit ratings stable and undertaking critical social services spending. </p>
<p>In my own research, which is currently under peer review, I looked at ratings changes across a group of 140 countries from 2000 to 2018. I found that downgrades in credit ratings lowered public spending on health care. </p>
<h2>The IMF’s rating system</h2>
<p>Even the International Monetary Fund, which is the main global agency that oversees development finance, uses a rating system that tends to penalize governments for any increase in public spending. That includes spending invested in their health care systems. </p>
<p>The IMF evaluates the creditworthiness of countries through a system it calls its <a href="https://www.imf.org/en/About/Factsheets/Sheets/2016/08/01/16/39/Debt-Sustainability-Framework-for-Low-Income-Countries">debt sustainability framework</a>. Countries are classified into three levels of “<a href="https://www.imf.org/en/About/Factsheets/Sheets/2016/08/01/16/39/Debt-Sustainability-Framework-for-Low-Income-Countries">credit capacity</a>” - strong, medium or weak. </p>
<p>Weak countries are deemed to have a low ability to handle additional debt based on their current levels of indebtedness. No distinction is made <a href="https://www.brettonwoodsproject.org/2017/12/debt-sustainability-review-tinkering-around-edges-crises-loom/">between debt</a> that was a result of important long-term investments in social services like health and education and debt incurred by more wasteful spending. Countries are then required by the IMF to improve their ratings as a condition of aid, such as by putting the focus on debt repayment, short-term economic objectives and across-the-board spending cuts. </p>
<p>An op-ed in The Lancet <a href="https://doi.org/10.1016/S2214-109X(14)70377-8">blamed similar IMF-induced austerity</a> in the early 2000s for a reduction in health care spending in Guinea, Liberia and Sierra Leone, leaving them susceptible to the Ebola crisis in 2014. The three were the <a href="https://www.theguardian.com/world/2021/jun/19/guinea-ebola-outbreak-declared-over-by-who">worst-affected countries</a> in an epidemic that lasted two years and led to over <a href="https://www.cdc.gov/vhf/ebola/history/2014-2016-outbreak/index.html">11,000 deaths</a>. </p>
<h2>Ratings reform</h2>
<p>The IMF recently announced a <a href="https://www.nytimes.com/2021/07/09/us/politics/g20-imf-vaccines.html">plan to issue US$650 billion</a> in reserve funds that low-income countries can use to buy vaccines and expand health care. While that should help more countries not to have to choose between credit ratings and the well-being of their citizens during the pandemic, it’s only a short-term fix.</p>
<p>A recent United Nations report <a href="https://undocs.org/A/HRC/46/29">urged reform of how private credit ratings agencies are regulated</a>, arguing they lack accountability and make it hard for poor countries to fulfill their human rights obligations. A proposal to put a moratorium on the sovereign credit ratings of debt-burdened countries during crises <a href="https://www.reuters.com/article/us-emerging-debt-ratings/credit-downgrade-buffer-proposed-for-poor-nations-seeking-debt-help-study-idUSKCN2DG0US">would also help provide a buffer</a>. </p>
<p>Permanent changes in how the IMF and private credit ratings agencies evaluate debt, however, may be needed so that they’re not penalizing countries for making important investments in health care and other public services. That would help countries can build their health care infrastructure so that they aren’t caught off guard by the next pandemic.</p>
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<p class="fine-print"><em><span>Ramya Devan does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Low-income countries that sought to spend more on health care during the pandemic have been hit with ratings downgrades, while others avoided borrowing entirely.Ramya Devan, Professor of Economics, Stockton UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/771942017-05-07T12:41:01Z2017-05-07T12:41:01ZZuma’s attack on capital is digging South Africa into a deeper hole<figure><img src="https://images.theconversation.com/files/168106/original/file-20170505-21018-1exv774.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">
</span> <span class="attribution"><span class="source">REUTERS/James Oatway</span></span></figcaption></figure><p>South Africa’s governing party, the African National Congress, is adopting a dangerous political approach used in failing states like Algeria, Zimbabwe and Venezuela. Its aim is to deflect attention from its <a href="https://www.project-syndicate.org/commentary/south-africa-zuma-knowhow-shortage-by-ricardo-hausmann-2017-03">policy failures</a> and from numerous scandals surrounding President Jacob Zuma, his <a href="http://city-press.news24.com/News/the-rise-and-fall-of-duduzane-zuma-20160409-2">family</a> and the politically connected <a href="http://www.bbc.com/news/world-africa-22513410">Gupta</a> network.</p>
<p>The approach was allegedly crafted by <a href="http://www.timeslive.co.za/sundaytimes/stnews/2017/03/19/White-monopoly-capital-chosen-distraction-in-PR-strategy-to-clear-Guptas1">Bell Pottinger</a>, a London based public relations firm. It focuses on two concepts. </p>
<p>The first is the term “white monopoly capital”. The phrase <a href="http://www.timeslive.co.za/local/2017/03/11/What-exactly-is-%E2%80%98white-monopoly-capital%E2%80%99-Mzwanele-Manyi-offers-a-definition">broadly refers</a> to control of the economy by apartheid beneficiary capitalist oligopolies at the expense of South Africa’s black majority. </p>
<p>Accompanying it is the term “radical economic transformation”. This is defined differently by various senior government officials. But is <a href="http://www.702.co.za/articles/251821/so-what-exactly-is-radical-economic-transformation">understood to mean</a> rapidly changing the economy’s ownership, control, and production patterns in favour of the previously disadvantaged.</p>
<p>However, beyond damaging South Africa’s social fabric, framing the country’s current economic impasse in such a dichotomous politically charged way has negative consequences. </p>
<p>Firstly it distracts attention from the private sector’s real sins. This makes it more difficult to objectively hold business to account for its own nefarious activities. These include tender fraud, collusion, price fixing, fronting, illicit capital flows and <a href="https://panamapapers.icij.org/">tax evasion</a>. Framing the discourse as “white monopoly capital” muddies the waters. It becomes unclear whether exposing private sector crimes is merely a politically motivated assault, or an attempt to uphold the law. </p>
<p>Secondly the ongoing rhetoric will further damage the chances of economic recovery. This is because it will deter long-term domestic and international investment. It will also encourage companies to move their <a href="http://www.businesslive.co.za/bd/economy/2017-04-28-more-investment-in-sa-likely-to-be-put-on-ice/">capital elsewhere</a> and use complex tax avoidance mechanisms.</p>
<p>Thirdly trumpeting vacuous slogans is also unlikely to raise the prospects of credible policies that will deal with the country’s structural challenges.</p>
<h2>Populist slogans don’t fix structural challenges</h2>
<p>Over the last two decades South Africa has failed to modernise its labour and education systems. This has meant limited success in rolling back <a href="http://www.politicsweb.co.za/documents/south-africas-troubles-a-diagnosis">poverty, inequality and unemployment</a>. As a result the country has one of the highest unemployment rates and <a href="http://www.worldbank.org/en/country/southafrica/overview">gini coefficients</a> in the world.</p>
<p>The structural problems in the education system have resulted in <a href="http://www.universityworldnews.com/article.php?story=20100114190733824">poorly prepared</a> senior school and <a href="http://www.capetalk.co.za/articles/240257/black-students-are-not-adequately-prepared-for-university-life-edu-professor">university graduates</a>. This is despite the number of children attending school increasing exponentially since compulsory education was introduced in 1994. </p>
<p>Consequently, the country is poorly positioned to take advantage of the <a href="https://www.weforum.org/agenda/2016/01/the-fourth-industrial-revolution-what-it-means-and-how-to-respond/">“fourth industrial revolution”</a>. This is broadly understood as a range of new technologies that fuse the physical, digital and biological worlds. </p>
<p>Making things worse is the failure to adopt industrial policies to diversify the country’s export mix away from commodities to more <a href="http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0351.2008.00337.x/full">sophisticated</a> beneficiation and manufacturing activities. Commodities such as gold, platinum and coal, thus continue to comprise a significant portion of the country’s <a href="http://atlas.media.mit.edu/en/profile/country/zaf/">export earnings</a>. </p>
<p>Although the services-based sectors have given rise to an <a href="http://www.news24.com/MyNews24/Rise-of-the-black-middle-class-20140604">emerging middle class</a>, this new wealth is largely <a href="http://www.destinyconnect.com/2015/05/22/sas-black-diamonds-riddled-with-debt/">debt-fueled and consumption driven</a>. This limits savings, capital accumulation and <a href="https://www.businesslive.co.za/bd/opinion/2017-01-27-household-wealth-drop-trips-up-economy/">class mobility</a> for most of the population. </p>
<h2>What’s at stake</h2>
<p>In mid-2017 the rating agency Moody’s will review South Africa’s <a href="http://www.enca.com/money/moodys-pushes-back-sa-credit-rating-decision">sovereign credit rating</a>. This comes after two recent downgrades by global credit rating agencies <a href="https://www.businesslive.co.za/bd/economy/2017-04-07-fitch-downgrades-south-africa/">S&P and Fitch</a>.</p>
<p>A great deal hangs on Moody’s decision. If it downgrades the government’s rand-based bond credit rating two notches to junk status, the country will be expelled from the <a href="https://www.businesslive.co.za/bd/economy/2017-04-10-sa--risks--losing-r150bn-with-more-downgrades/">World Government Bond Index</a>. This will compromise its credibility as an investment destination. It will stimulate significant capital flight as international bond funds with investment-grade mandates are forced to sell off South African sub-investment grade bonds. </p>
<p>The rand will then depreciate and the trade deficit will widen. The central bank could then be forced to hike interest rates to curb inflationary pressures. Unemployment will rise and the government’s fiscal slack will be further depleted. </p>
<p>A downgrade of the rand denominated bonds would spark economic instability, and potentially significantly weaken the country’s private sector. The country’s politically connected elite could respond to this crisis by seeking to consolidate political power. This could be achieved using “radical economic transformation” to decimate the vestiges of “white monopoly capital.”</p>
<p>In the wake of the recent downgrades, some politicians have been peddling an <a href="http://www.news24.com/Columnists/MaxduPreez/sa-is-making-a-historic-mistake-20170425">illusion</a> that the country’s current woes are simply <a href="http://www.news24.com/SouthAfrica/News/we-want-the-rand-to-fall-so-that-when-it-rises-we-will-control-the-economy-maine-20161222">“short-term pain</a> for long-term gain” for the majority of South Africans. </p>
<p>But the experiences of numerous countries have shown that there is no gain from going down the populist economic path – <a href="http://whynationsfail.com/summary/">only state failure</a>.</p>
<p>There are tentative signs that this risk is beginning to take hold among some ANC leaders. Even Zuma’s newly appointed Finance Minister began watering down the term “radical economic transformation” at the recent World Economic Forum Africa gathering. Instead he opted to use the phrase <a href="http://citizen.co.za/news/news-national/1503159/gigaba-tells-investors-not-worry-radical-economic-growth-talk/">“inclusive growth”</a>.</p>
<p>What needs to be made clear is that the debate around “white monopoly capital” and “radical economic transformation” is about much more than statistics and definitions. It is about the ownership and control of both public and private capital by a politically connected elite. Thus it comes with the potential risk of turning South Africa’s entire economy into a centrally controlled patronage network.</p><img src="https://counter.theconversation.com/content/77194/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Sean Gossel receives funding from the University of Cape Town. </span></em></p><p class="fine-print"><em><span>Misheck Mutize does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The populism politics adopted by South Africa’s ruling party, African National Congress, mask a strategy to deflect attention from the party’s policy failures and to hide its many scandals.Sean Gossel, Senior Lecturer, UCT Graduate School of Business, University of Cape TownMisheck Mutize, Lecturer of Finance and Doctor of Philosophy Candidate, specializing in Finance, University of Cape TownLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/723822017-02-07T15:46:32Z2017-02-07T15:46:32ZBRICS wants to set up an alternative rating agency. Why it may not work<figure><img src="https://images.theconversation.com/files/155615/original/image-20170206-23524-1woh02u.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Leaders of the BRICS bloc of states in Goa, India where they hatched the plan to launch a new credit rating agency</span> <span class="attribution"><span class="source">REUTERS/Danish Siddiqui </span></span></figcaption></figure><p>The idea of establishing an alternative credit rating agency led by the BRICS bloc of countries is <a href="http://www.fin24.com/Economy/brics-to-fast-track-new-credit-rating-agency-20161016">gaining momentum</a>. But there are questions as to whether it will prosper given the major challenges it’s bound to face.</p>
<p>Leaders from the bloc made of Brazil, Russia, India, China and South Africa are championing the idea. The idea formerly emerged during the 2015 BRICS summit in <a href="http://www.fin24.com/Economy/brics-to-fast-track-new-credit-rating-agency-20161016">Ufa</a> and was affirmed by the Goa Declaration at the <a href="http://timesofindia.indiatimes.com/business/india-business/BRICS-countries-agree-to-set-up-credit-rating-agency/articleshow/54881697.cms">8th BRICS Summit</a>. Most recently South Africa’s President <a href="http://city-press.news24.com/News/zuma-bashes-rating-agencies-that-dont-seem-to-be-well-balanced-to-brics-20161026">Jacob Zuma said</a> BRICS countries had taken the decision that they could rate themselves, and perhaps others too. The aim would be to ensure a more “balanced view” when ratings are made.</p>
<p>Both <a href="http://www.reuters.com/article/us-brazil-ratings-s-p-idUSKCN0RA06120150910">Brazil</a> and <a href="https://www.wsj.com/articles/moodys-downgrades-russia-to-junk-status-1424469136">Russia</a> have recently been downgraded by Moody’s. And for over a year South Africa has lived with a <a href="https://theconversation.com/south-africa-is-skating-on-thin-ice-as-rating-agencies-weigh-their-options-69243">possible downgrade</a> by the “big three” Western credit rating agencies, Standard & Poor’s, Moody’s and Fitch.</p>
<p>The big three have faced increasing criticism. <a href="https://www.businesslive.co.za/bd/economy/2017-01-10-moodys-sees-more-downgrade-misery-for-sub-saharan-africa/">Critics claim</a> that the frequent downgrades of developing countries are unjust and serve Western political interests. </p>
<p>BRICS has started engaging financial experts on a business model for the new rating agency as well as what <a href="http://in.rbth.com/economics/finance/2016/10/18/brics-in-search-of-business-model-for-new-rating-agency_639889">methodology it would adopt</a>. </p>
<p>This isn’t the first time there’s been an attempt to challenge the big three. China, Russia, India and Brazil have all established their <a href="https://www.rt.com/business/326232-dagong-russia-rating-agency/">own credit rating agencies</a>. But none has ever come close to establishing itself as <a href="https://www.rt.com/business/158856-russia-raitings-agency-ministry/">an alternative</a>.</p>
<p>Will the BRICS initiative be the exception? </p>
<h2>Alternative view</h2>
<p>Critics of the big three were emboldened after the 2008 financial crisis. The rating agencies were forced to pay over $2.2 billion in fines relating to their complicity in the <a href="https://www.theguardian.com/business/2017/jan/14/moodys-864m-penalty-for-ratings-in-run-up-to-2008-financial-crisis">credit crisis</a>. This further damaged their credibility and heightened accusations, particularly in emerging countries.</p>
<p>Critics have also attacked the rating agencies’ <a href="http://blogs.reuters.com/alison-frankel/2013/02/05/can-we-now-admit-its-time-to-end-issuer-pays-credit-rating-model/">issuer pay model</a>. Under this system credit rating agencies are paid by the institutions being rated (debt issuers) and not by the investors who use the information, creating a conflict of interest. Critics also argue that this entrenches geopolitical biases.</p>
<p>The hope is that a new agency would compensate for the perceived bias in the global financial architecture. It would also <a href="https://www.bloomberg.com/news/articles/2016-06-26/brics-eye-a-new-rating-company-to-reduce-established-firms-grip">create competition</a> and offer investors, issuers and other stakeholders a wider choice and a more diverse view on creditworthiness. </p>
<h2>Weakness in the BRICS muscle</h2>
<p>Given that BRICS is home to <a href="http://globalsherpa.org/bric-countries-brics/">half the world’s population</a>, accounts for more than a quarter of the <a href="https://www.weforum.org/agenda/2016/04/what-is-the-state-of-the-brics-economies/">world’s economic output</a> and has recently set up a nascent New Development Bank, the countries under its banner have, between them, the capacity to establish an influential credit rating institution. </p>
<p>But questions have been raised about whether the new rating agency satisfies a financial need or is <a href="http://www.fin24.com/Economy/brics-ratings-agency-is-politically-motivated-20161018">politically motivated</a>. And if it will be <a href="http://www.fin24.com/Economy/brics-ratings-agency-is-politically-motivated-20161018">competent to provide an independent</a>, objective and credible credit rating service based on sound methodology.</p>
<p><a href="http://afkinsider.com/134083/brics-members-divided-on-creating-their-own-credit-rating-agency-worry-about-credibility/">China has already expressed concerns</a> about the <a href="http://www.sabc.co.za/news/a/c77c8e004e76d43c979fdf3de8e44b3d/Mixed-feeling-about-proposed-Brics-ratings-agency-20160310">credibility of a new agency</a>. <a href="http://www.cfr.org/financial-crises/credit-rating-controversy/p22328">Analysts</a> have also strongly criticised the probable adoption of the existing “issuer-pay” model. This would mean that the current model is simply replicated.</p>
<h2>Tough market to crack</h2>
<p>Considering that the three major rating agencies <a href="http://www.reuters.com/article/uscorpbonds-ratings-idUSL2N17U1L4">control more than 90%</a> of the world’s ratings business, establishing a new one wouldn’t be easy. It could take years, or even decades, to gel. </p>
<p>There have been previous attempts to launch new ratings agencies. All failed to take off. Examples include the Lisbon headquartered <a href="http://business.financialpost.com/investing/the-big-3-credit-ratings-agencies-have-a-new-competitor">ARC Ratings</a> which was launched in November 2013 as a consortium of five national ratings agencies from South Africa, Malaysia, India, Brazil and Portugal. It is yet to release its first sovereign rating. </p>
<p>The CARE Rating agency of India, started in April 1993, is still rating <a href="http://www.careratings.com/about-us.aspx">small to medium enterprises</a>.</p>
<p>The Global Credit Ratings (GCR) was established in South Africa in 1995. It is only <a href="http://www.sabc.co.za/news/a/9f1c57004ea230f196dddedd3b82934c/SA-rating-agency-to-start-offering-sovereign-credit-ratings-20161810">planning to start offering sovereign credit ratings from 2017</a>.</p>
<p>Others that have been launched include:</p>
<ul>
<li><p><a href="https://www.marc.com.my">MARC of Malaysia</a> which has been operational since 1996, but still only covers corporate ratings;</p></li>
<li><p>The Hong Kong based <a href="http://www.ibtimes.co.uk/russia-china-setting-universal-credit-rating-group-rival-wests-big-three-credit-raters-1483341">Universal Credit Rating Group</a> which was launched in 2014l </p></li>
<li><p>Russia’s Analytical Credit Rating Agency (ACRA) which was established in 2015;</p></li>
<li><p>the Beijing based China Chengxin Credit Rating Group, established in 1992;</p></li>
<li><p>and Dagong Global Credit Rating established in 1994. </p></li>
</ul>
<p>None has established itself as an alternative credit rating agency of choice for emerging countries.</p>
<h2>The task ahead</h2>
<p>The biggest task for a new BRICS credit rating agency will be to convince investors, particularly those from the US and Europe, that the ratings assigned are politically impartial. One way of doing this would be to adopt the <a href="http://in.rbth.com/economics/finance/2016/10/18/brics-in-search-of-business-model-for-new-rating-agency_639889">“investor-pays” model</a> where investors subscribe to ratings released by the agencies, and the subscription revenues become its source of income. This would ensure transparency and credibility while avoiding conflicts of interests. </p>
<p>But adopting a new model might not fly given that main users of the credit rating information are global pension and mutual funds which currently use at least one of the “big three” rating agencies. They are therefore unlikely to trust any ratings from the new BRICS rating agency with a yet to be tested rating model.</p>
<p>Adopting a new model would also be tricky as the BRICS rating agency would need to wield enough influence to be able to attract sufficient subscriptions from international funds. </p>
<p>Finally, investors will be sceptical about the new BRICS rating agency’s ability to compensate for losses in the event that it issues false ratings as the “big three” <a href="https://www.theguardian.com/business/2017/jan/14/moodys-864m-penalty-for-ratings-in-run-up-to-2008-financial-crisis">did</a> in the US. </p>
<p>The BRICS agency is likely to be another failed rating agency project unless it can overcome these three hurdles.</p><img src="https://counter.theconversation.com/content/72382/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Sean Gossel receives funding from the University of Cape Town. </span></em></p><p class="fine-print"><em><span>Misheck Mutize does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The BRICS bloc of states have resolved to establish an alternative credit rating agency to counter western dominance in the financial markets. Will it work?Misheck Mutize, Lecturer of Finance and Doctor of Philosophy Candidate, specializing in Finance, University of Cape TownSean Gossel, Senior Lecturer, UCT Graduate School of Business, University of Cape TownLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/519642015-12-10T04:07:15Z2015-12-10T04:07:15ZQ&A: why credit rating agencies matter for developing countries<figure><img src="https://images.theconversation.com/files/104845/original/image-20151208-32402-qdxikn.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Credit rating agencies often elicit criticism when they downgrade countries. </span> <span class="attribution"><span class="source">EPA/Justine Lane</span></span></figcaption></figure><p><em>Credit rating agencies have played a crucial role in international debt markets for more than 150 years. But they have often attracted controversy. Matthew Kofi Ocran, Professor of Economics at the University of the Western Cape, explains why rating agencies matter for developing countries.</em> </p>
<p><strong>What do credit rating agencies do?</strong></p>
<p>Credit ratings express an agency’s opinion about the ability and willingness of any issuer – governments, financial institutions, corporations, insurance companies and structured finance – to meet its financial obligations in full and on time. </p>
<p>There are more than 70 agencies around the world. But three dominate, controlling 91% of the <a href="http://www.esma.europa.eu/system/files/2014-1583_credit_rating_agencies_market_share_calculation_2014.pdf">global market</a>. They are Standard & Poor’s, Fitch and Moody’s.</p>
<p>Though there are slight differences in the rating scales that the big agencies use, all fall into two broad categories. These are investment and speculative grades. The investment grades range from AAA, very high credit quality, to BBB-, moderate credit risk. There are eight other notches between AAA and BBB-. </p>
<p>The speculative grade ratings start from BB+, which is associated with substantial risk. The bottom of the scale of the non-investment or speculative grade ratings is designated as C by Moody’s, and D by Standard & Poor’s and Fitch. The last rating on the scale suggests that the issuer is very close to default or already in default. When considered as numerical scales, there are 22 - from AAA to D ratings. </p>
<p><strong>Do ratings agencies matter for developing countries?</strong></p>
<p>Credit rating agencies are incredibly important for developing countries for a number of reasons.</p>
<p>First, the ratings act as a kind of moral suasion that compels developing countries to pursue more prudent and sensible monetary and fiscal policies. Sovereign ratings serve as an incentive for sound monetary and fiscal policies because performance on these policies forms an integral part of the rating methodologies.</p>
<p>Second, a favourable rating enables governments and companies to raise capital in the international financial market. </p>
<p>Institutional investors in both the developed and developing world rely heavily on rating agencies in making investment decisions.</p>
<p>This is because credit ratings are essentially opinions about credit risk. Ratings provide insight into the credit quality of an individual debt issue and the relative likelihood that the issuer may default. </p>
<p>Fund managers often don’t know enough about the risk associated with parties they’re interested in. Credit rating agencies provide an opinion about the credit quality of borrowers such as governments, corporates, financial institutions, and their related debt instruments such as bonds. </p>
<p>This means that to attract investors with deep pockets you can’t avoid having a credit rating. And a good one at that.</p>
<p><strong>Why are they controversial?</strong></p>
<p>The key point here is that credit ratings are opinions. That means they are bound to be disputed or elicit criticism. </p>
<p>The credibility of credit rating agencies took a knock during the <a href="http://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-being-felt-five-years-article">financial crisis</a>. They were criticised for failing to do a diligent job in evaluating the credit worthiness of bonds in the lead up to the crisis. Some had punitive fines <a href="http://www.economist.com/news/business-and-finance/21642130-justice-departments-treatment-sp-raises-some-serious-questions-fine-too-far">imposed on them</a> by US financial regulators. </p>
<p>That said, their role has by no means diminished. The international financial industry still relies heavily on their opinions.</p>
<p>Even though the agencies use their own unique rating methodologies, they usually arrive at comparable conclusions. Very often an analyst may form an assessment based on a number of quantitative and qualitative measures which is then presented to a committee for review. Standard & Poor’s follows this process. In some cases assessments may be based on a quantitative model. </p>
<p><strong>What impact do they have on economies?</strong></p>
<p>The opinions by the rating agencies tend to have an important effect on the cost of financing for governments and companies. For example, the benchmark 10-year Government Bond issued by countries with high investment grade <a href="http://www.bloomberg.com/markets/rates-bonds">ratings</a> attract very low interest rates. This is usually less than 2.50%. For instance, Canada with its AAA rating borrows at 1.58%; Germany (AAA) 0.58% and France (AA+), 0.90%. </p>
<p>For low rated <a href="http://www.tradingeconomics.com/country-list/rating">countries</a> such as Greece (CCC), the rate is as high as 8.33%. </p>
<p>But more importantly downgrades from investment grade to non-investment grade can elicit unfavourable, and costly, market reactions. For example, South Africa is just a notch above investment grade rating by both Standard & Poor’s and Fitch. Any further downgrade would cause a significant escalation in the cost of raising finances. That’s why countries pay a lot of attention to their credit ratings.</p>
<p><strong>How objective are they?</strong></p>
<p>Like any human institution, the rating agencies cannot be said to be perfect. The recent global financial crisis demonstrated this. That said, by and large, the credit rating agencies have been found credible and <a href="http://siteresources.worldbank.org/FINANCIALSECTOR/Resources/G-RatingAgencies&TheirMethodologies-LauraFeinlandKatz.pdf">transparent</a> in the methodologies used in their assessments. </p>
<p>The critical variables that go into the assessment and rating of sovereigns for instance, include information on:</p>
<ul>
<li><p>macroeconomic outcomes such as economic growth;</p></li>
<li><p>the state of public finances;</p></li>
<li><p>the external finance situation including exchange rate management;</p></li>
<li><p>political risk; and </p></li>
<li><p>the performance of state institutions. </p></li>
</ul>
<p>Naturally, when countries, municipalities and companies are downgraded the rating agencies are heavily criticised. But a review of the rating performances often suggests a strong correlation between the ratings countries get and their propensity to default. For example, historically triple A issuers and issues have defaulted less frequently as compared with those with lower credit ratings. Indeed, lower-rate issues and issuers have usually correlated with defaults across all the leading <a href="https://www.imf.org/external/pubs/ft/gfsr/2010/02/pdf/chap3.pdf">rating agencies</a>.</p>
<p>Each of the three leading rating agencies has a well-defined methodology for assigning ratings. In most instances, ratings committees vote on the rating outcomes before they are published. In most cases these committees are made up of a lead analyst, managing directors or supervisors as well as a number of junior analytical staff. Decisions are made by a simple majority of the committee. The agency’s reports are also made available to the issuer for factual verification. </p>
<p><strong>How accurate are they?</strong></p>
<p>Governments have from time to time questioned the opinions of the credit rating agencies. Developed world countries such as the US and France have strongly criticised major agencies because of a <a href="http://www.nytimes.com/2011/08/07/business/a-rush-to-assess-standard-and-poors-downgrade-of-united-states-credit-rating.html?_r=0%5D">downgrade</a>.</p>
<p>But this has not stopped agencies from sticking to their guns. An International Monetary Fund <a href="https://www.imf.org/external/pubs/ft/gfsr/2010/02/pdf/chap3.pdf">review</a> suggests that since 1975 all the sovereigns that have defaulted were rated as non-investment grade at least one year before they defaulted. Between 1983 and 2009 no country with investment grade rating defaulted. </p>
<p>And just about 1% of the corporations rated as investment grade risk defaulted over the period in question. These statistic speaks volumes about the credibility of the risk assessment opinions of the top three agencies.</p><img src="https://counter.theconversation.com/content/51964/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Matthew Kofi Ocran receives funding from the NRF. He is affiliated with the African Economic Research Consortium, Nairobi. </span></em></p>Credit rating agencies have come in for a lot of flack. But the bottom line is that to attract investors with deep pockets countries can’t avoid having a credit rating. And a good one at that.Matthew Kofi Ocran, Professor of Economics, University of the Western CapeLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/126032013-03-06T04:10:31Z2013-03-06T04:10:31ZDowngrade your expectations: it pays to be wary of credit ratings agencies<figure><img src="https://images.theconversation.com/files/20996/original/ngzgf4c8-1362539769.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Credit ratings agencies wield an enormous amount of social, economic and political power.</span> <span class="attribution"><span class="source">AAP</span></span></figcaption></figure><p>Evaluating the creditworthiness of countries is far from an exact science, yet the influence of credit ratings agencies is extraordinary.</p>
<p>Recently, the <a href="http://www.bbc.co.uk/news/business-21554311">UK government’s</a> debt rating has been downgraded by credit rating agency Moody’s from AAA to Aa1. It joins France, whose credit rating was downgraded to Aa1 in November 2012. In August 2011, Standard & Poor’s (S&P) had downgraded the US from AAA to AA+. </p>
<p>Credit ratings enable investors and markets to assess the risks of government securities. In the case of the UK, a downgrade could increase the government’s borrowing costs. It would also further reduce the value of the pound sterling and thus stoke inflationary pressures by increasing the cost of imports, though the weak pound may help British exporters.</p>
<p>But the notions of social stability, justice, and fairness are beyond the remit of credit ratings agencies. The general message from the Moody’s downgrade is that the UK government must deepen its austerity program and attack hard-won social rights on education, pensions, healthcare and unemployment. </p>
<p>Credit ratings can have serious impact on national and household accounts, but are also a major money-spinner. In 2012, <a href="http://ir.moodys.com/releasedetail.cfm?releaseid=739085">Moody’s</a> reported profits of
$1,077 million and 2013 is expected to produce record profits as investors seek shelter from growing financial uncertainty. However, the models used by credit rating agencies continue to produce odd results, and there is an urgent need to check the economic, social and political power exercised by the rating agencies.</p>
<p>The UK government has provided around a trillion pounds in loan and guarantees to ailing banks. For many years, the UK-based banks engaged in organised <a href="http://www.bbc.co.uk/news/business-17181213">tax avoidance</a>, <a href="http://www.bbc.co.uk/news/business-18880269">money laundering</a>, <a href="http://www.reuters.com/article/2013/02/06/us-libor-rbs-scandal-idUSBRE9150TB20130206">interest rate manipulations</a>, mis-selling of pensions, endowment mortgages, payment protection insurance and many other scandals. These scams did not persuade credit rating agencies to reduce the UK’s credit rating. Perhaps they approved of hot money rushing to London to take advantage of scams. Just as the regulators began to show signs of getting off their bended knees to giant corporations, Moody’s has downgraded the credit rating.</p>
<p>The very concept of risk assessment requires some openness and a relatively free flow of information, but credit rating agencies continue to give higher ratings to opaque jurisdictions. <a href="http://www.bloomberg.com/news/2013-02-19/paulson-leads-funds-to-bermuda-tax-dodge-aiding-billionaires.html">Bermuda</a>, whose opaque structures often enable corporations and wealthy elites to avoid taxes elsewhere, is rated Aa2, while the economic powerhouse China is rated Aa3. Oil-rich Saudi Arabia is rated Aa3, the same as the <a href="http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/9763615/Facebook-hid-440m-in-Cayman-Islands-tax-haven.html">Cayman Islands</a> which is well-known for its secrecy, opaque structures and fiddle factories that facilitate tax avoidance. <a href="http://www.ft.com/cms/s/0/9e812fb4-a1da-11dd-a32f-000077b07658.html">Iceland</a>, bailed out by the European Union and the International Monetary Fund enjoys a credit rating of Baa3. It shares the same rating as India, which has foreign currency reserves of around $300 billion. In December 2009, Moody’s boldly stated that “investors’ fears that the <a href="http://www.moodys.com/research/Moodys-Investor-Fears-Over-Greek-Government-Liquidity-Misplaced--PR_191285">Greek government</a> may be exposed to a liquidity crisis in the short term are misplaced”, but barely four months later, the Greek government was negotiating bailout deals.</p>
<p>Credit rating agencies have a history of poor performance. <a href="http://www.uic.edu/classes/actg/actg516rtr/Readings-M/04-Enron-Senate-Report-Rating-agencies.pdf">Enron</a>, the fraud-ridden US energy giant, collapsed in December 2001. Right until its demise, it continued to attract favourable credit ratings. These enabled the company to overstate its profits and assets and understate its liabilities. Credit rating agencies said that lessons will be learnt, but the banking crash once again has shown that the emperor had no clothes. <a href="http://www.gpo.gov/fdsys/pkg/CHRG-110hhrg51103/html/CHRG-110hhrg51103.htm">Moody’s, Standard & Poor’s, and Fitch</a>, the world’s biggest credit rating agencies, maintained A-ratings for Lehman Brothers and US insurance giant AIG until early September 2009, just days before their collapse and bailouts.</p>
<p>In 2008, just prior to the banking crash, there were about twelve AAA-rated companies and about the same number of AAA-rated countries, but around 64,000 complex financial instruments received the AAA-rating. Banks sliced, diced and repackaged subprime mortgages, collateralised debt obligations and structured finance deals into what they described as “safe investments”. This illusion was supported by the AAA-ratings given by rating agencies, which subsequently turned out to be junk. The regulators were content to let the banks hold less capital for AAA securities and, as a result, banks did not have the buffer to deal with toxic debts. Investors, governments, taxpayers and markets were duped, and the whole financial system came tumbling down.</p>
<p>Credit rating agencies wield enormous economic, social and political power, but do not owe a “duty of care” to the stakeholders affected by their opinions. These issues have now become the subject of legal disputes. In February 2013, The <a href="http://www.justice.gov/opa/pr/2013/February/13-ag-156.html">US Department of Justice</a> sued Standard and Poor’s (S&P) for issuing “inflated ratings that misrepresented the securities’ true credit risk”.</p>
<p>The Australian case of <a href="http://www.imf.com.au/pdf/Judgment%20of%20Jagot%20J%20dated%205%20November%202012%20re_%20Local%20Government%20Financial%20Services%20Pty%20Ltd%20%28No%205%29.pdf">Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5) [2012] FCA 1200</a> held that credit ratings agency S&P was liable for the “misleading and deceptive” ratings issued by it because it made unfounded and irrationally optimistic assumptions in its analysis. Protracted litigation will follow as credit rating agencies try to wriggle out of any social obligations. These issues are important because credit ratings form the basis of economic experiments that can result in austerity drives, unemployment, loss of social welfare, and ruined lives.</p><img src="https://counter.theconversation.com/content/12603/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>I do not have any direct financial dealings or investment in any organisation mentioned in this article though in common with millions of people I am affected by the practices of the organisations named in this article.</span></em></p>Evaluating the creditworthiness of countries is far from an exact science, yet the influence of credit ratings agencies is extraordinary. Recently, the UK government’s debt rating has been downgraded by…Prem Sikka, Professor of Accounting, Essex Business School, University of EssexLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/54822012-03-14T03:06:30Z2012-03-14T03:06:30ZWhy we should be wary of ratings agencies<figure><img src="https://images.theconversation.com/files/8228/original/8p938x2j-1330492868.jpg?ixlib=rb-1.1.0&rect=124%2C65%2C3306%2C2224&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Demonstrators in front of Standard & Poor's credit rating agency offices in Paris 15 January 2012</span> <span class="attribution"><span class="source">AAP</span></span></figcaption></figure><p>For decades, credit ratings agencies were largely ignored by the masses, but in recent months they have continued to hit the headlines again and again. The big three (<a href="http://www.standardandpoors.com/SPComIPResolver">Standard & Poor’s</a>, <a href="http://www.moodys.com/Pages/default_au.aspx">Moody’s</a> and <a href="http://www.fitchratings.com/australia/index.cfm">Fitch</a>) have relentlessly embarked on an orgy of downgrading sovereign debt, despite calls for them to reign in their negative ratings. </p>
<p>In August, S&P downgraded the US credit rating, despite a last-minute Congressional agreement on raising the federal debt ceiling to avoid default. In January, they downgraded the credit ratings of nine European countries, stripping France and Austria of the top triple-A rating. The move put Italy at BBB+ level, the same as Kazakhstan, and pushed Portugal into junk status.</p>
<p>While the credit ratings agencies have come under fire from all sides in recent years, the effect of their downgrades is still under debate, more so since it has become common knowledge that the downgrading happens retrospectively. When the U.S. credit rating was downgraded to AA+, there were no adverse effects on the ability of the U.S. Treasury to borrow at low rates. In Europe, many countries have been severely punished by financial markets by having to pay more for borrowing, but this isn’t necessarily directly linked to downgrades by the ratings agencies. High borrowing costs have been par for the course for European countries for some time. </p>
<p>Therefore, the question is: why it is still “business as usual” for the rating agencies? They’re providing us with retrospective information that is useless at best - and destructive at worst. </p>
<p>Through a combination of the agencies’ recklessness in the run-up to the global financial crisis and their saturation of the market with excessive downgrades since the crisis began, we have come to the point whereby the ratings they spew out can largely be ignored. Yet they are still treated with a respect that many feel they do not deserve. We only need to look at the <a href="http://en.wikipedia.org/wiki/Basel_III">Basel III</a> provisions, which still require the calculation of regulatory capital on the basis of the ratings provided by the rating agencies.</p>
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<span class="caption">Barack Obama signing the financial reform bill into law.</span>
<span class="attribution"><span class="source">AAP</span></span>
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<p>In the US, the <a href="http://en.wikipedia.org/wiki/Dodd%E2%80%93Frank_Wall_Street_Reform_and_Consumer_Protection_Act">Dodd-Frank Act</a>, signed into law in July 2010, prohibits the use of ratings agencies when <a href="http://www.economist.com/node/21542463">calculating capital charges</a>. The decision of US regulators to disregard the views of the rating agencies is due to the belief that they contributed to the advent of the global financial crisis by rating junk debt instruments (CDOs) as AAA securities. </p>
<p>In its report on the global financial crisis, the U.S. <a href="http://fcic.law.stanford.edu/">Financial Crisis Inquiry Commission</a> concluded that “the failures of the credit rating agencies were essential cogs in the wheel of financial destruction”, that “the three credit rating agencies were enablers of the financial meltdown”, and that “this crisis could not have happened without the rating agencies”. The report states that “from 2000 to 2007, Moody’s rated nearly 45,000 mortgage-related securities as triple-A” and that “in 2006 alone, Moody’s put its triple-A stamp of approval on 30 mortgage-related securities every day”. </p>
<p>It’s only fair to say that the role played by the rating agencies in the materialisation of the global financial crisis would not have been possible without the Basel II requirement that regulatory capital be calculated on the basis of risk-weighted assets, where the weights are determined by the ratings agencies. Since financial institutions wanted to minimise the regulatory capital as required by Basel II, they rushed to accumulate triple A securities, including the bonds issued by Greece (at one time rated AAA by the rating agencies), thus making it easy for Greece to borrow excessively. Hence the rating agencies, in collaboration with the Basel Committee, have not only contributed to the advent of the global crisis but also to the current European credit crisis. </p>
<p>Reliance on the rating agencies to determine the riskiness of assets sounds ludicrous at this stage. One has to remember why the likes of Citigroup and Bank of America were <a href="http://www.economist.com/blogs/freeexchange/2010/09/basel_iii">brought to their knees</a>: it was exposure to the triple-A securitised debt, an allegedly risk-free asset manufactured, with the help of the rating agencies, from risky loans. The agencies granted these high ratings either because they were incompetent or corrupt. </p>
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<span class="caption">Standard & Poor’s offices in New York.</span>
<span class="attribution"><span class="source">AAP</span></span>
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<p>It has been well established that it is questionable whether or not the rating agencies meet the credibility, independence, objectivity and transparency criteria demanded by Basel II and Basel III. It is ironic then, that the Basel rules still take into account the views of the rating agencies. </p>
<p>Two economists at the Bank for International Settlements, where the Basel Committee resides, argued against the use of the ratings of these agencies back in 2000. The economists suggested that “<a href="http://siteresources.worldbank.org/INTMACRO/Resources/HawkinsTurner.pdf">many would be wary of putting too much emphasis on the assessment of credit-rating agencies</a>”. </p>
<p>To support their argument, the economists referred to the performance of the rating agencies during the Asian crisis. The big three refrained from downgrading most Asian countries before the crisis, when imbalances were developing, but continued to downgrade in the midst of the crisis, exacerbating the situation. The findings concluded that “rating agencies were backward-looking rather than forward-looking in their assessments”. </p>
<p>The credit rating agencies’ response to the outcry was to state that their advice constitutes “an opinion” that is only valid for a “point in time”. They argue that they never promise or guarantee a certain rating to a security, and that any change in circumstance regarding the risk factors of a particular security will invalidate their analysis and result in a different credit rating. So, what’s the point?</p>
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<span class="caption">The offices of Fitch Ratings in New York.</span>
<span class="attribution"><span class="source">AAP</span></span>
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<p>Apart from the destruction they inflicted on humanity by contributing to two major crises that have hit since 2007, the list of accusations against the rating agencies is long. They don’t downgrade companies and countries promptly enough (Enron’s rating remained at investment grade four days before the company went bankrupt). This, coupled with the fact that they have been accused of manipulating business executives and are known to have engaged in heavy-handed blackmail tactics in order to solicit business from new clients (pay or run the risk of being downgraded), illustrates the point. </p>
<p>The gang of three represent an oligopoly that is kept intact by barriers to market entry. It has also been suggested that a conflict of interest is involved in assigning sovereign credit ratings, as the agencies have a political incentive to show that they do not need stricter regulation by being overly critical in their assessment of governments intending to regulate them. </p>
<p>In the big picture, a financial world without the rating agencies would not be in a worse shape than it is now. The market itself could do a better job revealing deteriorating creditworthiness than any of the big three.</p><img src="https://counter.theconversation.com/content/5482/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Imad Moosa receives funding from ARC.</span></em></p>For decades, credit ratings agencies were largely ignored by the masses, but in recent months they have continued to hit the headlines again and again. The big three (Standard & Poor’s, Moody’s and…Imad Moosa, Professor, Finance, RMIT UniversityLicensed as Creative Commons – attribution, no derivatives.