Q&A: why credit rating agencies matter for developing countries

Credit rating agencies often elicit criticism when they downgrade countries. EPA/Justine Lane

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.

What do credit rating agencies do?

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.

There are more than 70 agencies around the world. But three dominate, controlling 91% of the global market. They are Standard & Poor’s, Fitch and Moody’s.

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-.

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.

Do ratings agencies matter for developing countries?

Credit rating agencies are incredibly important for developing countries for a number of reasons.

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.

Second, a favourable rating enables governments and companies to raise capital in the international financial market.

Institutional investors in both the developed and developing world rely heavily on rating agencies in making investment decisions.

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.

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.

This means that to attract investors with deep pockets you can’t avoid having a credit rating. And a good one at that.

Why are they controversial?

The key point here is that credit ratings are opinions. That means they are bound to be disputed or elicit criticism.

The credibility of credit rating agencies took a knock during the financial crisis. 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 imposed on them by US financial regulators.

That said, their role has by no means diminished. The international financial industry still relies heavily on their opinions.

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.

What impact do they have on economies?

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 ratings 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%.

For low rated countries such as Greece (CCC), the rate is as high as 8.33%.

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.

How objective are they?

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 transparent in the methodologies used in their assessments.

The critical variables that go into the assessment and rating of sovereigns for instance, include information on:

  • macroeconomic outcomes such as economic growth;

  • the state of public finances;

  • the external finance situation including exchange rate management;

  • political risk; and

  • the performance of state institutions.

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 rating agencies.

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.

How accurate are they?

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 downgrade.

But this has not stopped agencies from sticking to their guns. An International Monetary Fund review 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.

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.

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