tag:theconversation.com,2011:/us/topics/fitch-23379/articlesFitch – The Conversation2022-02-13T07:14:21Ztag:theconversation.com,2011:article/1768272022-02-13T07:14:21Z2022-02-13T07:14:21ZMoody’s has bought a leading African rating agency: why it’s bad news<figure><img src="https://images.theconversation.com/files/445887/original/file-20220211-23-zg02tz.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">EMMANUEL DUNAND/AFP/Getty Images</span></span></figcaption></figure><p>Moody’s Investors Service, one of the three dominant global credit rating agencies, <a href="https://www.news24.com/fin24/companies/why-moodys-is-buying-africas-largest-ratings-agency-20220202">is acquiring</a> a majority shareholding in Global Credit Rating (GCR), a leading credit rating agency in Africa. </p>
<p>The move is based on Moody’s anticipation that there will be a robust increase in demand for credit rating services in Africa. Moody’s also has a <a href="https://merisratings.com/#page-127">significant stake</a> in the Egypt-based Middle East Rating and Investors Service or MERIS. </p>
<p>Credit ratings agencies are key players in financial markets. They provide a quantified assessment of the creditworthiness of a borrower. In Africa, the demand for borrowing through financial markets is growing exponentially as traditional <a href="https://www.un.org/africarenewal/magazine/august-november-2017/alternative-financing-strategies-boost-small-businesses-africa">funding sources dry up</a></p>
<p><a href="https://gcrratings.com/">GCR</a> is the largest rating agency headquartered in Africa. It accounts for most of the ratings issued on the continent. It was established in 1996 and is based in Mauritius, with offices in South Africa, Nigeria, Kenya and Senegal. </p>
<p>The ‘big three’ rating agencies – Moody’s, S&P Global Ratings and Fitch – control more than 95% of the global credit rating business. They have been accused of monopolising the credit rating market by implementing anti-competition tactics to maintain their market dominance. In the US and Europe, <a href="https://www.govinfo.gov/content/pkg/CHRG-110hhrg51103/html/CHRG-110hhrg51103.htm">they were fined for anti-competition practices</a>. </p>
<p>Other shortcomings include a lack of understanding of the domestic context of African economies. This is because their primary analysts barely conduct field visits in rated countries. Moody’s only has one office in South Africa which covers all the <a href="https://tradingeconomics.com/country-list/rating?continent=africa">28 African countries</a> that it assigns ratings.</p>
<p>Having an increased presence in Africa will certainly enhance Moody’s understanding of the local context in rated countries. Nevertheless, its acquisitions are a huge setback for the development of alternative rating agencies to compete against the monopoly of the ‘big three’.</p>
<h2>Home-grown capabilities</h2>
<p>GCR has pioneered the ratings of domestic instruments that were aligned with Africa’s long-term strategy for promoting access to affordable capital and promoting the development of domestic financial markets. An example is an <a href="https://www.uneca.org/?q=private-sector-development-and-finance">innovative financing initiative</a> that’s supporting governments to mobilise domestic resources through domestic financial markets. It’s been supported by the African Union and United Nations Economic Commission for Africa.</p>
<p>African-based rating agencies mainly assign ratings for domestic issuances. Their ratings are more detailed and significantly higher than both international ratings issued by the ‘big three’. This is because they understand the local contexts and that domestic borrowings have no exposures to exchange rate risk. </p>
<p>The danger is that Moody’s entrance into the domestic ratings market ushers in the challenge of negative analyst biases against African countries. This trend has been visible in the <a href="https://www.dw.com/en/africa-imf-bias-discrimination-debt-international-investors/a-54564359">international ratings market</a>. </p>
<p>There is also a problem of regulation when it comes to international rating agencies operating on the continent. They are largely <a href="https://theconversation.com/african-countries-need-to-manage-the-rising-power-of-credit-rating-agencies-109594">unregulated</a>. Most rated African countries have domestic bond markets. But they lack legislation for credit rating services. In addition, they do not have competent authorities to oversee the regulation and licensing of international rating agencies.</p>
<p>The exception is South Africa which has the G20 comparable laws requiring international rating agencies to be registered and licensed locally. They are also required to operate within the country’s credit rating services regulations.</p>
<p>Without competent authorities that enforce regulations in each country, there is no central coordination to keep the work of international rating agencies under check. </p>
<p>This is true too when it comes to the issue of anti-competitive behaviour. In a well regulated environment, Moody’s acquisition of GCR would have been assessed on the basis of anti-competitive considerations. </p>
<h2>Moody’s failures</h2>
<p>Moody’s has been <a href="https://www.bloomberg.com/news/articles/2015-09-28/zambia-tells-investors-to-ignore-unsolicited-moody-s-downgrade">called out</a> for issuing unsolicited credit ratings. These are sovereign ratings that are assigned without being requested by either the rated country or its agents. Effectively, the rated country does not have any formal contractual relationship with the rating agency. So it’s not paid for. </p>
<p>Among the ‘big three’, Moody’s has the highest number of countries it assigned unsolicited ratings. </p>
<p>There are a number of downsides to unsolicited ratings. Firstly, the rating agency does not consult adequately with government representatives during the review process. This means it doesn’t gain an understanding of the sovereign risk exposures and the government’s strategy in addressing the downside risk factors. </p>
<p>Secondly, the lack of an agreement with the country being rated opens the door to rating agencies using unfavourable unsolicited ratings as a <a href="https://academic.oup.com/rfs/article-abstract/27/2/484/1581201?redirectedFrom=fulltext">credible ‘threat’</a>, forcing countries into contracts.</p>
<p>Over and above the issue of unsolicited ratings, a number of African countries have registered their displeasure with credit ratings, especially from Moody’s. Media statements have been issued advising stakeholders that the ratings aren’t reflective of the countries’ creditworthiness. In some instances, countries have appealed the ratings.</p>
<p>Examples include:</p>
<ul>
<li><p>The Zambian government <a href="https://www.bloomberg.com/news/articles/2015-09-28/zambia-tells-investors-to-ignore-unsolicited-moody-s-downgrade">rejecting</a> Moody’s rating downgrade in 2015;</p></li>
<li><p>The Namibian Government <a href="https://www.reuters.com/article/namibia-ratings-idAFL5N1KZ0GD">appealed Moody’s downgrade</a> of the country to junk status in 2017;</p></li>
<li><p>Nigeria strongly contested Moody’s downgrade in both <a href="https://allafrica.com/stories/201711090049.html">2016 and 2017</a>;</p></li>
<li><p>Tanzania <a href="https://www.reuters.com/article/tanzania-ratings/tanzania-criticises-moodys-for-negative-rating-outlook-idUSL5N1QN4U8">appealed against Moody’s</a> inaccurate rating in 2018;</p></li>
<li><p>Ghana recently <a href="https://africa.businessinsider.com/local/markets/ghana-accuses-moodys-of-bias-after-its-credit-rating-was-downgraded-by-the-ratings/bbbf14p">appealed against</a> its rating by Fitch and Moody’s, which is not reflective of the country’s risk factors.</p></li>
</ul>
<p>No country has successfully appealed a decision. This is for a number of reasons. Firstly, there is no appeal authority on the continent that can conduct a fair hearing of the country’s submissions and pronounce a decision. Instead the appeals are in accordance with the agency’s own rules provided under the <a href="https://www.sec.gov/Archives/edgar/data/1698547/000119312519091962/d721318dex99e2nrsro.pdf">Procedures and Methodologies Used to Determine Credit Ratings</a>. </p>
<p>Secondly, the rating agencies are both ‘the player and referee in Africa’. This is not the case in other <a href="https://www.esma.europa.eu/press-news/esma-news/esma-finds-high-level-divergence-in-disclosure-esg-factors-in-credit-ratings">territories</a>.</p>
<h2>Solutions</h2>
<p>There is a growing appetite for African-issued financial instruments. An indication of this is bond issuances being <a href="https://theconversation.com/african-governments-have-developed-a-taste-for-eurobonds-why-its-dangerous-165469">oversubscribed by at least three times</a>. This has resulted in rating agencies positioning themselves for more business on the continent. </p>
<p>As their dominance and influence continues to expand through mergers and takeovers, African countries need to consider taking the following steps.</p>
<p>First, enact legislation on credit rating services to ensure that regulation of international credit rating agencies is at least on a par with international requirements. They should be in line with the G20 requirement of regulated and accountable credit rating agencies at a global level.</p>
<p>Second, competent authorities responsible for enforcing the credit rating services legislation, should be mandated to issue rules and guidelines to provide additional guidance and ensure uniform implementation of the laws.</p>
<p>In addition, the African Union and its agencies should coordinate national competent authorities to institute a continental regulatory body as a platform of appeal for countries that seek recourse from the unfair practices by rating agencies. This should be an equivalent of the <a href="https://www.esma.europa.eu/about-esma/esma-in-short/complaints">European Securities and Markets Authority</a> and the <a href="https://www.sec.gov/page/ocr-section-landing%E2%80%8B">US Securities and Exchange Commission</a></p>
<p>Without these, African countries will continue to face the challenges of unsustainable borrowing in both domestic and international markets.</p><img src="https://counter.theconversation.com/content/176827/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Misheck Mutize is the Lead Expert researcher with the African Union - African Peer Review Mechanism (APRM) on supporting countries on their engagements with international credit rating agencies.
</span></em></p>Moody’s acquisitions are a setback for the development of alternative rating agencies to compete against the monopoly of the ‘big three’.Misheck Mutize, Post Doctoral Researcher, Graduate School of Business (GSB), University of Cape TownLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1095942019-01-22T13:56:13Z2019-01-22T13:56:13ZAfrican countries need to manage the rising power of credit rating agencies<figure><img src="https://images.theconversation.com/files/254723/original/file-20190121-100270-bjhnl0.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">shutterstock</span> </figcaption></figure><p>The rising gap between developmental needs and available financial resources – including <a href="https://www.devex.com/news/opinion-what-the-data-tells-us-about-africa-s-declining-revenue-93555">poor revenue collection</a> – has pushed sub-Saharan African governments to consider different options to support their budgets. </p>
<p>One route to raise capital has been the issuing of sovereign bonds on international financial markets. But to do this successfully, governments need a sovereign credit rating from at least one of the three dominant international credit rating agencies. These are Standard & Poor’s (S&P), Moody’s and Fitch. The number of African countries seeking a sovereign credit rating has increased from one in <a href="https://tradingeconomics.com/country-list/rating?continent=africa">1994 to 31</a> in 2018.</p>
<p>There’s been growing dissatisfaction with the three agencies. A number of rated countries on the continent, such as Nigeria, are <a href="http://www.businesstimesafrica.net/index.php/details/item/2436-nigeria-govt-disagrees-with-moody-s-downgrading-of-nigeria-to-b2-stable-rating">unhappy</a>, joining a chorus of dissatisfied <a href="https://qz.com/india/982240/india-says-ratings-firms-like-sps-moodys-and-fitch-are-biased/">voices around the world</a>. Their unhappiness stems from the fact that, outside the US and the European Union (EU), the agencies don’t subscribe to any international regime or governance body. This means that their misconduct remains largely unchecked.</p>
<p>The international rating agencies have operated unregulated even though the need for them to be regulated has become apparent. </p>
<p>The EU and US provide examples of how it can be done. After the 2008 crisis the <a href="https://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:146:0001:0033:EN:PDF">EU introduced regulations</a> and <a href="https://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:176:0338:0436:EN:PDF">several directives</a> to manage the agencies more tightly. In the US, the <a href="https://www.congress.gov/111/plaws/publ203/PLAW-111publ203.pdf">Dodd-Frank & Consumer Protection Act</a> of 2010 expanded the regulatory power of the Securities and Exchanges Commission to enforce full disclosure about the rating agencies’ methodologies. </p>
<p>The only country in Africa that has comparable laws is <a href="https://www.gov.za/sites/default/files/gcis_document/201409/37014bn228.pdf">South Africa</a> –although there is still <a href="https://open.uct.ac.za/handle/11427/9155">very weak to no civil liability</a> of rating agencies. These laws were passed partly to make it easier for European countries and the US to litigate against rating agencies in cases of misinformation, as well as controlling their influence.</p>
<p>There are no laws elsewhere in Africa to hold the rating agencies’ operations on the continent to account. And there’s no central coordination of their activities within individual African countries. This is because no single institution is responsible for administering their regulations or managing them. Either the ministry of finance, or sometimes the central bank, works hand in hand with rating agencies and liaises on issues relating to a sovereign’s rating profile.</p>
<p>So what can African countries do? The problem is that, as the influence of international rating agencies continues to expand, individual African countries have limited power to act against them. One possibility is that the continent establishes collective and well defined ways to ensure they present a common front to the rating agencies. </p>
<h2>Countries that have complaints</h2>
<p>In 2015, the Zambian government urged <a href="https://www.lusakatimes.com/2015/09/28/ignore-moodys-credit-downgrade-on-zambia-government-tells-investors-and-the-public/">investors to ignore unsolicited credit downgrade</a> from the rating agencies. It challenged the correctness of its rating, which it said hadn’t been discussed with the country’s representatives. </p>
<p>In 2017, Namibia <a href="https://af.reuters.com/article/africaTech/idAFL5N1KZ0GD">rejected Moody’s decision</a> to downgrade the country’s credit rating to junk status. It said the downgrade was contrary to its generally stable economic outlook. </p>
<p>The government of Nigeria also <a href="http://www.businesstimesafrica.net/index.php/details/item/2436-nigeria-govt-disagrees-with-moody-s-downgrading-of-nigeria-to-b2-stable-rating">strongly disagreed with its downgrading</a>. It questioned both the general rating premises as well as the agency’s conclusions. The government believed the economy had successfully emerged from a recession and recorded important improvements across a broad range of sectors. </p>
<p>In 2018, Tanzania criticised Moody’s decision to assign a low credit rating with a negative outlook on the country’s first international credit rating. <a href="https://www.reuters.com/article/tanzania-ratings/tanzania-criticises-moodys-for-negative-rating-outlook-idUSL5N1QN4U8">Tanzania rejected the rating</a>. It argued that it hadn’t been thoroughly consulted.</p>
<p>There are more general complaints too. Judging from the way in which African countries are rated, an argument could be made that rating agencies view the African continent as a homogeneous entity. They appear to consider all African economies as unstable. Only three – Mauritius, Morocco and South Africa – out of 31 rated countries have a rating just above “junk status”. Only one – Botswana – has an <a href="https://countryeconomy.com/ratings">A-class rating</a>. Compared to other regions, 87% of African countries are rated “junk status”. That’s compared to approximately <a href="https://www.businessinsider.com.au/credit-ratings-government-sovereigns-moodys-2018-11">19% in Western Europe, 27% in the Middle East, 38% in Central and Eastern Europe, 54% in Asia Pacific and 55% in Latin America and The Caribbean</a>.</p>
<p>The effect of this is that African countries have to issue sovereign bonds at high discounts, and are subject to higher interest rates. </p>
<p>Another area of contention is that credit rating methodologies consistently over-emphasise political risk in the rating criteria. Political components constitute <a href="https://www.moodys.com/Pages/HowMoodysRatesSovereigns.aspx">approximately 50%</a> of the composite rating. Other components such as financial and economic components each contribute to the <a href="https://www.spratings.com/documents/20184/4432051/Sovereign+Rating+Methodology/5f8c852c-108d-46d2-add1-4c20c3304725">remaining 50%</a>. While the qualitative factors are judged purely based on the ideology of the credit analysts, their <a href="https://theconversation.com/african-citizens-have-good-reasons-to-be-fed-up-with-their-politicians-81053">perception towards</a> the political institutions in Africa is <a href="https://www.cmi.no/projects/302-political-institutions-in-africa">generally negative</a>.</p>
<p>The <a href="https://tradingeconomics.com/country-list/credit-rating?continent=africa">data shows</a> that the rating agencies have downgraded more countries than they have upgraded over the past 24 years. There have been 47 downgrades, compared to only 22 upgrades and 113 negative changes in outlooks; only nine positive changes have been recorded. </p>
<h2>Solutions and action plan</h2>
<p>African countries should design a collective response mechanism to save the continent from rating abuse. This mechanism can also be used to bring the operations of agencies under control. The aim should be to avoid unfair and exploitative business practices.</p>
<p>One option would be for the African Union to establish a continental regulatory authority. It could govern the cross-border activities of international rating agencies, administer a prudential standard framework and evaluate the accuracy and fairness of ratings assigned to particular countries.</p><img src="https://counter.theconversation.com/content/109594/count.gif" alt="The Conversation" width="1" height="1" />
<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>African countries need to find a way to present a common front to the rating agencies.Misheck Mutize, Lecturer of Finance, Graduate School of Business (GSB), University of Cape TownLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/693612016-11-24T11:27:14Z2016-11-24T11:27:14ZWhy credit ratings matter and why they can’t be ignored<figure><img src="https://images.theconversation.com/files/147339/original/image-20161124-15330-cbwrbg.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">South Africa faces a possible downgrade by credit rating agencies.</span> <span class="attribution"><span class="source">Shutterstock</span></span></figcaption></figure><p><em>This article was first published in 2016 as South Africa faced a possible downgrade by rating agencies. The Conversation Africa’s Charles Leonard asked Mampho Modise to explain the significance of a rating agency downgrade.</em></p>
<p><strong>What do the agencies look at in the process of reviewing a country?</strong></p>
<p>In their rating <a href="http://faculty.nps.edu/relooney/3040_2.pdf">methodologies</a>, rating agencies have developed rating criteria for assessing the performance of key macroeconomic and socioeconomic indicators. By assessing the indicators, the rating agencies are able to determine the borrower’s ability and willingness to honour debt obligations. </p>
<p>Rating criteria focus on the following components and indicators: </p>
<ul>
<li><p><strong>Economic structure and performance:</strong> Real GDP, per capita income, headline inflation rate, gross investment as a percentage of GDP and gross domestic savings as a percentage of GDP.</p></li>
<li><p><strong>Government finances:</strong> Government revenue to GDP, government expenditure to GDP, government debt to GDP, debt interest payment to revenue and the budget balance as a percentage of GDP.</p></li>
<li><p><strong>External payments and debt:</strong> Current account balance as a percentage of GDP, the ratio of external debt to GDP and level of official reserves.</p></li>
<li><p><strong>Susceptibility to event:</strong> Political risk, socioeconomic risk, external vulnerability risk and institutional independence. </p></li>
</ul>
<p>When reviewing the sovereign ratings, rating agencies hold discussions with various stakeholders in government, labour, civil society and the private sector. The reason the private sector is included is for the rating agencies to get an independent view on government policies and strategies.</p>
<p><strong>What do they do with their results?</strong></p>
<p>Once their reviews are concluded, the agencies will announce credit rating opinions which will reflect the borrower’s credit worthiness. That is the likelihood that the borrower will pay back a loan within the confines of the loan agreement, without defaulting. </p>
<p>A high credit rating indicates a high possibility of paying back the loan in its entirety without any issues. A poor credit rating suggests that the borrower has had trouble paying back loans in the past, and might follow the same pattern in the future.</p>
<p>The credit rating opinions are used by various stakeholders and for different reasons.</p>
<p>Firstly, investors use credit ratings as a guide to their investment decisions. Credit ratings provide an independent and objective assessment of the credit worthiness of countries and corporations. This assists investors to decide how risky it is to invest money in a certain country or corporation. </p>
<p>Secondly, for corporations and governments who want to raise money in the capital market, a favourable rating means a country will be able to obtain funds at a lower cost.</p>
<p>Lastly, governments could also use credit ratings as a measure for gauging their performance relative to peers to effect improvements. </p>
<p><strong>Which political developments in South Africa are likely to have an impact on the reviews?</strong></p>
<p>A few areas of concern have been cited.</p>
<p>The outcome of the <a href="http://ewn.co.za/2016/08/25/ANC-Divided-Confused-No-plan--Except-in-Gauteng">2016 local government elections</a> is one. The rating agencies are concerned that a drop in the voter percentage could result in fiscal loosening to draw votes back to the ruling party.</p>
<p>Another concern is the <a href="http://ewn.co.za/2016/10/11/Finance-Minister-Pravin-Gordhan-issued-with-summons-for-fraud">charges</a> instituted against the Minister of Finance Pravin Gordhan and later <a href="http://www.bbc.com/news/world-africa-37822600">withdrawn</a>. This threatened the institutional stability and integrity of the National Treasury.</p>
<p>And the political disagreements on the findings of the <a href="http://www.news24.com/SouthAfrica/News/statecapturereport-live-the-public-protector-has-been-ordered-to-publish-the-state-capture-report-20161102">state capture report</a> threatened the institutional independence of the office of the Public Protector and the courts.</p>
<p>Finally, the upcoming <a href="http://www.news24.com/SouthAfrica/News/early-anc-elective-conference-a-non-starter-20160908">elective conference</a> for the governing African National Congress (ANC) in 2017 is raising a concern on policy continuity and predictability. </p>
<p><strong>Do the agencies operate in every country around the world?</strong></p>
<p>Not necessarily. Rating agencies can operate unsolicited. But major rating agencies such as <a href="https://www.moodys.com/Pages/atc.aspx">Moody’s Investors Service</a> (Moody’s), <a href="https://www.spglobal.com/">S&P Global Ratings</a>(S&P) and <a href="https://www.fitchratings.com/site/home">Fitch Ratings</a> (Fitch) are solicited by countries to provide credit ratings. </p>
<p>Moody’s operates in 36 countries, S&P in 28, and Fitch in more than 30 countries.</p>
<p><strong>What happens to a country downgraded to junk status?</strong></p>
<p><a href="http://www.fin24.com/Economy/sa-junk-rating-seems-inevitable-economists-20161118">Junk status</a> is associated with high risk. Therefore, high borrowing costs. This is the main reason why a sovereign has to avoid being downgraded into a junk, or sub-investment grade. </p>
<p>For fund managers (who are representing the investors) a downgrade to junk status means they will have to sell the assets (bonds) they hold. Their mandates require that they only invest in investment grade assets.</p>
<p>For an ordinary person it means paying more interest, leaving little money for savings and expenditure on rent, school fees and food.</p>
<p>For governments it means allocating more to debt servicing costs (interest payment). Less money will be available for social grants, investment priorities, creating jobs and ultimately reducing the GDP growth potential of the country. More interest payment also crowds out other critical spending. Social services is an example.</p>
<p><strong>Is it possible for a government to simply ignore their ratings?</strong></p>
<p>Not really. Solicited credit ratings ensure easy access to international capital markets. Favourable credit ratings imply low borrowing costs. The South African government has solicited credit ratings from the top agencies to ensure that it can easily and cheaply access foreign funding needed to accomplish its economic development agenda. </p>
<p>South Africa therefore can’t ignore the credit ratings assigned to it, especially given that foreign investors hold more than <a href="http://www.treasury.gov.za/documents/national%20budget/2016/review/chapter%207.pdf">30% of government debt</a>.</p>
<p><strong>Which agency is taken most seriously?</strong></p>
<p>Sovereign credit rating is the most concentrated industry. There are approximately <a href="https://theconversation.com/qanda-why-credit-rating-agencies-matter-for-developing-countries-51964">70 rating agencies</a> globally. But most investors base their investment decisions on the credit ratings published by Moody’s, S&P and Fitch. These three control approximately 95% of the rating business.</p><img src="https://counter.theconversation.com/content/69361/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Mampho Modise is affiliated with National Treasury</span></em></p>Credit ratings have an impact on government, as well as ordinary people. This article was first published last year as South Africa faced a possible downgrade.Mampho Modise, Post graduate researcher, University of PretoriaLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/534072016-01-19T14:33:42Z2016-01-19T14:33:42ZIf UK votes for Brexit, its borrowing costs will soar – here’s why<figure><img src="https://images.theconversation.com/files/108594/original/image-20160119-29756-1ih3x7q.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">In-out, in-out, shake it all about.</span> <span class="attribution"><a class="source" href="http://www.shutterstock.com/cat.mhtml?lang=en&language=en&ref_site=photo&search_source=search_form&version=llv1&anyorall=all&safesearch=1&use_local_boost=1&autocomplete_id=&searchterm=brexit&show_color_wheel=1&orient=&commercial_ok=&media_type=images&search_cat=&searchtermx=&photographer_name=&people_gender=&people_age=&people_ethnicity=&people_number=&color=&page=1&inline=338831222">JMiks</a></span></figcaption></figure><p>There have been a couple of notable signals about the upcoming EU referendum lately. A public opinion poll <a href="http://www.telegraph.co.uk/news/newstopics/eureferendum/12054924/More-Britons-want-to-leave-the-EU-than-stay.html">showed a</a> clear majority lead for Brexit, then a Financial Times poll of more than 100 leading economists <a href="http://www.ft.com/cms/s/0/1a86ab36-afbe-11e5-b955-1a1d298b6250.html#axzz3wvKEFmrz">concluded that</a> a vote to leave would damage UK growth. But while the arguments for and against are still shaping up, everyone appears to be ignoring how the credit-ratings agencies would respond to Brexit.</p>
<p>This is surprising. Only recently, credit-rating agency Standard & Poor’s fired a warning shot, <a href="http://www.theguardian.com/politics/2015/oct/29/britain-two-notch-credit-slip-leave-eu">saying that</a> the UK would be downgraded one notch on leaving, and this could double if relations with Brussels soured. And unlike Standard & Poor’s, the other two main credit-ratings agencies, <a href="http://www.bbc.co.uk/news/business-21554311">Moody’s</a> and <a href="http://www.bbc.co.uk/news/business-22219382">Fitch</a>, have already stripped Britain of its precious AAA rating – the highest possible. If all three downgraded Britain after a Brexit, the road back to AAA status would be even harder. </p>
<p>Whether or not one agrees with these decisions, they do matter. Sovereign credit ratings estimate the probability that a country will default on its debts. They set the tone for the borrowing costs in international markets both for the country and the financial institutions operating there. Increasing the interest rates that the country pays to borrow means less money to spend on schools, hospitals and so forth. Downgrades <a href="http://onlinelibrary.wiley.com/doi/10.1111/jmcb.12080/abstract">also weaken</a> the share prices of banks that are expected to receive stronger support from their governments – particularly in advanced economies. </p>
<figure class="align-center zoomable">
<a href="https://images.theconversation.com/files/108595/original/image-20160119-29777-z2t9e3.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/108595/original/image-20160119-29777-z2t9e3.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/108595/original/image-20160119-29777-z2t9e3.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=398&fit=crop&dpr=1 600w, https://images.theconversation.com/files/108595/original/image-20160119-29777-z2t9e3.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=398&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/108595/original/image-20160119-29777-z2t9e3.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=398&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/108595/original/image-20160119-29777-z2t9e3.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=501&fit=crop&dpr=1 754w, https://images.theconversation.com/files/108595/original/image-20160119-29777-z2t9e3.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=501&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/108595/original/image-20160119-29777-z2t9e3.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=501&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
<figcaption>
<span class="caption">AAAmen!</span>
<span class="attribution"><a class="source" href="http://www.shutterstock.com/cat.mhtml?lang=en&language=en&ref_site=photo&search_source=search_form&version=llv1&anyorall=all&safesearch=1&use_local_boost=1&autocomplete_id=&search_tracking_id=kKPbHu9ovHwDUYC5wm2meQ&searchterm=credit%20ratings%20agences&show_color_wheel=1&orient=&commercial_ok=&media_type=images&search_cat=&searchtermx=&photographer_name=&people_gender=&people_age=&people_ethnicity=&people_number=&color=&page=1&inline=90305071">Wolfilser</a></span>
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<h2>How sovereign ratings work</h2>
<p>The three agencies cite a number of factors that come into their sovereign ratings, including GDP growth rate developments and public finance trends. They provide little guidance as to how they weight each factor, but <a href="http://onlinelibrary.wiley.com/doi/10.1002/ijfe.416/abstract">academics</a> fortunately have studied the agencies’ models extensively and reached the following conclusions: </p>
<ol>
<li>An increase in annual GDP growth by one percentage point improves a country’s rating by about one-tenth of a notch.</li>
<li>An annual drop in general government gross debt by one percentage point of GDP justifies about one-tenth of a notch upgrade.</li>
<li>An annual drop in government deficit by one percentage point of GDP justifies about one-tenth of a notch upgrade.</li>
<li>EU membership enjoys a “premium” of as much as two notches. It improves a country’s financial credibility, since its economic policy is restricted and monitored by other member states; and it provides enormous economic benefits as it offers free trade access to a population of around 503m.</li>
<li>Last but not least, Moody’s matters more than Standard & Poor’s <a href="http://www.sciencedirect.com/science/article/pii/S0165176515003699">because</a> investors value more of its decisions (Fitch was not examined).</li>
</ol>
<p>What do these mean in the case of the UK? According to the <a href="http://budgetresponsibility.org.uk/category/topics/economic-forecasts/">latest estimates</a> of the UK’s Office for Budgetary Responsibility, the country’s economy is expected to have grown at a rate of 2.4% per annum in 2015 and is expected to achieve the same rate in 2016. Thanks to the government’s cuts, general government gross debt is expected to drop by some 0.4 percentage points of GDP (from 87.5% in 2014-15 to 87.1% in 2015-16). The deficit is also projected to drop by 1.2 percentage points of GDP (from 5.1% in 2014-15 to 3.9% in 2015-16). </p>
<figure class="align-right zoomable">
<a href="https://images.theconversation.com/files/108596/original/image-20160119-29793-1ir20bq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/108596/original/image-20160119-29793-1ir20bq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/108596/original/image-20160119-29793-1ir20bq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=905&fit=crop&dpr=1 600w, https://images.theconversation.com/files/108596/original/image-20160119-29793-1ir20bq.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=905&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/108596/original/image-20160119-29793-1ir20bq.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=905&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/108596/original/image-20160119-29793-1ir20bq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=1137&fit=crop&dpr=1 754w, https://images.theconversation.com/files/108596/original/image-20160119-29793-1ir20bq.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=1137&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/108596/original/image-20160119-29793-1ir20bq.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=1137&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<span class="caption">Economic truths.</span>
<span class="attribution"><a class="source" href="http://www.shutterstock.com/cat.mhtml?lang=en&language=en&ref_site=photo&search_source=search_form&version=llv1&anyorall=all&safesearch=1&use_local_boost=1&autocomplete_id=&search_tracking_id=JKHE3CV17h4zdCmB-nC3qA&searchterm=GDP&show_color_wheel=1&orient=&commercial_ok=&media_type=images&search_cat=&searchtermx=&photographer_name=&people_gender=&people_age=&people_ethnicity=&people_number=&color=&page=1&inline=192213977">Zhaoliang70</a></span>
</figcaption>
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<p>Taken together, the slight debt and deficit “improvements” justify roughly two-tenths of a notch upgrade. And the fact that GDP is not expected to gain momentum means it won’t offer any contribution either. This is not sufficient to offset a potential downgrade by (up) to two notches if British voters decide to vote against staying in the EU. And there is an increasing risk of the economic outlook deteriorating, according on the <a href="http://www.ft.com/cms/s/0/3be75cc4-be98-11e5-846f-79b0e3d20eaf.html#axzz3xhF7RFuv">latest speech</a> of Bank of England governor Mark Carney. If so, we can expect less “improvement” in the debt and deficit, too. </p>
<p>My feeling is that we will avoid Brexit as such a decision would be a “jump into the unknown”. Nevertheless, I have hopefully shown that the government’s cuts will prove powerless in counteracting a post-Brexit downgrade. And since Brexit looks possible based on the latest polls, the authorities may want to be ready to respond. For instance the Bank of England should be prepared to defend the government from rising borrowing costs by authorising additional quantitative easing in the event of a Brexit. Government officials would also want to use all diplomacy at their disposal to avoid additional tensions with our EU partners that are bound to emerge. We need to start planning for this now. Waiting until the day after the EU referendum would be far too late.</p><img src="https://counter.theconversation.com/content/53407/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Costas Milas 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 credit-ratings agencies are already circling to cut the UK’s grade if it votes to leave the EU. Here’s how their calculations work, and what we should do about it.Costas Milas, Professor of Finance, University of LiverpoolLicensed as Creative Commons – attribution, no derivatives.