Rating agencies cannot be brushed aside

The recent outcry against international rating agencies springs from dissatisfaction with India’s low rating of BBB- remaining unchanged for over a decade, in spite of many impressive achievements since then — 7 per cent economic growth, reduction in debt/GDP ratio, and several major economic reforms.

While it may seem like a storm in a tea cup, the debate also raises a few important questions: One, do ratings really matter, a question that relates to the rationale as also the power of rating agencies, and two, why are rating agencies reluctant to revise their opinions in the light of evidence, a question which concerns methodology.

The rating rationale is straightforward: The opinion on “the ability and willingness of debt issuers to meet obligations in full and on time” benefits both investors and issuers. But unlike private debt, the contextual rationale for government debt can be quite different, especially for developing economies. The contentious 68 per cent debt to GDP ratio for India, for instance, consists of mostly internal debt (81 per cent), owed mainly (75 per cent) to banks, insurance companies and the RBI, whose investment mandates flow from regulation.

In fact, banks have been investing in zero risk-weighted government securities beyond mandated levels on safety considerations. Even external debt (6 per cent of total) is predominantly aid from multilateral agencies, all of which suggests that our debt is largely rating-agnostic; but in theory, low sovereign ratings influence the cost of credit for private borrowers in global capital markets.

Another impact, pointed out by the earlier RBI governor, was the reluctance of foreign banks to expand business in India, as it required setting aside higher capital. But overall evidence in terms of foreign capital flows indicates that foreign investors have greater faith in Indian markets than rating agencies.

A larger issue is the power and influence that the ratings industry wields. Internationally, the ratings business is virtually a duopoly with two big names dominating the market. But their power actually arises from their “regulatory licence”, a point well explained by Christopher Bruner and Rawi Abdelal of Harvard Business School in their excellent paper (‘To Judge Leviathan: Sovereign Credit Ratings, National Law, and the World Economy’, Journal of Public Policy , August 2005). It means that ratings are valuable not because they contain valuable information, but because they grant regulatory licences vouchsafing compliance. We can see this in banking regulations (Basel II) too, where capital adequacy rules are built in part upon credit ratings.

The paper goes on to describe how their power grew when the US government incorporated ratings into regulation, placing them in the position “to express their interpretation of good economic policy” to governments. The sovereign ratings business in the 90s gave them a further boost, when the so-called Brady bonds (re-packaged emerging market debt in default) came into the market. Since then, the number of countries seeking ratings especially from the Third World grew phenomenally reflecting not necessarily debt-raising intentions, but “a communication of their commitment to transparency and flexibility”, in the hope that international capital markets would look at them favourably.

Finally, the sovereign rating methodology has often been criticised for being subjective and reflecting ideological biases.

There is some merit here. The methodology itself is elaborate: according to one of the agencies, it considers five main factors when rating sovereigns — institutional, economic, external, fiscal and monetary — amongst several other aspects. But as the paper points out, the problem is with the implied litmus tests of acceptance. For instance, under institutional assessment “a market economy with legally enforceable property rights’’ is seen as being ‘‘less prone to policy error”. While this may be relevant for advanced economies, it would seem an ideological bias in, say, Asian countries.

Similarly, economic assessment reckons “a wealthy, diversified, resilient, market-oriented and adaptable economy as being less likely to default” — probably why low growth in per capita incomes and low tax base are seen as constraints, as in India’s case. Surely, these can only grow at modest rates, given the relative sizes of income and population. Likewise, fiscal assessment views a low or medium human development index as a negative, because it necessitates high debt to meet the significant shortfall in basic services — the solution becomes the problem!

Many of these factors actually relate to structural deficiencies that take time to fix but if they have actually influenced the final rating numbers, then the cynicism about rating agencies telling us what we already know would seem justified.

The writer is an independent consultant