On March 10, ratings agency Moody’s placed Ethiopia on watch for downgrade. The problem is not the violence and repression in Ethiopia’s beleaguered Tigray region. On the contrary, Moody’s concluded that the Ethiopian government’s commitment to engage with private creditors, as part of the G20 Common Framework for Debt Treatment Beyond the Debt Service Suspension Initiative , increases the risk that these creditors will suffer losses. For this, the country must apparently be punished.
While the DSSI aims to provide immediate relief to low-income countries during the pandemic, the Common Framework was designed to help struggling sovereign states reschedule or reduce their commitments. For many countries, it offers the best chance of making their debt burden bearable. But today, the threat of a ratings downgrade is clouding the outlook for these countries.
This highlights a systemic problem in international finance: the extraordinary – and undeserved – power wielded by a few private credit rating agencies. Just three – Moody’s, S&P Global Ratings and Fitch Ratings – control more than 94% of outstanding credit ratings. And there are significant cross-shareholdings between them.
These oligopolistic firms are market movers and makers, influencing the allocation of financial portfolios, the pricing of debt and other financial instruments, and the cost of capital. Bolstering their authority, the United States Securities and Exchange Commission recognized them as official statistical rating organizations. And many institutional investors, required by law to hold only “higher quality” assets in their portfolios, must comply with rating agency verdicts.
Responsibility of rating agencies
Concerns about rating agencies were first widely expressed during the Enron scandal in 2001. Enron, an energy trading company, used accounting tricks and complex financial instruments to mislead investors, creditors and regulators on its value. The rating agencies were certainly fooled: the Big Three all issued Enron investment ratings just days before the company collapsed.
The lack of regulatory action partly reflects the lobbying power of the Big Three.
Rating agencies have also been accused of fostering the subprime mortgage bubble in the United States, which triggered the global financial crisis when it burst in 2008, and of exacerbating the crisis through reversals and rapid downgrades. And they’ve been known to adjust ratings in ways that seem to reflect ideological positions, like a commitment to fiscal austerity.
And yet, as Yuefen Li, the United Nations Independent Expert on Foreign Debt and Human Rights, points out in a new report, rating agencies are not held accountable for their mistakes or harmful behavior. . Their ratings are legally described as “opinions,” which are protected by free speech laws, and they don’t disclose their methodology. In short, rating agencies do not bear proper responsibility for the enormous power they wield.
Conflicts of interest
Moreover, as Li also notes, conflicts of interest abound. Rating agencies are private companies, funded largely by the institutions they rate. And they are actors in the markets they are expected to value, which means that self-interest inevitably shapes their decision-making. Rating agencies were, for example, involved in the creation of financial products which they were then responsible for rating – including mortgage-backed securities which, flush with AAA ratings, helped to provoke the crisis of 2008.
And yet, even as regulators strive to limit conflicts of interest between most financial market participants, they seem content to let rating agencies police themselves. The lack of regulatory action partly reflects the lobbying power of the Big Three. And it generates serious risks, which the coronavirus pandemic has intensified.
If G20 countries are serious about improving the debt position of developing countries during the Covid-19 crisis, they should start by supporting the temporary suspension of credit ratings.
For example, the procyclicality of ratings – another issue Li highlights in his report – makes financial market conditions inhospitable for developing countries whose economic prospects have been undermined by the Covid-19 crisis. In addition, the threat of a ratings downgrade prevents many governments from pursuing sufficient fiscal spending. Today, with Moody’s latest move, developing country governments must be wary of entering into debt restructuring negotiations with private creditors, even under multilateral debt relief programs.
A truly independent global rating agency
If G20 countries are serious about improving the debt position of developing countries during the Covid-19 crisis, they should start by supporting the temporary suspension of credit ratings. In the medium term, regulators must take steps to ensure that rating agencies fulfill their role of stabilizing the market. It is essential to tackle conflicts of interest, for example by limiting the dependence of agencies on the payments of those they rate.
But regulating private rating agencies may not be enough. The United Nations Conference on Trade and Development has long argued that the world needs an independent public rating agency to conduct objective assessments of government and corporate creditworthiness. Such an agency is also needed to assess the instruments used to finance new public investments, which will be in great demand in the years to come.
A global agency makes sense because credit ratings, especially for sovereign debt, are international in scope. Perhaps more importantly, it would provide a much-needed counterweight to irresponsible private agencies. It could even force the Big Three to enact reforms they have long resisted.