Rating agencies owe more transparency to the market

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The writer previously chaired the Securities and Exchange Board of India and ran India’s largest mutual fund.

Fear has stalked global efforts to fight Covid-19 – fear of infection, unemployment and economic decline. But another fear paralyzed policymakers trying to solve these problems: that of sovereign rating agencies.

Policymakers, especially in developing countries, are concerned that the spending needed for the pandemic response could lead to ratings downgrades. These in turn can lead to massive capital outflows and potentially trigger macro-financial instability and currency crisis.

They are not wrong to worry. Fitch has downgraded a record 33 sovereign ratings this year, including the UK, and placed 40 countries on negative watch for downgrades. S&P downgraded the outlook for Thailand and Indonesia, among others. In recent weeks, Moody’s has placed several countries, including Ivory Coast, Cameroon and Pakistan, on negative watch for downgrade. The ratings agency cited as a reason that countries could potentially take advantage of the G20’s offer to suspend debt payments to developing countries that need to focus those funds on Covid-19 relief. As the economic pain increases, more countries are potentially vulnerable to similar actions.

The IMF predicts that global output will fall by almost 5% this year, as will the gross domestic product of more than 170 countries. Developing countries will experience even steeper declines.

These unprecedented challenges have prompted unprecedented responses. The IMF has pledged $1,000,000,000 in loan support. Banking and securities regulators have postponed the implementation of some global standards. Central banks have opened the liquidity taps.

Now rating agencies need to step up and disclose their metrics. Sovereign ratings are complex affairs and methodologies are not transparently shared. Data is not always comparable between countries and often the same jurisdiction is rated differently by different agencies at the same time. Developing countries, most of which are just a notch above non-investment grade, are the most vulnerable to downgrades.

Countries need to know the relative importance rating agencies place on per capita income, reserves, structural reforms and political stability. How will they weigh an immediate increase in the fiscal deficit against a country’s medium-term fiscal trajectory and growth or judge between foreign currency debt and local currency debt? A jurisdiction whose majority of its debt is due next year cannot be on the same footing as one whose majority is due in 10 years.

Rating agencies run the risk of losing their relevance if they do not provide more guidance on relative risks. Currently, there is essentially a pass/fail test: is a jurisdiction investment grade or not? In a crisis, investors want information about relative strengths and weaknesses, rather than a binary statement of a downgrade at a time when everyone is hurting.

Sovereign ratings also guide the global movement of trillions of dollars of bond investment funds. Most major government bond indices – those calculated by Citigroup, JPMorgan, FTSE and MSCI – filter out countries that are not top quality. The inclusion or exclusion of a bond index can significantly affect capital flows, currency strength and a country’s macro-financial situation.

Bloomberg Barclays Global Aggregate Bond’s decision in 2019 to include China in the index resulted in over $100 billion being reallocated there. The MSCI-EM index is tracked by nearly $1.9 billion in assets. Although there are several factors for inclusion in the index, the first filter is investment quality.

On the other hand, if a country that is part of the index becomes non-investment grade, the speed and volume of exits can be penalizing.

The pandemic highlights the critical role of rating agencies and bond indices. The industry must rise to the occasion. Their response to this crisis must be swift and transparent. Failure to act now would exacerbate one of the worst challenges we have faced and would drive a much deeper chasm from which humanity could emerge.

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