Sovereign risk calls cannot be left to rating agencies alone


Sovereign credit ratings have grown in importance over time. The complexity of assessing sovereign risk has always been greater than what is necessary to rate companies or banks. The challenge has grown now that public finances have moved further into uncharted territory, starting with the quantitative easing (QE) policies adopted after 2008. Heightened economic uncertainty due to the covid pandemic has added to the challenge. . The effectiveness of credit rating agencies (CRAs) in forecasting sovereign defaults was questionable even in relatively normal times, and a paradigm shift may be needed in how a country’s default risk is assessed. Inappropriate rating changes on the basis of inadequate methodologies can have a domino impact on global stability. Given the size and scale of the effort, a multilateral agency such as the Bank for International Settlements (BIS) is better placed to take on the work of sovereign risk assessment.

The pandemic has strengthened the bespoke ‘sovereign-bank-business bond’ in which these three are so dependent on each other that if one falls, the other two can follow. It’s different from 2008, where we could take comfort in the fact that at least the balance sheets of companies were stable.

To minimize the economic fallout from the pandemic, governments have used banking channels to support businesses. This has taken the form of government guaranteed loans and loan moratoriums. Central banks have flushed the market with liquidity. Banks often used it to invest in public debt. Governments have borrowed heavily to support the economy. A delicate balancing act has appeared in most of the economies ravaged by the Covid. A downgrade in an emerging market’s (EM) rating may force not only its government but also other EMs to cut spending. This could lead to increased commercial delinquency, leading to bank losses and erosion of capital, forcing banks to seek help from the government. A rating mishap can therefore have far-reaching consequences.

The predictive power of sovereign ratings is questionable. Even in the period prior to 2008, ratings by rating agencies were observed to be pro-cyclical. As Standard & Poor’s data shows, for the period 2005 to 2008, there were more upgrades than downgrades until 2007. Then, in 2008, when sovereign defaults started to rise, a trend degradation has started. If sovereign ratings had only limited predictive power in relatively normal times, what are the chances that risks are better valued now that complexity levels have risen so sharply?

After 2008, the approaches adopted by rating agencies to these ratings were criticized by regulators such as the European Securities and Markets Authority and the European Banking Authority. In response, rating agencies have only fine-tuned their basic rating approaches.

Thanks to QE in advanced economies (EAs), the most intuitive drivers of sovereign risks, such as the debt-to-gross domestic product ratio and the budget deficit, were already skyrocketing in 2019. Public spending induced by the pandemic provoked a deterioration in public finances to their ten-year low. Decades of historical data on public finances have provided quite useful benchmarks for classifying sovereigns by risk. However, the current set of macroeconomic and fiscal ratios is unprecedented, making benchmarking difficult. Such a situation requires sophisticated analysis using fishtail distributions and computational intensive scenario analysis. None of this is done.

The best solutions offered by rating agencies are linear regressions performed on previously assigned ratings. Such approaches fail a basic risk modeling odor test. They assume that past ratings are correct and that macroeconomic variables have almost linear relationships with country risk. Then comes the implementation of this framework. Even today’s limited quantitative framework would be unable to explain in purely numerical terms the large gap in the ratings of some high-quality AEs and MSs (like India). This is where the qualitative superimpositions of RCAs’ judgment come in.

All aspects of sovereign risk cannot be covered by quantitative models alone. But the current approach to assessing qualitative aspects leaves room for improvement. The inputs to qualitative judgments are often surveys or selective perceptions. In these, one cannot exclude well-studied elements such as dominance bias. Polls tend to treat the regions from which they originate favorably. The World Bank’s now discredited “ease of doing business” rating also had an impact on ratings. This only underscores the problem of over-reliance on qualitative inputs, let alone perception cues.

Normally, the cost of a bad sovereign rating is borne by corporate borrowers. Governments often express their dissatisfaction with their sovereign rating, but this tends to be dismissed as lobbying. In the current situation, a badly judged rating downgrade can have much worse effects.

He calls for a sovereign scoring framework that clearly breaks with the past. We need a significant upgrade of its quantitative aspects, as well as a more judicious and defensible deployment of qualitative approaches. The form in which sovereign risk is represented itself may need to be rethought. For historical, commercial and acceptability reasons, rating agencies may not be ideal candidates for a system overhaul. The stability of the international bank is a global social good. As its multilateral depository, the BIS is perhaps best placed to take on this vital task.

Deep Mukherjee is Visiting Professor of Finance at IIM Calcutta and Risk Management Consultant

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