Global credit rating agencies (CRAs) found themselves in the crosshairs of the Economic Survey 2021, released yesterday.
The study castigates credit rating agencies as “noisy, opaque and biased” and says India’s sovereign credit ratings do not reflect its economic fundamentals.
The government’s anger may or may not be well-founded, but it gives us an opportunity to look at the role rating agencies play in the global economy and then try to understand whether India’s rebuke of them could affect investor perception.
What caused this?
The bone of contention was probably something that happened in June of last year, when two credit rating agencies – Moody’s and Fitch – reviewed Sovereign Rating of India. While Moody’s downgraded the rating from Baa2 to Baa3, Fitch retained its BBB- rating but changed the outlook to negative. S&P, the other major CRA, retained its BBB- rating.
While all three agencies kept India in investment grade (BBB and above), the revisions nonetheless raised concerns. After all, India was pushed to the bottom of the investment grade ladder and was a stone’s throw from “junk” or “speculative” territory (BB+ and below). Another downgrade would have driven overseas pension funds and investment banks away from Indian markets.
FOR YOUR INFORMATION: The agencies cited the high debt burden, COVID-19 and the prolonged economic downturn that preceded the pandemic as reasons for the downgrade.
What do rating agencies do?
These are companies that issue letter grades to issuers of bonds and other debt and fixed income securities. Issuers can be governments, corporations, financial institutions, insurance companies, etc. These ratings provide valuable information to individual or institutional investors on the ability of issuers to honor their short or long-term debts.
Basically, rating agencies are supposed to provide objective and independent analyzes of the companies and countries that issue such securities.
What are the types of ratings?
It depends on who or what is being evaluated. The aforementioned sovereign credit rating is assigned to countries and takes into account several macro parameters such as the volume of public and private investments, economic growth and foreign exchange reserves.
Credit ratings are also issued for companies and securities such as corporate bonds and government bonds. Here too, the individual report cards examine the past performance, financial health and risk of default of the entity or security.
What are the global credit rating agencies?
The global ARC market is highly concentrated. So much so that only three companies – Moody’s, Fitch and S&P – control almost the entire sector (95%).
All three are headquartered in the United States. Together they are called the “Big Three”.
FOR YOUR INFORMATION: There are also many ARCs based in India. The most important of these is CRISIL. Others include CARE, ICRA, SMERA and ONICRA.
A Brief History of the Big Three
The dominance of these three companies has been a fact since the 1990s, often cemented by law as in the United States and Europe.
For a long time, concerns about overreliance on just three credit rating agencies were hushed up. They seemed to be doing a good job and had a global footprint – everything seemed to be going well.
Then came the Great Recession. The financial crisis of 2007-09 subjected the three companies to intense scrutiny and much criticism.
Reviews of the Big Three
Most of the criticism revolved around the Big Three giving high marks to truly bad investments, particularly mortgage-backed securities in the United States, which received AAA ratings. Investors were falsely led to believe that these were safe bets with low risk of default.
What followed was the subprime mortgage crisis and accusations that the Big Three issued positive ratings on junk investments in order to pocket profits and increase market clout. Indeed, a commission appointed by the US Congress has called the Big Three “key factors in the financial crisis”. Some were even a fine massively by the US government.
In the years that followed, the reputation of these agencies deteriorated further due to their role in the European sovereign debt crisis. The downgrading of Greece, Portugal and Ireland in 2010 worsen crisis.
Shady business practices aside, the very dominance of these three companies is a matter of risk. The ARC market, it has often been pointed out, is essentially an oligopoly at the moment, ruled by three companies with dubious pasts and tainted reputations, whose supremacy prevents small and medium-sized competitors from obtaining a fair luck.
The importance of the big three
The three major credit rating agencies may have flaws – the very way the credit rating agency market is constructed may be problematic – but none of these factors absolves the fact that the Big Three remain indispensable to finance international.
That’s because, all things considered, these three companies do a more or less good job and provide valuable, informed opinions. They have well-defined methodologies for assigning ratings. In most cases, rating results are determined by intra-agency voting and subject to simple majorities. Furthermore, the reports of the rating agencies are available to the issuer or the public for consultation and verification.
In fact, an IMF study suggests that in 1975-2015, all sovereigns that defaulted were rated as non-investment grade at least one year before their default. And between 1983 and 2009, no Investment Grade rated country defaulted. As far as companies are concerned, only about 1% of those rated as risky companies defaulted during this period.
Yes, the ARC market is in dire need of reform. Yes, many fault lines that led to the Great Recession remain unplugged. And no market should be dominated by just three big players based in a single country in the world.
But until these reforms take place, there is no escaping the crucial role played by the Big Three. Their reports and opinions are sought after by everyone from analysts and banks to global fund companies. And because what they have to say commands attention, not paying attention to what they have to say can be a costly mistake.
Which brings us back to this year’s Economic Survey, where ECA Krishnamurthy Subramanian argued that India’s fiscal policy should not fear rating downgrades, and should instead “reflect Gurudev Rabindranath Thakur’s sentiment of a fearless spirit”.
But daring for daring’s sake can be a reckless path. Because the bottom line is that even if the Indian government ignores credit rating agencies, institutional investors won’t. A rating downgrade into speculative territory can be disastrous. Especially for a country going through its worst recession on record. Especially for a country that chooses to ignore the rating (i.e. warning signs) in the first place.
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