RATING LORDS

How rating agencies thwart development.

By Karl-Heinz Bächstädt, Markus Henn and Franziska Richter

            Rating agencies assess the creditworthiness of debtors. They check whether debtors are willing and able to meet obligations. In this context, debtors are not only private-sector companies, but national governments too. The agencies issue their judgments in the form of ratings. The higher the ratings, the more attractive a country or company is to investors.

            Accordingly, the conditions for borrowing money become more favourable. When the situation of a debtor changes, the ratings change too. Downgrades make new loans more expensive and harder to get.

            Rating agencies rate innovative financial products too. Their failure to do so ­accurately was one of the causes of the global financial crisis. Three private sector companies dominate the world market: Standard & Poor’s, Moody’s and Fitch. Together, they account for a market share of about 90 percent.

Disadvantaged developing countries

            So far, many developing countries and companies based there have never been rated. Therefore, their access to the global financial market remains limited. Foreign direct investment normally bypasses them. One reason why countries have not been rated is high costs. In the rating business, those who want to issue bonds have to cover the rating expenses (“issuer pays”).

            To improve matters, the United Nations Development Programme (UNDP) started its ‘Rating Initiative’ in cooperation with Standard & Poor’s in 2003. The UNDP and the US State Department sponsored 16 ratings, including seven for subSaharan countries. In regard to developing countries, the rating agencies still lack staff and expertise nonetheless. They do not do the kind of complex analysis needed. Instead, they rely only on a few data relating to GDP, debt and growth.

            Generally speaking, ratings for developing countries tend to be lower because the agencies take too much account of the world region. A country’s rating is lower if its region is economically weak – regardless of the country’s performance. Making matters worse, a country’s rating is, in most cases, the highest possible rating for all companies based there (“sovereign ceiling”). Accordingly, strong companies from developing countries tend to have unjustifiably low ratings. More ratings, in themselves, will therefore not do to improve developing countries’ access to financial markets.

            Indeed, powerful rating agencies are prone to thwart development for two ­reasons:
– Typically, they favour free market policies and object to government interventions in an economy. Under permanent threat of being downgraded, governments are thus likely to adopt short-term, investor-friendly strategies, for instance, by keeping their debt levels low. The downside is that such a stance often hampers longterm devel­opment.
– Rating agencies tend to see as risks some developments that are actually healthy in a political perspective – consider, for instance, democracy movements in Arab countries. In the worst case, agencies can contribute to the failure of new governance institutions by downgrading a nation in a time of political transition.

            Due to their crucial role in the global financial system and their influence on capital flow, the big three rating agencies command extraordinary power. This should not be so. The agencies have no democratic legitimacy whatsoever.

Compounding problems

            Ratings, moreover, play an important part in bringing about financial crisis. They tend to be procyclical. Agencies normally overestimate the performance of countries and companies during upswings and, in recessions, tend to adjust their judgments too late and too radically. One reason for such failures is that they only take into account very few macroeconomic data, including economic growth or inflation. This practice makes them blind to probable market instabilities.

            Since developing countries’ economies tend to be vulnerable, the rating agencies’ influence tends to be particu­larly relevant. In boom times, favourable ratings invite a massive inflow of “hot money”, further fuelling the bonanza. When agencies downgrade the same country at a later point, portfolio investors flee, aggravating economic troubles.

            Institutional investors such as insurance companies and pension funds respond to downgrades particularly fast, because regulation forces them to hold only financial products with good ratings. The dangers of this practice have become evident again and again, for instance in the Mexican crisis of 1994/95 and the Asian crisis of 1997/98.

            In spite of well-argued criticism of the rating agencies, however, their influence has grown in recent years. The Basel guidelines (Basel II) on how much equity banks must hold are of special relevance in this context. They spell out that banks must hold a certain level of equity for every financial product they own in order to cover risks. How much money they must reserve for this purpose depends on the ratings. The lower the ratings are, the less operations the bank can run.

            In theory, the Basel guidelines are just recommendations, but for all practical purposes, emerging markets and devel­oping countries are under great pressure to comply. The reason is that transna­tional investors insist on global standards and rules.

            For good reason, however, many governments tackle Basel II with caution. Because they normally lack strong authorities to regulate the financial sector and do not have domestic rating agencies, they cannot implement Basel II readily.

            Moreover, Basel II may hurt them. That is the case, for instance, when a country is downgraded and, consequently, all or most of its bonds are downgraded too. As a result, the domestic banks which typically hold the bulk of such papers suddenly need more equity. In the end, the country’s access to the global financial market worsens at the very time that its domestic banks have to reduce operations. This is a sure recipe for compounding recessions. ­Making matter worse, domestic private-sector companies are downgraded too, due to the sovereign ceiling.

            Some countries – Brazil for instance – do not rely on ratings for regulating bank equity. Basel II affects them nonetheless, to the extent that multinational banks are active in their markets. Multinational financial institutions, after all, operate according to the rating-based regulations of where their headquarters are, the EU for instance. Financial crises can be triggered by wrong or misleading ratings and transcend national borders fast.

New agencies

            In many developing countries and emerging marktes, new rating agencies have been – or are being – established. Their business models vary a great deal. The South Africa-based company Global ­Credit Rating, for examples, specialises in the ­African market, where it carries out some 60 % of ratings today. The company was initially branch office of the agency Duff & Phelps, a company later acquired by Fitch. Today, European development banks are among Global Credit Rating’s shareholders, spearheaded by the German KfW Banking Group.

            In India, CARE Rating (Credit Analysis & Research) was started in 1993. At the time, several banks, including from the public sector, were involved. Today, two government-run banks and the Reserve Bank of India, the central bank, are the biggest shareholders. India’s financial sector regulators, the central bank and other government agencies rely on CARE ­Rating, including for the implementation of Basel II.

            Today, some rating agencies specialise in microfinance, a sector that has recently experienced serious problems. The best known agency of this kind is the non-governmental Microfinance Information Exchange (MIX). It was started in 2003 and is based in Washington DC. Agencies of its kind, however, mostly assess financial data such as debt recovery rates or loan volume. Their priorities are not fighting poverty and sustainability, which are what microfinance institutions focus on. MIX is therefore unlikely to contribute much to improving microfinance institutions’ developmental effectiveness.

Taxing competently

            Ultimately, rating agencies’ influence is limited to governments and companies that rely on credit. States that fund their action with loans instead of taxes are subject to the judgment of banks, capital markets and ­rating agencies. In view of recent financial turmoil, developing countries are well advised to think twice before opting for credit. In most cases, smart tax policies matter more, especially if they prevent tax evasion.

            The EU is currently reviewing its legislation on rating agencies and, in the process, should consider agencies’ impact on developing countries. Governments and financial institutions have to become less dependent on rating agencies. Regulators must pay more attention to the needs of developing countries. Ratings must take into account many more issues. International agreements like Basel II must grant adequate policy space to developing countries. Finally, ratings have to take account of sustainability issues, including social and environmental dimensions. – Third World Network Features.

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 About the writers: Karl-Heinz Bächstädt is a management consultant and a certified rating advisor and works for the German company Rating & Risk Consulting GmbH.

Markus Henn is a political scientist and a policy officer with WEED (World Economy, Environment and Development), a non-governmental Germany think tank.

Franziska Richter is a student of political economy and associated with WEED.

The above article is reproduced from the Development and Cooperation (D+C), Vol 53, No. 5, 2012.

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