Sovereign Debt and Rating Agency Bias

D. Tennant, M. Tracey

• Publisher: Palgrave Pivot
• Year: 2017
• Print ISBN: 9781137397102
• eBook ISBN: 9781137391506
• Topic: Business
• Subtopic: Accounting
• Index: Business

Sovereign Debt and Credit Rating Bias rejects the notion that credit rating agencies' rigorous and transparent determination of ratings leaves no room for bias, and debunks the myth that the value CRAs place on their reputational capital precludes prolonged biases. To determine the extent of CRAs' biased actions, Tennant and Tracey apply a rigorous methodology to a well-established economic model of the determinants of sovereign debt quality. They present strong evidence of bias against poor countries and demonstrate how biased rating changes could disadvantage such countries and the companies operating therein as they seek access to international capital markets. They discuss plausible explanations for the bias and suggest remedial measures that would help ensure balance in credit rating changes. This book fills an important gap by rigorously examining a long-standing but often ignored concern about the rating practices of credit rating agencies.

1

Credit Rating Agencies as Gatekeepers

Abstract: This chapter begins by introducing the theme of the book and providing a brief outline of subsequent chapters. It then contextualizes the discussion by presenting the varied but conjoined interests of the key players in the sovereign debt market—the national governments which seek to borrow on the international capital market, and the investors which seek to hedge their risks as they supply the requisite funds. It shows how the intersection of these interests has established the big-three CRAs as the gatekeepers of the international capital markets, indicates how these agencies may be flawed as they fulfill this role, and highlights the implications of this for the affected countries.

Keywords: Credit Rating Agencies; Developing Countries; Gatekeepers; International Capital Markets; Sovereign Debt

Tennant, David F., and Marlon R. Tracey. Sovereign Debt and Credit Rating Bias. New York: Palgrave Macmillan, 2016. DOI: 10.1057/9781137391506.0005.

In the past three decades, credit rating agencies (CRAs) have had significant influence on the terms on which developing countries can tap international capital markets. This is because of the stagnation of concessional financial assistance and significant increases in private capital flows. Reisen (2002) asserts that, unlike in the 1960s, 1970s and 1980s, the most important visit that a developing country now expects is not from major aid agencies or from the International Monetary Fund (IMF), but rather from one of the big-three credit rating agencies (Moody’s, Standard and Poor’s [S&P] and Fitch). This is because in developing countries, problems of limited information and lack of transparency are particularly severe, forcing investors to primarily rely on the “expert” opinions encapsulated in the ratings when making their investment decisions (Ferri 2004). This is exacerbated by the fact that many institutional investors in developed countries are only permitted to hold securities with ratings above a certain threshold (Cantor and Packer 1996). When a sovereign debt rating is downgraded, particularly if it crosses the threshold from investment grade to speculative grade, there are costly implications for national governments.

It is in this context that this book investigates rating agencies’ assignments of sovereign debt upgrades and downgrades to ascertain whether any biases can be shown. Subsequent chapters examine the pervasive allegation that there is a systemic difference in rigor and accuracy of ratings ascribed to certain categories of countries. This allegation is serious, as, if true, it could unduly disadvantage both those countries and the companies operating within them as they seek access to international capital markets. In the next two chapters, we contextualize the discussion by examining how the CRAs determine their rating assignments and analyzing the demand-side and supply-side conditions in the credit ratings industry. This allows us to highlight the conditions that present opportunities for biases to be introduced in the CRA industry. We, however, can only show such biases in sovereign debt ratings when we control for the key theorized determinants of such ratings, and then examine whether CRAs still exhibit a tendency to downgrade or not upgrade a particular category of country. This analysis and the methodology used are presented in chapters 4 to 6, wherein we explore preliminarily and econometrically whether biases are evident on the basis of a country’s level of development, or are apparent for certain regional groupings of countries. The implications of our findings are discussed in the final chapter.

The rest of this introductory chapter presents the varied but conjoined interests of the key players in the sovereign debt market—the national governments which seek to borrow on the international capital market, and the investors which seek to hedge their risks as they supply the requisite funds. We show how the intersection of these interests have established the big-three CRAs as the gatekeepers of the international capital markets, indicate how these agencies may be flawed as they fulfill this role, and highlight the implications of this for the affected countries.

Sovereign indebtedness and the role of credit rating agencies

All countries have needed to borrow money at some point in time. Borrowing makes more resources available to finance the technology gains and capital deepening that precipitate economic progress. Sovereign debt is, however, different from private debt in that there is no clearly defined procedure for enforcing sovereign debt contracts, with the legal recourse available to creditors having limited applicability and uncertain effectiveness (Panizza et al. 2010). This is of concern, particularly as there is much empirical evidence indicating that, even though low to moderate levels of sovereign debt can be beneficial to economic growth, high levels of debt tend to be deleterious to such outcomes.¹ Debt at such levels can be unsustainable, heightening the likelihood of sovereign debt default (Tennant 2014a).

There has been a significant increase in sovereign indebtedness in the past three decades (Cecchetti et al. 2011; Panizza et al. 2010). Increased borrowing and lending were incentivized with the popularization of financial liberalization after the late 1970s. Financial liberalization precipitated the removal of restrictions on financial market activity and lending in many countries, and intensified financial innovation stemming from improved financial theory and information technology. This, when coupled with a relatively stable global macroeconomic climate between the mid-1980s and the start of the 2007–2009 global crisis, created the conditions that fostered heightened demand for sovereign debt and the supply of the requisite funds (Cecchetti et al. 2011).

The instability associated with the global crisis did not reduce sovereign debt levels. Direct bail-out costs in some countries, the usage of stimulus packages by many governments to deal with the recession, and the substantial declines in government revenues that affected most economies, led to increased debt levels (Tennant 2014a). Reinhart and Rogoff (2010) note that between 2007 and 2009, average debt levels in countries that did not experience systemic financial crises increased in real terms by approximately 20%, and by approximately 75% in countries that did.

With many countries having much higher levels of sovereign debt, borrowers, particularly the national governments of developing countries, now face an intensified debt-development dilemma. Tennant (2014b, 1) notes that:

To protect the world’s poor and vulnerable from the continuing impacts of the Triple F crises (food–fuel–financial) and impending effects of a likely climate change crisis, developing countries need resources. Herein lies the often unacknowledged Fifth Crisis facing many poor countries—the burden of increasingly unsustainable debt, the servicing of which precludes growth-inducing and poverty-reducing government expenditures.

Such poor countries often end up in a vicious cycle wherein they are forced to borrow to repay debt. The critical questions that they face is how to get the best terms for future debt, and whether the cost of restructuring existing debt exceeds the benefit of the improved terms that they can negotiate.

Not even the rich countries of the world have been able to avoid the difficult questions that come with significantly increased levels of sovereign debt. Cecchetti et al. (2011, 1) note that:

The ratio of debt to GDP in advanced economies has risen relentlessly from 167% in 1980 to 314% today, or by an average of more than 5 percentage points of GDP per year over the last three decades. Given current policies and demographics, it is difficult to see this trend reversing any time soon. Should we be worried? What are the real consequences of such rapid increase in debt levels? When does its adverse impact bite?

These questions are of concern not only to the borrowers, but naturally to the creditors as well. Investors face the complex task of assessing the creditworthiness of sovereign debt issues in an environment characterized by increased uncertainty in the post-global crisis era. Even without the heightened uncertainty, the complexity of assessing the creditworthiness of sovereign debt should not be underestimated. This is because a country’s ability and willingness to repay debt is affected not only by its economic, social and political dynamics, but also by increasingly commonplace internal and external shocks.

How do creditors make their decisions as to a country’s creditworthiness? Increasingly they have come to rely on the assessments provided by credit rating agencies (CRAs). CRAs garner information on borrowers from a variety of sources and assess the default risk of the financial products being offered. The default risk is computed and condensed into a single relative measure—a credit rating in the form of a letter grade (Kruck 2011). This rating is a judgment on the “future ability and willingness of an issuer to make timely payments of principal and interest on a security over the life of the instrument.”² This judgment forms the basis of the important but often uneasy relationship between countries which rely on funds from international capital markets, and the CRAs which influence the countries’ ability to access such funds.

Gatekeepers to the international capital markets

The CRAs’ outputs are used to guide the investment choices of government agencies and key institutional investors in the capital markets (pension funds, investment banks and other financial institutions). At the start of the millennium, the two major CRAs (Moody’s and S&P) passed judgment on approximately US$30 trillion worth of securities each year. According to their own estimates, at that time Moody’s had 4,000 clients for its publications and approximately 30,000 regular readers of its print output, and both Moody’s and S&P regularly issued press statements about credit conditions (Sinclair 2005). Output produced for dissemination through the Internet was just then gaining popularity. By the end of the 2007–2009 global crisis, however, CRAs have become known to even the casual newspaper reader. This is not only because of the plethora of articles that have blamed the CRAs for several failures leading up to and exacerbating the crisis, but also because of the demonstration of the critical role that the CRAs play in global investment decisions (Kruck 2011).

Canuto et al. (2012, 5) have noted that “in spite of the criticisms and shortcomings of sovereign risk assessment, the importance of ratings has tended to increase . . . Ratings increasingly influence decisions in both developed and developing countries.” As of 2011, Moody’s, S&P and Fitch issued a staggering 2,219,437 government, municipal and sovereign debt ratings. This represents 99.4% of the total number of such ratings issued by Nationally Recognized Statistical Rating Organizations (NRSROs) globally.³ The credit rating market, particularly that for sovereign debt, is thus heavily dominated by the big-three CRAs. These CRAs operate globally, having subsidiaries in numerous countries. Their ratings are typically requested and paid for by issuers, because investors rely heavily on them. According to Alcubilla and del Pozo (2012, 12),

Issuers seek ratings because they help them to place their securities in the markets at a lower cost. Ratings are disclosed in promotional materials distributed in connection with the issue of a security as a way to ease the selling process. Ratings are also used to help price securities that are traded in the secondary markets. Several studies confirm that liquidity is enhanced and pricing is more favourable when a security has at least one rating.

It is virtually impossible to raise reasonably priced funds in the international capital markets without being rated by at least one of the big-three CRAs. Sinclair (2005, 2) thus notes that these agencies control access to capital markets. They are the gatekeepers to these markets, and, as such, wield enormous power. Ratings by the big-three CRAs “affect the interest rate or cost of borrowing for businesses, municipalities, national governments, and, ultimately, individual citizens and consumers” (Sinclair 2005, 4). As gatekeepers to the international capital markets—often the only viable alternative to the IMF that national governments have for financing their budget deficits—the big-three CRAs possess, via rating downgrades (or the threat thereof), the capacity to forcibly direct borrowing governments that are eager to obtain scarce funds. These agencies “put a price on the policy choices of governments . . . seeking funds” (Sinclair 2005, 10).

Numerous governments have further legitimized the big-three CRAs’ role as gatekeepers by enshrining their ratings in the legislation governing investors. The United States is noted as having the most widespread usage of credit ratings in regulations that establish capital requirements in the banking and securities sectors. The legislation further restricts the ratings used for these purposes almost exclusively to those issued by CRAs designated as NRSROs, which we have already established as being heavily dominated by the big-three. Such practices are, however, not limited to the US government. In 2009, a Joint Forum investigating the use of credit ratings in 12 advanced economies, found that such ratings are also heavily used in their legislation.⁴ Kruck (2011, xv) thus argues that state regulatory authorities have empowered CRAs by making increasing use of private credit ratings in public financial regulation. This is a practice which he asserts should call into question the power, reliability and accountability of CRAs.

Are credit rating agencies flawed gatekeepers?

Markets and governments take account of CRAs because they are thought to be an authoritative source of judgments, providing clear, internationally harmonized indicators of the risk of default (Sinclair 2005; Alcubilla and del Pozo 2012). Their reputation as such has allowed them to serve as gatekeepers to the international capital markets. This reputation has, however, taken a severe beating in recent times, particularly after the Asian crisis of the mid-to-late 1990s and the 2007–2009 global crisis. In the aftermath of both crises, dissatisfaction with the role played by the CRAs precipitated deeper examination of the variables and models used in the calculation of debt ratings. As a consequence, numerous studies have now confirmed widely held notions that the big-three CRAs made mistakes leading up to both crises. Kruck (2011, xv) notes that “innumerable articles have appeared blaming credit rating agencies for failing to ...

Table of contents

• Cover
• Title
• 1  Credit Rating Agencies as Gatekeepers
• 2  Establishing the Determinants of Sovereign Debt Ratings: Is There Really Room for Bias?
• 3  Resilience in Spite of Controversy: Conditions for Bias in the Credit Rating Industry
• 4  Trends in Sovereign Debt Ratings: Are There any Preliminary Signs of Bias?
• 5  Introducing Greater RigorMethodological Approach
• 6  Are Poorer Countries Disadvantaged by the CRAs? Empirically Establishing a Bias
• 7  Now That We Have Found Bias, What Are We Going to Do with It?
• References
• Index