The Finance Ministry recently unveiled a document named “Re-examining Narratives: A Collection of Essays“. This document sets out to offer different viewpoints on various aspects of economic policy. These viewpoints could significantly influence India’s growth and priority areas in the long run.
Critical Review of Credit Rating Agencies: The first out of five essays included in the collection is a critique of the government’s statement on the unclear methods used by credit rating agencies to determine sovereign ratings.
Issues with Credit Rating Methodology: This particular essay aims to highlight the problematic approach used by the top three global credit rating agencies. Furthermore, it seeks to illustrate how these methodologies, through the Finance Ministry’s calculations, have a negative impact on India.
Why Do Sovereign Ratings Matter?
Sovereign ratings are similar to credit scores. Just like an individual with a good credit history – someone who has been diligent in paying back loans and has significant assets or income streams – can get a new loan at a lower interest rate, the same applies to governments. Governments with high sovereign ratings can borrow at lower interest rates.
Impact on Businesses
These ratings are not just important for the government, but also affect businesses in that country. The government is seen as the safest entity within a country, so if a country’s sovereign rating is low, businesses in that country will have to pay higher interest rates to borrow funds from global investors.
Developing Countries and Sovereign Ratings
Many developing countries, while rich in labor resources, land, or mineral resources, often lack capital. Without sufficient financial resources, these countries find it challenging to capitalize on their natural strengths. A low sovereign rating can limit the ability of these countries to borrow money, just as a good rating can facilitate increased productivity and poverty reduction.
Sovereign Ratings and Foreign Direct Investment
Not only do countries seek sovereign credit ratings for issuing bonds, but it’s also a strategy to attract foreign direct investment (FDI). To encourage investor confidence, many countries aim to get ratings from the largest and most recognized credit rating agencies.
Which Are The Main Rating Agencies?
Credit ratings, which predate even institutions like the World Bank or the International Monetary Fund, are an essential part of global finance. There are several credit rating agencies worldwide, but three stand out: Moody’s, Standard & Poor’s, and Fitch.
There are also other notable agencies such as China Chengxin International Credit Rating Company, Dagong Global Credit Rating, DBRS, and Japan Credit Rating Agency (JCR). Occasionally, subdivisions within countries release their sovereign bonds, and these also need ratings.
A Brief History of Credit Rating Agencies
Moody’s, the oldest among these agencies, established itself in 1900 and issued its initial sovereign ratings just before World War I. In the 1920s, two other companies, Poor’s Publishing and Standard Statistics, began rating government bonds. These two eventually merged to become what we know as Standard & Poor’s today.
Impact of Global Events on Credit Ratings
Credit ratings aren’t fixed, and global events often influence them. For example, during the Depression of the 1930s, there was a sharp rise in sovereign defaults, leading to a downgrade in most ratings. By the end of the decade, all European countries except the UK found themselves in the speculative grade.
Examples of Sovereign Credit Ratings
Fitch gives a BBB- or higher rating to countries it considers investment grade, and grades of BB+ or lower are deemed to be speculative or “junk” grade. Standard & Poor has a similar system.
Moody’s considers a Baa3 or higher rating to be of investment grade, and a rating of Ba1 and below is speculative.
Which Countries Have the Highest Credit Rating?
Ten countries have the highest possible credit rating with all three major ratings agencies. Those countries are Australia, Canada, Denmark, Germany, Luxembourg, the Netherlands, Switzerland, Norway, Sweden, and Singapore. Each of these countries has a rating of AAA from Standard & Poors, Aaa from Moody’s, and AAA from Fitch.
Government Critique: An Overview
The Indian Finance Ministry has flagged three primary concerns with the approaches employed by credit rating agencies.
Issue 1: Opaque and Unfair Practices
First off, these methodologies are often unclear and seem to unjustly disadvantage developing economies. For example, Fitch, a renowned rating agency, has indicated a preference for high foreign ownership in the banking sector. The Ministry also mentions Fitch’s view that public-owned banks tend to suffer from political interference.
These perspectives, according to the government, are prejudiced against developing nations where public sector banks are predominantly in operation. They argue this view neglects the crucial role these banks play in promoting financial inclusion and welfare in a developing country.
Issue 2: Non-transparent Selection Of Experts
The second concern revolves around the non-transparent selection of experts consulted for these rating assessments, which adds another layer of ambiguity to the already complex methodology.
Issue 3: Unclear Parameter Weights
The third issue is related to the lack of clear communication about the weights assigned to each evaluated parameter. While Fitch does share some numerical weights for each parameter, it also mentions that these weights are merely illustrative. This statement further confuses the understanding of their methodology.