Credit rating agencies have played a crucial role in international debt markets for more than 150 years. But they have often attracted controversy. Matthew Kofi Ocran, Professor of Economics at the University of the Western Cape, explains why rating agencies matter for developing countries.
What do credit rating agencies do?
Credit ratings express an agency’s opinion about the ability and willingness of any issuer – governments, financial institutions, corporations, insurance companies and structured finance – to meet its financial obligations in full and on time.
There are more than 70 agencies around the world. But three dominate, controlling 91% of the global market. They are Standard & Poor’s, Fitch and Moody’s.
Though there are slight differences in the rating scales that the big agencies use, all fall into two broad categories. These are investment and speculative grades. The investment grades range from AAA, very high credit quality, to BBB-, moderate credit risk. There are eight other notches between AAA and BBB-.
The speculative grade ratings start from BB+, which is associated with substantial risk. The bottom of the scale of the non-investment or speculative grade ratings is designated as C by Moody’s, and D by Standard & Poor’s and Fitch. The last rating on the scale suggests that the issuer is very close to default or already in default. When considered as numerical scales, there are 22 - from AAA to D ratings.
Do ratings agencies matter for developing countries?
Credit rating agencies are incredibly important for developing countries for a number of reasons.
First, the ratings act as a kind of moral suasion that compels developing countries to pursue more prudent and sensible monetary and fiscal policies. Sovereign ratings serve as an incentive for sound monetary and fiscal policies because performance on these policies forms an integral part of the rating methodologies.
Second, a favourable rating enables governments and companies to raise capital in the international financial market.
Institutional investors in both the developed and developing world rely heavily on rating agencies in making investment decisions.
This is because credit ratings are essentially opinions about credit risk. Ratings provide insight into the credit quality of an individual debt issue and the relative likelihood that the issuer may default.
Fund managers often don’t know enough about the risk associated with parties they’re interested in. Credit rating agencies provide an opinion about the credit quality of borrowers such as governments, corporates, financial institutions, and their related debt instruments such as bonds.
This means that to attract investors with deep pockets you can’t avoid having a credit rating. And a good one at that.
Why are they controversial?
The key point here is that credit ratings are opinions. That means they are bound to be disputed or elicit criticism.
The credibility of credit rating agencies took a knock during the financial crisis. They were criticised for failing to do a diligent job in evaluating the credit worthiness of bonds in the lead up to the crisis. Some had punitive fines imposed on them by US financial regulators.
That said, their role has by no means diminished. The international financial industry still relies heavily on their opinions.
Even though the agencies use their own unique rating methodologies, they usually arrive at comparable conclusions. Very often an analyst may form an assessment based on a number of quantitative and qualitative measures which is then presented to a committee for review. Standard & Poor’s follows this process. In some cases assessments may be based on a quantitative model.
What impact do they have on economies?
The opinions by the rating agencies tend to have an important effect on the cost of financing for governments and companies. For example, the benchmark 10-year Government Bond issued by countries with high investment grade ratings attract very low interest rates. This is usually less than 2.50%. For instance, Canada with its AAA rating borrows at