Credit Ratings: The Govt View

Why in News?

• Recently, the Finance Ministry released a document titled ‘Re-examining Narratives: A Collection of Essays’, which is an attempt to present alternate perspectives on diverse areas of India’s economic policy.
• The first of the five essays in the document is a criticism of what the government calls the opaque methodologies adopted by credit rating agencies (CRAs) to arrive at sovereign ratings.
• Amidst these developments, it is important to evaluate the govt’s argument, and why sovereign credit ratings matter.

Credit Rating Agencies (CRAs)

• CRAs are independent organisations that assess the creditworthiness of individuals, corporations, and governments.
• Their primary function is to evaluate and assign credit ratings to debt securities and other financial instruments issued by these entities.
• Credit ratings provide investors and other market participants with an opinion on the risk associated with a particular investment or borrower.

Key Features of Credit Rating Agencies

• Credit Ratings
  • These are alphanumeric symbols or letter grades assigned to debt instruments or issuers.
  • Common rating scales include AAA, AA, A, BBB, etc., with higher ratings indicating lower credit risk.
  • Independence
  • Credit Rating Agencies strive to maintain independence and objectivity in their assessments.
  • They are expected to provide unbiased opinions on credit risk to facilitate informed investment decisions.
• Issuer-Pays Model
  • Historically, CRAs were compensated by the issuers of the securities they rated.
  • This raised concerns about potential conflicts of interest, as agencies might be motivated to provide favourable ratings to attract more business.
  • Efforts have been made to address this issue and improve the transparency of the rating process.
• Regulatory Mechanism of CRAs
  • Many countries have regulatory bodies overseeing Credit Rating Agencies to ensure transparency, accuracy, and fairness in their assessments.
  • Investors often use these ratings as a benchmark for assessing the risk associated with various investment opportunities.
  • Additionally, regulatory requirements may mandate certain institutions to hold securities with specific minimum credit ratings.
• Types of Ratings
  • Credit Rating Agencies provide ratings for a wide range of debt instruments, including corporate bonds, municipal bonds, government bonds, asset-backed securities, and more.
  • They may also provide issuer credit ratings, reflecting the overall creditworthiness of a company or government.

Evolution of Main Sovereign Rating Agencies

• Pre-Bretton Woods Institutions
  • Sovereign credit ratings precede the establishment of the Bretton Woods institutions (World Bank and IMF).
  • Three globally recognised credit rating agencies are Moody’s, Standard & Poor’s (S&P), and Fitch.
• Moody’s: Moody’s is the oldest; it was established in 1900 and issued its first sovereign ratings just before World War I. 
• Standard & Poor’s and Fitch Origins: In the 1920s, Poor’s Publishing and Standard Statistics (predecessor of S&P) began rating government bonds.

Importance of Sovereign Ratings

• Creditworthiness Marker
  • Sovereign ratings assess the creditworthiness of governments.
  • They serve as a crucial indicator for investors worldwide regarding a government's ability and willingness to repay debt.
• Assess the Borrowing Ability
  • Like an individual's credit rating influences loan availability and interest rates, sovereign ratings affect a country's borrowing capacity.
  • Governments with higher ratings are considered more reliable borrowers.
• Affects Interest Rates for Governments and Businesses
  • Governments with well-established repayment history and substantial assets pay lower interest rates on borrowed money.
  • Lower sovereign ratings result in higher interest rates for governments, impacting their borrowing costs.
  • Businesses within a country are also affected; a lower sovereign rating can lead to higher interest rates for them when borrowing globally.
• Set Safety Benchmark
  • Governments are viewed as a benchmark for safety in a country.
  • A low sovereign rating indicates higher risk, affecting not only the government but also businesses within the country.
  • Affects Global Investments and Borrowing Costs
  • Developing countries, despite having abundant resources, often lack capital. A poor sovereign rating limits a country's ability to borrow from global investors.
  • This limitation hampers the utilisation of natural strengths and obstructs economic productivity.
• Impacts Mass Poverty and Economic Productivity
  • A favourable sovereign rating can facilitate easier borrowing, enabling countries to leverage their resources for economic development.
  • On the other hand, a poor rating may hinder economic growth, making it challenging to alleviate poverty and maximise productivity.

Indian Government's Criticism of Rating Agencies

• Opaque Methodology and Bias Against Developing Economies
  • The Finance Ministry criticises the opacity of rating methodologies, particularly highlighting biases against developing economies.
  • It points out Fitch's preference for high levels of foreign ownership in the banking sector, disadvantaging countries where the public sector dominates the banking industry.
  • The assessment is seen as discriminatory, overlooking the developmental role of public sector banks in promoting financial inclusion.
• Criticism of Transparency in Selection of Experts
  • The government raises concerns about the non-transparent selection of experts consulted for rating assessments.
  • The lack of clarity in the selection process adds another layer of opacity to an already complex methodology.
  • Unclear Assignment of Weights for Parameters
  • The Finance Ministry argues that rating agencies do not clearly convey the assigned weights for each parameter
  • While Fitch provides numerical weights for some parameters, it states that these weights are for illustrative purposes only which leads to ambiguity.
• Questionable Use of Composite Governance Indicator
  • The government questions the use of the composite governance indicator (weighted at 21.4), derived solely from the World Bank's Worldwide Governance Indicators (WGI).
  • The WGI incorporates subjective assessments on aspects like freedom of expression, rule of law, corruption, etc., relying on perception-based surveys.
  • The government contends that an excessive reliance on such subjective appraisals, along with the Qualitative Overlay, raises concerns about the objectivity of the rating process.
• Criticism of Subjectivity and Arbitrary Indicators
  • The influence of the composite governance indicator and perceived institutional strength is criticised for surpassing the collective influence of other macroeconomic fundamentals in determining credit rating upgrades.
  • Developing economies are said to be required to demonstrate progress along arbitrary indicators, criticised for being constructed from one-size-fits-all perception-based surveys.

Conclusion

• Sovereign ratings play a pivotal role in shaping a country's economic landscape, affecting government borrowing, business operations, and overall economic development.
• The essay released by the finance ministry seeks to flag issues with the methodology adopted by the three main global credit rating agencies, and to show how these gaps affect India adversely.
• The government's criticism revolves around the lack of transparency, biases against developing economies, and the subjective nature of certain indicators used by rating agencies.

Q1) What is the primary purpose of credit rating agencies?

Credit rating agencies assess the creditworthiness of individuals, companies, or governments, providing investors with a risk evaluation of financial instruments like bonds or securities.

Q2) How do credit rating agencies determine credit ratings?

Credit rating agencies analyse financial statements, economic conditions, and other relevant factors to assign credit ratings, ranging from high credit quality to high risk, influencing investment decisions and interest rates.

Source: The Indian Express