II. The Emerging Markets Challenge to Credit Rating Agencies

II. The Emerging Markets Challenge to Credit Rating Agencies

Credit rating agencies play a low-profile, but high-impact, role in modern financial markets. Their determinations of the risk presented by loans to or investments in bonds of corporations, countries, states, municipalities and other public agencies is a major factor in the ability of these entities to raise funds and to a great extent establishes the rate of interest they must pay to obtain credit. Even U.S. Treasury bond yields, a benchmark for the rates of interest paid on other sovereign bonds, have been known to fluctuate when rating agencies voiced concern about fiscal imbalances or the ability of the U.S. to finance its huge current account deficit.

It is possible for corporations to issue bonds without obtaining a credit rating. But most large international corporations consider a rating desirable if not essential to attract the broadest possible class of investor. Countries ask agencies to provide a rating for the same reason: to establish credibility as a borrower. [ Even a low rating might be better than no rating at all. At a conference on the impact of sovereign credit rat ings on African countries held by the Center for Strate gic and International Studies in April 1998, agency representatives „made it clear that they would be happy to undertake credit ratings at the request of a country and for a reasonable price, even if no specific bond issue was under consideration. Furthermore, the rating did not have to be made public if the country chose to keep it confidential. Credit rating agencies could help countries to better understand how their economies appear to outside investors and what measures might be taken to improve that image. By enabling investors to distinguish among markets, even a speculative rating, with the implicit likelihood of being upgraded, can play an important role in attracting capital to stable and reform-oriented economies. A country with a rating is further down the road toward integration into the inter national financial system than one without a rating." See: „Integrating Africa into International Financial Markets; The Impact of Sovereign Credit Ratings," CSIS, Washington, D.C., Fall 1998, P. 14.]

Rating agencies emerged in the United States near the end of the 19^th century as publishers providing investors with information on the financial state of mercantile firms. In 1909, John Moody started to publish ratings of railroad bonds, extending this soon after to utility and industrial bonds. In 1933, publishers Robert Dun and John Bradstreet merged their enterprises to form Dun & Bradstreet, which bought Moody's Investor Service 30 years later. Standard & Poor's Inc., Fitch IBCA and Duff & Phelps emerged in similar fashion. [ IMF, op cit., p. 188] Today these four companies, led by Moody’s and Standard & Poor’s, dominate the global credit ratings industry.

The agencies once rated companies free of charge, deriving their revenues from the sale of publications. Income from publishing proved insufficient, though, and the agencies started to charge issuers to provide ratings. The risk that a conflict of interest might arise was considered to be minimized by competition between the agencies and an individual agency’s interest in maintaining credibility. Today payments from rated entities account for 90% of revenues, though the agencies can issue ratings on their own initiative in response to demand from investors. A corporation or country which has commissioned a rating from an agency has the right, however, to decide whether or not that rating should be made public.

The rating agencies use alphabetical-numerical scales to qualify the risk that a country or corporation might not make interest payments on time or reimburse the bond principal at maturity. Investors, brokers and other market participants generally refer to the ratings issued by Moody’s and Standard & Poor’s. Ratings from Fitch IBCA or Duff & Phelps provide an additional perspective and can tip the balance if the two top agencies disagree. The highest rating a borrower can receive is ‘Aaa‘ from Moody’s and ‘AAA’ from Standard & Poor’s, indicating that the issuer offers „exceptional financial security" or „extremely strong capacity to meet its financial commitments," as Moody’s and S&P’s respectively put it. (see Table 1; p. 12)

Below that pinnacle of creditworthiness, the critical distinction is between investment-grade issuers and those rated speculative grade. On the Moody’s scale, bonds rated ‘Baa’ or better are considered investment-grade; the corresponding level on the Standard & Poor’s scale is ‘BBB.’ This distinction is important, because many pension funds and other such fiduciary institutions, which in the United States are subject to regulation under the Employee Retirement Income Security Act (ERISA), are obliged to invest a minimum percentage if not all of their funds in investment-grade securities. This legislation provided a powerful incentive for corporations to seek a rating, and significantly increased the influence of the U.S. ratings agencies at home and abroad.

Once a rating is issued, it is periodically confirmed or revised according to economic or other developments, including political changes in the case of sovereign ratings; trends in the interim are signaled with „positive," „negative," or „neutral" readings. Although agency ratings are forward looking in quantifying risk, the agencies do not try to predict the future. [ „The rating agencies view their ratings as providing a forward-looking indication of the relative risk that a debt issuer will have the ability—and willingness—to make full and timely payments of principal and interest over the life of a particular rated instrument. The agen cies do not regard their ratings as providing either a prediction of the timing of a default or an indication of the absolute level of risk associated with a particular financial obligation. The absolute level of the default risk is seen as being influenced by the state of the busi ness and credit cycles. During the Great Depression of the 1930s, even highly rated corporates were more likely to default than in other periods; but the agencies would expect that a more highly rated firm would de fault with less frequency than a lower-rated firm during even difficult times. Nonetheless, in assigning ratings, the agencies indicate that they try to see through eco nomic, political, credit and commodity cycles." IMF, op. cit., p. 192 ]

Rating agencies developed not as mere information providers, but as arbiters of risk. The assignment of a rating indicates a certain level of risk and places the issuer in a certain category of borrowers who pay a roughly comparable rate of interest to borrow money or to issue bonds. This interest is roughly proportionate to the risk – or at least the perceived risk – that interest payments due on a bond might not be made in a timely manner or that the bond principal amount might not be repaid. It also reflects the length of time before repayment is due.

The approach to country ratings is similar to the analysis which an agency carries out on corporations. Both consider an entity’s revenue stream and balance sheet, in particular the debt a corporation or country has on its books and the burden of servicing that debt. Past financial performance is also considered: a corporation or country which has defaulted on its financial obligation within recent memory inevitably is seen as seriously credit-impaired and will receive a low rating.

Country or sovereign ratings by their nature present a significant challenge to the agencies. In the case of a sovereign nation the agencies must consider not only its ability but its eventual willingness to meet financial obligations. Creditors can seek redress in court when corporations default, but have limited recourse when governments fail to live up to their promises. Politics complicates matters as well. Agencies must consider the risk that the government’s economic policies might change, or that a new administration or regime might actually repudiate debt.

Ratings are issued only after analysts have conducted due diligence by collecting data, visiting the country and interviewing its senior financial officials. The matter is then put to a vote by committee of agency analysts and managers, though not before the country has an opportunity to respond to the preliminary report by the analysts and their recommendations as to what rating should be assigned.

Countries can influence the ratings process by appealing adverse decisions. This may not always produce the desired outcome, but shows a country’s leadership is attentive and provides opportunities to discuss rating issues and impacts.

The rating assigned to a country has a significant impact on all entities within its borders seeking a rating, be they states, municipalities or private companies, as the sovereign rating generally functions as a ceiling for all other ratings. It is rare for a well-managed city to receive an investment-grade rating when its country is considered speculative-grade. Similarly, it is difficult for a corporation to obtain a rating higher than that of the country in which it is based. Ratings on debt issued in the local currency can rise through this sovereign ceiling, but foreign-currency debt ratings are most often capped by the sovereign rating. This is because the government’s imposition controls on capital flows can obstruct debt payments.

The agency workload with respect to country ratings greatly increased in the late 1990s. Moody's and Standard & Poor’s saw a sevenfold increase in the number of emerging market sovereign issuers obtaining foreign currency debt ratings. Sovereign issuance climbed sharply with capital flows into emerging market bonds more than doubling from $117 billion in 1993 to $286 billion in 1997. [ IMF, op. cit., p. 203; http://www.imf.org/external/ pubs/ft/icm/1999/index.htm]

One reason for this surge was the rehabilitation of Latin American borrowers through the debt-restructuring program sponsored by and named after U.S. Treasury Secretary Nicholas Brady. [ Under the Brady Plan commercial bank debt on which countries had defaulted or were in arrears, was converted into marketable securities beginning in the early 1990s. In most Brady deals, the banks forgave part of the principal and interest in exchange for bonds issued by the countries. Such bonds featured different maturities, interest rates and guarantees, including in some cases U.S. Treasury bond collateral. Banks ini tially traded these bonds among themselves, but Bradys soon found their way into speculative and institutional portfolios in the emerging world as well as major mar kets (Brazilian banks, for instance, became major play ers in Brazilian Brady debt). The creation of a $300 billion Brady bond market set the stage for the issuance later in the 1990s of sovereign Eurobonds.] The subsequent emergence of a liquid market in Brady bonds in the early 1990s whetted investor appetites for high-yielding emerging markets securities just as developing countries coming out of their 1980s recessions sought lower-cost, longer-term alternatives to bank loans. Official lenders like the IMF and World Bank, and bilateral creditors in the OECD bloc, hoped private-sector investors would step up to meet the borrowing needs of more developed countries, letting the IFIs focus on poorer nations.

This unprecedented demand for sovereign ratings strained agency resources. It has been estimated that the average ratio for rating agency coverage by the late 1990s was one senior analyst to seven countries. One response by the agencies was to increase cooperation with agencies in developing countries, most often by acquiring equity stakes in them or buying them outright. Global agencies brought capital and expertise; local partners offered insight into local conditions and fresh talent. But increased staff and information did not prepare the rating agencies for the startling capital surges and market volatility seen as of July 1997.