I. A Post-Crisis Reconsideration of the Credit Ratings Process

A Post-Crisis Reconsideration of the Credit Ratings Process

The economic and financial crisis that started in Thailand in 1997 was not the first to draw attention to the vulnerabilities of developing countries, flaws in the global financial system or the inadequacies of financial institutions. But the crisis focused attention in a new way on the pivotal role of the major international credit rating agencies in the movement of capital into and out of emerging markets.

Numerous observers, including the International Monetary Fund, later concluded that by overreacting to the crisis in its earlier stages, the agencies probably made it worse in its later stages. Their issuance of credit downgrades with an alarming frequency encouraged an exodus of foreign capital and fed the downward spiral. The four big international rating agencies – Moody’s Investors Service, Standard & Poor’s Corp., Fitch IBCA and the Duff & Phelps Credit Rating Co., were also faulted for not having issued clearer storm warnings ahead of the crisis. [ „Rather than being an important independent stabiliz ing force, the major credit rating agencies did not be have very differently from the vast majority of partici pants… While the ratings assigned prior to the crisis were too high, it is arguable that the agencies over reacted and in some cases went to the other extreme." (see International Monetary Fund, Report on Interna tional Capital Markets, September 1999, p. 224; WWW: http://www.imf.org/external/pubs/ft/icm/1999/ index.htm]

Also notable was their failure to understand, once the crisis began, that it had as much to do with conditions in financial markets, particularly the disappearance of liquidity in East Asia, as it did with the region’s underlying economic conditions. [ Liquidity is an important but somewhat elusive con cept in financial markets. On one level it can refer to the ready availability of money or credit, often through the actions of central bankers in generously providing funding to the banking sector, or through the accumu lation of cash in the market for other reasons. But li quidity also refers to the ability of a financial market – in stocks, bonds, currencies or commodities, for in stance – to accommodate trading. Liquid markets typi cally feature a strong volume of transactions with ready buyers, sellers and intermediaries. ] Critics of the agencies, and some of the agencies themselves, were to conclude that they had focused too narrowly on classic indicators of country risk such as national trade and current account balances, and overlooked more dangerous imbalances building up in capital accounts, particularly in short-term money market flows, and the huge pre-crisis buildup of Asian corporate debt.

For developing countries affected by these events, the crisis illustrated the extent to which their economic destinies remained subject to outside forces. The events of 1997-99 suggested that the leading rating agencies not only set the bar which developing countries had to surmount to attract foreign investment, but also had the power to send capital flowing out again to highly destabilizing effect.

Concern about the growing influence of rating agencies has not been limited to the developing world. Considerable controversy has arisen from proposals from the Basel Committee on Banking Supervision that agency credit ratings be used to determine how much capital international banks must hold on balance sheets to offset assets such as loans they have made or bonds they have bought. The lower the credit rating of the borrower or issuer, the more capital a bank would be obliged to set aside. Therefore, a bank holding the bonds of a developing country might prefer to sell off these securities than to allocate capital to cover the risk in the investment. Such a pattern among banks would make it harder or at the very least more expensive for developing countries to access global capital markets.

So the capacities and the influence of the international credit rating agencies are under scrutiny not only by developing countries but by international bankers and their regulators. These considerations are all the more important given the drive by the leading industrial economies and the international financial institutions, or IFIs, to upgrade what has been described as the global financial architecture to address the implications, particularly the strains, of financial globalization.

Many of the assumptions behind this renovation are embedded in the so-called Washington Consensus, a collection of reforms which the U.S. and other leading economies advocate for developing nations. It includes orthodox macroeconomic management (essentially fiscal discipline and attention to reducing inflation), the privatization of state-owned enterprises, and more open financial markets and economies, among other prescriptions. [ „A convenient, shorthand expressions for this new economic model, which replaced the old government-dominated closed-economy stance of the post-war pe riod, is the phrase „Washington Consensus," coined by British economist John Williamson (1990). Washington is the name in part because it is the seat of the Inter national Monetary Fund (IMF) and the World Bank, which negotiate with developing and transition econ omy Governments and financially support the reform programs they adopt. But Washington is also in the name because of the policy leadership on adjustment issues that emanated from the United States in the 1980s, spearheaded by U.S. President Ronald Reagan. „The Washington Consensus was a list of 10 reforms focused on macro-economic stability, domestic finan cial liberalization, privatization and trade liberalization. Interestingly, it did not include international financial liberalization. Indeed, Williamson noted that he saw ‘relatively little support for the notion that liberaliza tion of international capital flows is a priority objective for a country that should be a capital importer and ought to be retaining its own savings for domestic in vestment.’" (See: „International Finance and the De veloping Countries," Barry Herman and Barbara Stall ings, Chapter 2, Global Financial Turmoil and Reform; A United Nations Perspective, U.N. University Press, Tokyo, 1999)] One effect of the Asian crisis has been to validate earlier skepticism and intensify criticism of the Washington consensus as the most appropriate response to the problems of developing nations. This discussion intersects at many points with the debate on rating agencies.

Against this backdrop, the Friedrich Ebert Stiftung (FES) organized a conference in October 1999 in New York to examine the credit rating system and its impact on development. This conference, the inaugural event in a series sponsored by FES on the broader theme of globalization, brought a group of some 30 opinion makers from the developing regions together with representatives of the leading rating agencies, multilateral officials and private sector specialists. They were asked to look at the country rating system, consider its impact on development and consider ways countries could improve their standing and thereby expand their access to capital. The two-day meeting was a rare opportunity for these groups to engage a wide-ranging discussion of the sometimes obscure link between the rating system and the process of economic development.

At the outset, the organizers stated that they did not intend to rake the agencies over the coals one more time on the score of the Asian crisis, or lay the problems of development at their doorstep. The aim, rather, was to focus minds on how the rating system influences capital allocation to emerging economies and initiate a dialogue among all parties as to how the rating process might be improved.

But the question inevitably arose as to whether the agencies as conceived and organized have the vision and the tools to assess the economic resources and productive capacities, political maturity and social cohesion of a developing country – in short, its development potential. And are they able to convey that information to investors in a clear and impartial manner so their ratings do not unfairly deprive developing countries of capital? Information in financial markets is imperfect; the agencies cannot offer perfectly balanced information. But the brief handed to the participants in New York was to ask how the system might be refined in a manner satisfactory to countries, agencies and investors alike.

For many developing country officials and economists, international capital flows seem at best elusive or at worst a source of instability. [ „[A] large literature now bears testimony to capital and financial market liberalization, whatever the effi ciency benefits that might be derived from them (and some recent literature has even questioned that…), unambiguously contributing to economic volatility and an increased probability of financial and currency crises and recessions." See: Joseph Stiglitz: „Democratic Development as the Fruits of Labor : Keynote Address to the Industrial Relations Research Association" Bos ton, January 2000, mimeograph .] Even countries that have seen strong capital inflows have not reaped the benefits they had hoped for, and in some cases sustained serious setbacks when flows were cut off or reversed.

The question is how to encourage the flow of funds into less-developed countries where capital is in short supply. Rating agency officials are quick to respond that it is not their job to direct capital flows, even if at times changes in credit ratings can serve as a trigger for capital flows into or out of developing markets.

There is no global capital shortage – in fact, it could be argued that there are not enough high-quality, high-return investment opportunities for the capital that has accumulated in the trillions of dollars in institutional coffers in the United States, Japan, Europe and even some later-stage developing countries. These savings could be put to productive use in emerging economies if investors felt confident of a reasonable return and the eventual repayment of the principal amount.

What stands in the way is risk – the main impediment to longer-term capital flows into developing countries. Risk is always and everywhere present in the markets, especially in emerging markets where economic conditions are often less stable and a higher level of political risk is common. Sophisticated investors will accept risk if the expected return is commensurate with the risk. But such risks must be quantifiable and investors must have confidence in the country where their funds are to be placed. Yet confidence is founded on information, and the information provided by the governments of countries is often incomplete or out of date.

It could be argued, in fact, that inaccurate or delayed macroeconomic data was a significant factor in most emerging markets crises of the 1990s. Such incomplete, delayed or misleading data series included the level of Mexican foreign exchange reserves before the 1994-95 peso crisis (Mexico stopped releasing it at a certain point) and debt levels among East Asian corporations before the 1997 crisis. The other side of this coin is that financial market participants, particularly the hedge funds and other leveraged players, have also been reluctant to provide data on their positions to central banks and other lenders of last resort. This illustrates that information and risk are elements that must flow in both directions.

The present paper tries to distill themes and ideas of this sort which emerged in the two-day FES conference. Despite some clear differences between the ratings specialists and proponents of development, there was agreement as to the need to measure country risk and the corresponding need for accuracy and fairness in that process. It was agreed that more research is needed on how investors and markets behave under stress; that more comprehensive and timely information is critical so the global investor can make well-informed decisions; and that global financial „architects" must give thought to the structural role of agencies.