IV. The Intersection of Credit Ratings and Economic Development

IV. The Intersection of Credit Ratings and Economic Development

Basic issues of development, too seldom at the forefront of global attention, were even further obscured by the Asian crisis. Before the crisis, the postwar model of development assistance to poor nations had been supplanted by the notion that only free markets provided the necessary leverage and transformational capacity to break the cycle of poverty. The growth of emerging markets investment funds offered the hope that a virtually unlimited supply of capital could be mobilized for development. The Asian crisis represented a significant setback to this process (though the longer-term impact on capital inflows remains to be determined).

Nonetheless, the 1990s produced a dichotomy between countries which could develop economic momentum, attract capital and service debt (if at times with extreme difficulty), and countries whose economies were entirely dysfunctional, whose markets were marginal at best, and whose debt was unlikely ever to be repaid. The Asian crisis left the latter group even less able to attract global capital as it rolled back the gains of countries on the brink of economic success.

The crisis was not without salutary effects. The inadequacy of multilateral crisis-intervention mechanisms in the teeth of the crisis showed the urgent need for a more robust global financial regime. The collapse of debt-laden corporations and the exhaustion of central bank resources across Asia revealed the unstable foundation of crony capitalism and challenged the sustainability of the region’s export-oriented development model. The extension of emergency credit lines to ailing Tigers resulted in increased moral pressure on rich countries to ease the debt burdens of poor nations as sought by the Jubilee 2000 campaign. The crisis most of all focused attention on the risks of untrammeled and volatile global capital flows in and out of the developing economies of the world.

The Asian crisis delivered powerful shocks to emerging economies worldwide as the volume of private market financing to emerging markets fell from $85 billion in the third quarter of 1997 to less than $31 billion in the third quarter of 1998 (it hit a crisis low of 27.6 billion the next quarter). Flows into Asia went from $36 billion in the third quarter of 1997 to 5.5 billion in the 1998 third quarter, an 85% plunge. Capital flows into Africa came to a virtual standstill over the same period as they plunged 99% from $8.4 billion to a $100 million – real money, but insignificant. [ IMF, op. cit., p. 97]

Such numbers are more understandable if expressed as a percentage of gross domestic product. In 1995-96, Indonesia, South Korea, Malaysia, the Philippines and Thailand collectively received net private capital inflows amounting to 6.6% of their combined GDP. Following the onset of the crisis in mid-1997, such flows dramatically reversed: in 1996-97, those five countries experienced net outflows equal to 4.4% of GDP for a total swing from 1995 to 1997 of 11% of GDP.

The crisis meanwhile directed private investment into more highly rated assets. Research by Chase Securities showed that while 70% of new emerging market bond issues in the January-October 1998 period were rated beneath investment grade, 60% of the bonds brought to market a year later in January-October 1999 were rated BBB+ or higher. The higher average ratings in the latter period strongly suggests that investors raised their credit standards; countries with sub-investment grade ratings found fewer ready buyers or paid higher interest rates.

The crisis had significant social costs. The U.N. Development Program estimated that the crisis left 13 million people out of work and sharply cut real wages. Some observers reckon it will take five years to restore the lost jobs. [ The authors of the UNDP 1999 Human Develop ment Report state that, „The financial turmoil in East Asia in 1997-99 demonstrates the risks of global finan cial markets. Net capital flows to Indonesia, the Re public of Korea, Malaysia, the Philippines and Thai land rocketed in the 1990s, reaching $93 billion in 1996. As turmoil hit market after market, these flows reversed overnight—with an outflow of $12 billion in 1997. The swing amounted to 11% of the pre-crisis GDP of these countries. Two important lessons come out of this experience. „First, the human impacts are severe and are likely to persist long after economic recovery. Bankruptcies spread. Education and health budgets came under pres sure. More than 13 million people lost their jobs. As prices of essentials rose sharply, real wages fell sharply, down some 40-60% in Indonesia. The consequences go deeper—all countries report erosion of their social fabric, with social unrest, more crime, more violence in the home." „Globalization With a Human Face," UNDP Development Report 1999, pp. 3-4; WWW: http://www.undp.org/hdro/report.html] Faced with these lingering effects, developing world critics of the rating system understandably see the agencies as poorly tuned to such realities, or inclined to subsume them into a set of statistics that obscure the human face of economics. Critics also voice the suspicion that agencies „parachute" analysts into countries to render judgment.

One response to this is that developing country governments are responsible for the priorities they set and the policies they pursue. [ The authors of a U.N. Development Program occa sional paper on the social impact of the crisis comment: „We argued that unlike the Latin American countries in the early 1980s, Asian countries had not mismanaged macroeconomic policies prior to the crisis. Fiscal and monetary policies were conservative and the exchange rates were not extremely overvalued. However, this does not imply that the economic policy makers in these Asian countries were not responsible for the cur rent crisis. In fact, by committing a series of policy mistakes in coping with the crisis in 1997, they unnec essarily aggravated the situation and completely lost reputations built on a history of prudent economic management. Among the series of policy mistakes, the crucial ones include their mal-handling of foreign re serves and domestic bankruptcy problems on the eve of the crisis; their unprofessional performance in negoti ating with the IMF adjustment program; and inexperi ence in implementing economic policies within a global context." (See „Social Impacts of the Asian Crisis: Policy Challenges and Lessons," by Jong-Wha Lee and Changyong Rhee, UNDP Human Development Report Office, January 1999, WWW: http://www.undp.org/ hdro/oc33a.htm)] From this perspective, rating agencies are merely messengers bringing intelligence to countries and investors alike, and should not be blamed if the import is troublesome. Nor does it serve to pressure these messengers to dilute the content of their messages to spare the sensibilities of the recipients (although clarity and tact have a place too). On the other hand, the agencies as compilers of data and information have an obligation to make sure their dispatches offer a balanced and comprehensive picture.

Another criticism that has been lodged against the rating agencies is that they do not put enough emphasis on political risk, although it is a good leading indicator for credit risk. Political risk measurements like those offered commercially by the Economist Intelligence Unit, are a key input to the ratings process because they encompass a government's ability and determination to achieve macroeconomic and social objectives, as well as the strength of institutions and civil society.

Beyond political risk there are a broad range of alternative indicators which rating agencies might incorporate to a greater degree in their process, though there are differences of opinion between rating agencies and their critics as to how much a rating agency should weight nonfinancial factors bearing obliquely on credit. One case in point is the impact on a country’s environment of government policies.

Markets usually fail to recognize the economic value of environmental resources other than as commodities for export. Consequently, a narrow focus on reducing the current account deficit can encourage ruthless exploitation of natural assets. Rating analysts typically do not assign such considerations a significant weight, though they impact the country’s long-term well-being and prosperity; consider the health effects and economic loss from the 1997 Indonesian forest fires.

In fact, rating agencies take into account the environmental impact of corporate decisions more frequently, because there are more likely to be repercussions on project financing if the company flouts environmental standards. Environmental principles need to be reinforced at the sovereign level as well, although ratings analysts express some doubt how strongly they bear upon country credit.

Agencies have also been faulted for paying too little attention to development as a factor in credit. Development metrics are not entirely overlooked: for instance, Fitch IBCA looks at qualitative variables including the effectiveness and stability of government, income distribution, unemployment, human capital expenditure, and corruption. Fitch has generally shifted away from quantitative models toward more detailed information on a wider range of issues; the approach provides a better handle on the motives of borrowers and lenders in assessing risk.

Under such a qualitative approach, certain factors not typically associated with financial performance may influence ratings, including the government’s record on human rights or its commitment to democratic practices. While the agencies clearly are not comfortable with expressing judgments on the desirability of one kind of political regime over another, there is ample historical evidence to show that the kind of stability provided by repressive regimes is not always enduring. Beyond this, the mere expression of such concerns by the rating agencies can provide pro-democratic, pro-reform forces with leverage in bringing change.

Moral judgments aside, it seems evident that the priorities of any government, its commitment to universally recognized values, should be appropriately weighted. Putting it another way, competent, honest and enlightened governments deserve to obtain favorable ratings and over time tend to do so. One implication of this is that there need not be a conflict between credit ratings and development.

The notion of development itself, the process of building economic capacity to raise living standards and expand human rights, often seems excluded from the reasoning of investors. Yet it is here that the interests and objectives of investors and developing countries converge. Just as an enlightened government which is competent and diligent deserves favorable consideration in the ratings process, the enlightened investor should prosper by placing funds in countries where the population is healthy and educated and the government is stable and honest.

In this sense, there is ample room for the rating agencies to play an enhanced role as arbiters of the mutual interests of investors and developing countries.

Yet there are limits to how much the credit rating system can be refined; ratings are ultimately a matter of human judgment, therefore subject to error as well as the vagaries of local political decisions. Even in cases where the rating agencies get it right, there is still no guarantee that investors will heed their advice. Capital poured into Russian GKOs or treasury bills in 1998 even after the country had been downgraded, similar to the train of events before the Tequila crisis.

Even if ratings methods could be perfected to include non-monetary parameters sufficiently, the question would remain as to what role the agencies should play in development. Underdeveloped countries typically are caught in a vicious circle: they need to access capital markets to finance essential public infrastructure and private production, but can’t tap such markets until they have reached a level of sophistication in financial governance that in turn requires public infrastructure and a broad tax base provided by a productive economy.

Thus the challenge of enhancing credit access for developing countries via the credit rating mechanism has two dimensions. One concerns whether the rating methodology fully captures a developing country’s longer-term capacity to meet its financial obligations. This capacity is reflected in a country’s macroeconomic indicators, but is in fact a function of deeper attributes: social cohesiveness, good governance, and a realistic development framework. To measure it, ratings need to take into account the overall political reality of a country. The other dimension has to do with whether a country’s leadership, including civil society, understands and embraces the ratings process not as a hurdle to be surmounted, but a tool with which to build confidence among the investors who control capital.