The Ministry of Finance, Government of India has published an excellent and much needed examination of the methodologies adopted by sovereign rating agencies. It's a rare example of India taking the lead in setting the agenda for a debate on a critical part of the plumbing of the international financial market system.
Given the central role played by credit ratings in determining cost of capital for sovereigns, its reform should be one of the most important priorities for global financial market reform. This assumes greater significance in the context of the climate change financing agenda on channeling private capital to developing countries.
The basic argument is that the rating functions of rating agencies rely disproportionately on qualitative measures of sovereign risk that are in turn drawn from data sources whose methodologies are both questionable and biased. They are doubly distorted - their bias under-estimates the sovereign risks of western countries and over-estimates that of the developing countries. This amplifies the cost of capital for developing countries.
Avinash Persaud has highlighted this over-estimation problem with financial markets in general by pointing to the striking difference between FX futures cost and the actual FX depreciation experienced by developing countries compared to their developed counterparts. The cost of FX hedging considerably overstates the actual risk, thereby resulting in large overpayments by developing countries. It amounted to an average of 4.65 percentage points for a sample of developing countries on their historical five year forward FX rates. This overpayment of scarce capital should be seen as a market-driven subsidy from the developing country governments to western private financial institutions.
The paper informs that sovereign ratings are defined by the agencies themselves as forward looking assessments of the "ability" and "willingness" of countries to repay their debts. But its analysis finds that they place a disproportionate emphasis on "willingness to pay", drawing on qualitative indicators. Given the subjectivity associated with such "willingness" to pay assessments, the paper argues that developing countries pay a "perception" premium instead of a "risk" premium in their sovereign borrowings.
It does an excellent job of unpacking the blackboxes of each rating agency, to the extent possible given the opacity surrounding them. It exposes the likely failings and problems with the qualitative measures, and asymmetricities in their application to developed and developing countries. What comes out is not very edifying.
The summary of the paper is,
Our review of the credit rating methodologies reveals that there is considerable reliance on qualitative variables to capture ‘willingness to pay’. The enormous degree of opaqueness in the methodology makes it challenging to quantify the impact of qualitative factors on credit ratings. The significant presence of qualitative factors in credit rating methodologies also gives rise to bandwagon effects and cognitive biases amply reflected in various studies, generating concerns about the credibility of credit ratings. From our quantitative analysis, we find that over half the credit rating is determined by the qualitative component. Institutional Quality, proxied mostly by the World Bank’s Worldwide Governance Indicators (WGIs), emerges as the foremost determinant of a developing economy’s credit rating, which presents a problem since these metrics tend to be non-transparent, perception-based, and derived from a small group of experts, and cannot represent the “willingness to pay” of the sovereign. Their effect on the ratings is non-trivial since it implies that to earn a credit rating upgrade, developing economies must demonstrate progress along arbitrary indicators while simultaneously contending with the discriminations the ratings tend to carry.Reform in the credit rating process is the need of the hour. As the rated sovereign is obligated to be completely transparent, establishing symmetry of obligations warrants that the rating agencies make their processes transparent and avoid employing untenable judgements. Enhanced transparency in credit rating may compel the use of hard data and likely result in credit rating upgrades for a good number of sovereigns... Reforming the sovereign rating process will correctly reflect the default risk of developing economies, saving them billions in funding costs.
The paper uses the example of India as a case study and does an econometric modelling to assess the degree of correlation between fiscal performance, external debt variables, monetary variables, national income, and governance impact ratings. The first four capture the "ability" to pay and the last reflects "willingness" to pay.
We can infer that better governance, a healthy fiscal position, and low external liabilities emerge as the most important determinants of India’s rating... We observe that the composite governance indicator has the largest and statistically significant coefficient of 15.85 within our specification. To put it another way, the composite governance indicator explains approximately 68 per cent of our assigned rating (the governance coefficient divided by the sum of all absolute coefficients). Further, in terms of sensitivities, the assigned credit rating to India is most sensitive to changes in the governance parameter. For a 0.74 unit change in the average WGI score, India stands a chance to be upgraded from BBB- to BBB. Such a high sensitivity to the governance indicator implies that they are granted a far higher than specified weightage in the methodology documents published by the rating agencies... the influence of the composite governance indicator and perceived institutional strength surpasses the collective influence of all other macroeconomic fundamentals when it comes to the chances of earning India and other developing economies an upgrade. The effect is non-trivial because it implies that to earn a credit rating upgrade; developing economies need to demonstrate progress along arbitrary indicators, which are also criticised for being constructed from a set of several one-size-fits-all perception-based surveys.
I'm inclined to believe that apart from the cognitive biases discussed in the paper, the reliance on qualitative factors betrays some laziness on the part of rating agencies. It appears as an excuse to cover up for inadequate diligence on the macroeconomic side. In the absence of standardised and good quality measures of macroeconomic data and forecasts, rating agencies ought to be exploring proxies, innovative methodologies, and look at more granular data to evaluate sovereign credit worthiness. However, a rating methodology that relies on this approach cannot use the standardised and simplified templates that agencies currently deploy. Instead, sovereign ratings will have to be a bespoke exercise anchored around some basic principles and a common objective function.
It's understandable that making the entire rating process quantitative, objective, and public may not serve the purpose. After all, if everything is made public then the only differentiator between different rating agencies would be the parameters included and their respective weights. You don't need a professional agency to do such evaluations.
It has to be acknowledged that there's a fundamental information asymmetry problem with sovereign ratings. Unlike corporates who are regulated, sovereigns are not accountable to disclose their accounts in a standardised format. Apart from publicly available documents and certain disclosures made to the IMF, there are no independently evaluated data on current national macroeconomic indicators. There are wide variations in quality of this data across countries and quality is questionable especially in low income countries. This is unlikely to change. In the circumstances, it may be necessary to settle for second best strategies.
Historical data on macroeconomic indicators (specifically the variances in important economic, fiscal, monetary, currency, and external parameters) and risk incidence episodes (high inflation periods, sovereign defaults, policy induced shocks etc) may be good practical second-best measures of a country's capability and willingness to repay its debts. They rely on the only two reliable measures - variances of macroeconomic indicators (measures macroeconomic stability) and repayment track record. This should be complemented with some subjective assessment, based on a commonly applied set of principles, of the country's economic prospects given the likely global economic conditions. The rating agency could then be held accountable for that subjective assessment.
This approach should be no worse than the outcomes from the current rating approach. The history of corporate credit ratings is replete with countless examples of extremely embarrassing defaults even immediately after investment rating endorsements. After all, the objective is a comparative measure to assesses the relative credit worthiness across countries. Shedding inherently biased and secondary (for credit worthiness assessment) measures on institutions and governance and qualitative assessments should not detract from the basic comparative evaluation objective of any sovereign ratings exercise. In any case, in an inherently complicated exercise, adding too many parameters, and that too deeply subjective ones, ends up only amplifying the noise and detracting from credibility.
In the circumstances, I propose the following steps as a leadership agenda for Government of India:
1. Refine the methodology used in the paper based on a rigorous enough peer-review. The GoI could then support a credible research institution in the country use this methodology to calculate and make available the variations between the ratings given by the agencies and that calculated using this method, the magnitude of the "perception" premium in terms of cost of capital, and the additional debt service burden incurred by the country. This database should be updated on a continuing basis and should strive to become a reference source for debates on rating agency reform.
This research agenda could be expanded to build on the work of Avinash Persaud and create a historical data depository for all countries on their market priced sovereign bond yields, foreign exchange futures, credit default swaps etc and their actual realised rates. This database could be updated continuously and form an area of high-value policy research. There are several examples of such databases like that on cross-border capital flows, cross-border tax evasion etc. and those maintained by various UN and other international agencies on a variety of sectors. Finally, the sovereign rating reform research agenda could expand into a wider research agenda of reforms to the seriously flawed process of corporate credit ratings.
2. Posit the outlines of an alternative ratings methodology focused on parameters of macroeconomic stability and track record of risk incidence, with a principles-based assessment of economic prospects. Prepare a draft concept paper, have it circulated widely internationally to solicit feedback, organise a conference, and have it introduced as a reform agenda in multilateral fora. Have this included as a top priority item in the the Government of India’s international diplomacy agenda. Pursue it actively and diligently with a 3-5 year timeframe for change.
3. Formulate a narrative around the imperative for change to the ratings methodology. The climate finance agenda could provide the most appropriate and current anchor. The need to attract large volumes of private capital to developing countries is widely acknowledged as being central to any meaningful efforts to address climate change. It's also becoming clear that cost of capital is the biggest deterrent to attracting such capital. And as we have seen above, the prevailing sovereign ratings with their "perception" premia impose a prohibitive additional cost on borrowings by developing countries. The need for reform becomes clear and important.
4. Identify an institution to host standards management guidance and regulation of rating agencies. This institution could cover the wider area of corporate ratings too. The BIS sets the agenda on the harmonisation and continuous calibration of banking sector risk parameters and the OECD provides the forum for international negotiations on tax avoidance practices of multinational corporations through its Base Erosion and Profit Shifting (BEPS) initiative. The IMF or another multilateral institution could be encouraged to take the lead on reforming the rating agencies. In fact, in the context of the wider corporate credit ratings, the IMF has already written about the need for a global regulatory mechanism for credit rating agencies and outlined some principles for such ratings.
One more item that should be on the agenda for the Government of India in its financial market shaping efforts should be to champion reforms to the international arbitration system on inter-state dispute settlements. As I blogged here and here, it subordinates sovereign law, elevates contractual obligations beyond even sovereign law, and is heavily biased towards multinational corporations and against developing country governments. India could put forth an objective and neutral framework for international arbitration to replace the current one-sided mechanism. UNCITRAL should be encouraged to take the lead on reforming the international arbitration process. India could put forth its agenda and demonstrate genuine global leadership in pushing forward both these issues.
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