Rating agencies help investors to find out whether they will get return on their investment.
Finance Secretary TV Somanathan on Tuesday accused rating agencies of “double standards” when assessing emerging markets and developing economies. He was responding to a claim by rating agencies that the country is the most indebted emerging market and that the latest budget did not provide clarity on fiscal consolidation plans.
What did the rating agencies say?
Rating agency Fitch had said the high deficit and continued lack of clarity on medium-term consolidation plans in the recent Union Budget were rationale for anticipating a downward trajectory in the country’s debt/GDP. “The government at its current levels has little financial headroom to respond to potential growth shocks,” the report concluded.
Another agency, Moody’s, said the Union Budget was growth-oriented, debt positive for many issuers but budgetary provisions posed fiscal challenges. It said focus on capital expenditure, it supported near-term growth but challenged long-term fiscal consolidation. Additionally, the budget projected only a marginal reduction in the central government’s deficit.
What is rating agency?
Rating agencies assess the creditworthiness or potential of an equity, debt or country. Their reports are read by investors so that an informed decision can be taken about whether or not to invest in companies in a particular country or that geography. They assess whether a country, equity or debt is financially stable and whether it is at low/high default risk. In simple words, these reports help the investors to find out whether they will get return on their investment.
Agencies periodically re-evaluate previously assigned ratings following new developments (for example, a coronavirus pandemic or a geography-specific climate change), geopolitical events or a significant economic announcement by the relevant entity.
Their reports are sold and published in financial and dailies.
What grading pattern do they follow?
The three major rating agencies, namely, Standard & Poor’s, Moody’s and Fitch largely subscribe to similar grading patterns.
Standard & Poor’s has awarded its highest grade, i.e. AAA, to countries, equity or debt, with extremely high potential to meet their financial commitments. Its lowest grade is a ‘D’, given to entities with a high probability of defaulting on payments or breaching an alleged promise. This is specifically given in case the entity concerned has filed for bankruptcy. Its grading slab consists of the letters A, B and C with a single or double letter indicating a higher grade.
Moody’s divides ratings into short- and long-term definitions. The former includes liabilities maturing in thirteen months or less while the latter includes liabilities maturing in eleven months or more. Its long-term grading ranges from A to C, with A being the highest. The succession pattern is similar to that of the S&P. The short-term rating scale ranges from P-1 to NP, with P-1 being the highest.
Fitch, too, rates AAA to D, with D being the lowest. It follows a succession plan similar to that of Moody’s and Fitch.
Criticism of rating agencies
Popular rating agencies publicly disclose their methodology, which is based on publicly available macroeconomic data by a country, to give credibility to their estimates.
However, credit rating agencies have faced severe criticism for allegedly fueling the financial crisis in the United States, which began in 2017. The Asian Development Bank paper The Financial Crisis and the Regulation of Credit Rating Agencies: A European Banking Perspective points to this broad consensus. It states, “agencies underestimated the credit risk associated with structured credit products and failed to adjust their ratings quickly to account for deteriorating market conditions”. He was accused of methodological errors and conflicts of interest in several cases.
Do countries pay attention to rating agencies?
A low rating of a country can potentially cause panic buying or selling investments by a foreign investor.
In 2013, the European Union opted to regulate the agencies. “… an over-reliance on credit ratings could reduce the incentive for investors to develop their capacity for credit risk assessment,” argued the EU. Rating agencies in the European Union are now allowed to issue ratings for a country only three times a year and after the trade is closed across the Union. To discourage the dominance of three agencies (namely Fitch, Moody’s and Standard & Poor’s), it further recommends the use of smaller credit agencies. In September, finance ministry officials had urged Moody’s Investor Service to improve India’s rating. According to business news publication Bloomberg, officials were to provide details on how India would meet its budget targets for the fiscal year ending March 2022. Moody’s downgraded India’s rating to Baa3 in June 2020. The agency said the lowest investment grade was given due to a prolonged economic slowdown and deteriorating fiscal situation.
In November, Fitch had confirmed India’s rating on BBB-.