Sovereign credit rating has come in importance over time. The complexity involved in assessing sovereign risk has always been greater than the need to rate corporates or banks. The challenge is compounded now that the government has moved into unknown territory starting with quantitative easing (QE) policies adopted after FY 2008. The increased economic uncertainty due to the COVID pandemic has added to the challenge. The efficacy of credit rating agencies (CRAs) in predicting sovereign defaults was a matter of debate even in relatively ordinary times, and may require a paradigm shift in how a country’s risk of default is assessed. Inappropriate rating changes based on inadequate methods can have a domino effect on global stability. Given the gravity and magnitude of the effort, a multilateral agency such as the Bank for International Settlements (BIS) is better positioned to undertake a sovereign-risk assessment.
The pandemic exacerbated the ‘sovereign-bank-corporate nexus’ in which these three are so dependent on each other that if one collapses, the other two may follow. This is different from 2008, when one could take solace from the fact that at least the corporate balance sheet was stable.
To mitigate the economic fallout of the pandemic, governments have used banking channels to support businesses. This took the form of government-guaranteed loans and loan moratoriums. Central banks flooded the market with liquidity. Banks often used it to invest in government debt. Governments took huge loans to support the economy. A delicate balancing act has emerged in most Covid-ravaged economies. A downgrade in the rating of an emerging market (EM) could force not only its government but other EMs to reduce spending. This can create high business crime, resulting in banking losses and capital erosion, which will bring banks back to the government for support. Thus, a rating misadventure can have far-reaching consequences.
The predictive power of sovereign ratings is questionable. Even during the period prior to 2008, the rating of the CRA was viewed as pro-cyclical. As data from Standard & Poor’s shows, for the period 2005 to 2008, there were more upgrades than downgrades until 2007. Then in 2008, when sovereign defaults started rising, the downgrade trend began. If sovereign ratings had only limited predictive power in relatively normal times, what are the chances of better assessing risk now that the level of complexity has increased so rapidly?
After 2008, the approaches adopted by the CRA for these ratings were criticized by regulators such as the European Security Markets Authority and the European Banking Authority. In response, the CRA has only changed its core rating approaches.
Thanks to QE in advanced economies (AEs), more easing drivers of sovereign risks, such as the debt-to-GDP ratio and fiscal deficit, were already skyrocketing by 2019. Government spending driven by the pandemic caused a decline. Government finances to decade low. Decades of historical data on government finances created some useful benchmarks for ranking sovereigns based on risk. However, the current set of macro and fiscal ratios have no precedent, which makes benchmarking difficult. Such a situation requires sophisticated analysis using fat-tailed distributions and computationally intensive scenario analysis. None of this is being done.
The best measures the CRA has offered are linear regression running on the previous assigned rating. Such approaches do not pass a basic risk-modeling odor test. They assume that past ratings are accurate and that macro variables have a roughly linear relationship with a country’s risk. Next comes the implementation of this framework. Today’s limited quantitative framework would also be at a loss to explain the significant difference in ratings of some high investment-grade AEs and EMs (such as India) on purely numerical terms. That’s where the CRA’s judgmental qualitative overlay comes in.
Not all aspects of sovereign risk can be covered by quantitative models alone. But the present approach of assessing the qualitative aspects leaves room for improvement. Inputs for qualitative judgments are often surveys or selective assumptions. Among these, well-studied elements such as Dominion bias cannot be ruled out. Surveys behave favorably to the regions in which they occur. The World Bank’s now infamous ‘Ease of Doing Business’ ranking has also had an impact on the ratings. This only underscores the problem of over-dependence on qualitative inputs, not to mention perception indices.
In normal times, the cost of a faulty sovereign rating is borne by corporate borrowers. Governments often vocalize dissatisfaction with their sovereign rating, but this is sidelined as lobbying. In the current situation, the rating downgrade has been badly judged, which could have even worse implications.
It calls for a sovereign rating framework that gives a clear break from the past. What we need is a significant upgradation of its quantitative aspects as well as a more prudent and defensible deployment of qualitative approaches. The form in which sovereign risk is represented may require reconsideration. For historical, commercial and acceptance reasons, CRAs may not be ideal candidates for system reform. The sustainability of international banking is a global social good. As its multilateral custodian, the BIS may be best positioned to perform this important function.
Deep Mukherjee is Visiting Faculty of Finance and Risk Management Consultant at IIM Calcutta
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