Helmut Reisen: Green light for danger TUESDAY FEBRUARY 3 1998
Credit rating agencies need radical reform if they are to do their job properly
The Asian financial and currency crisis of 1997-98 and the Mexican
crisis of 1994-95 have again demonstrated how vulnerable emerging markets
are to sudden and excessive swings in flows of private capital. The
problem is a bit like a traffic jam. These build up as the number of cars
increases partly because individual drivers do not take into account their
personal contributions to congestion (unless there is road pricing). In
the same way, emerging countries are vulnerable when the supply of foreign
capital soars because private borrowers do not take into account the rise
in the marginal social cost of a country's foreign debt.
In this analogy, sovereign credit rating agencies might be thought of
like a traffic light: by flashing early warning signs, they help smooth
the flow of money. At least, they are supposed to.
In fact, the evidence suggests that sovereign credit ratings are
reactive rather than preventive.* As a result, they tend to amplify
boom-bust cycles in emerging-market lending. It is rather as if the
traffic lights flashed green whenever traffic was building up.
Credit rating agencies were conspicuous among the many who failed to
predict the Mexican and Asian currency crises. Having failed to perceive
the extent of problems as long as foreign money flowed in, the rating
agencies then overreacted by downgrading the affected countries to junk
The trouble is that credit rating agencies are not at all separate from
the financial markets as a whole. They do not have superior information on
emerging-market economies. They have little scope for acquiring advance
knowledge of matters that affect sovereign risk. And they share with
investors the same views about what determines defaults. This can be seen
by looking at the information on which sovereign-risk ratings are based,
and the nature of sovereign risk itself.
First, sovereign-risk ratings are primarily based on publicly-available
information, such as foreign debt and reserves or political and fiscal
constraints. This makes them different from ratings of companies. With
companies, credit rating agencies may have access to inside information
from domestic corporate borrowers (such as acquisitions, new products and
debt issuance plans). Such advance knowledge or better information can
then be conveyed to market participants through ratings on private
borrowers. This is not the case with sovereign borrowers.
Second, in the absence of a credible international mechanism to sanction
a sovereign default the premium charged to reflect the risk of default is
determined by a borrower's willingness to pay, rather than by his
ability to pay. Borrowers know whether they are willing to pay.
Lenders cannot be sure. It is also a problem of enforceability: the
authorities cannot give an absolute promise that in future they and their
successors will put foreign capital to productive use or that future
returns will be used to repay foreign debt.
Moreover, the sovereign rating agencies get most of their revenue from
governments to provide a debt rating. Naturally, they are loath to
downgrade their clients. This may well introduce 'downgrade rigidity' into
ratings especially in periods of large capital inflows.
Unlike with private-sector ratings, then, sovereign ratings can hardly
be interpreted as an indication that rating agencies lead the market by
conveying new or superior information. Yet sovereign yields tend to rise
when ratings worsen. Why are ratings so influential? The answer may well
be that herd instinct, often reinforced by poor prudential regulation,
give sovereign ratings the power to influence sovereign bond yields even
though they add little to the market's information. Many institutional
investors may not hold any form of debt security, except investment grade.
Hence, sovereign ratings absolve money managers from making independent
judgments about sovereign risk.
So reactive sovereign ratings tend to amplify boom-bust cycles. During a
boom, improving ratings reinforce euphoric expectations and stimulate
excessive capital inflows. During a bust, downgrading adds to panic among
investors, driving money out of the country.
So what should be done? The answer is to turn sovereign ratings into
proper early warning signals. Since part of the problem is that rating
agencies get much of their revenue from borrowers, the industry will have
to reorient its fee structure towards investors. Their dependence on
borrowers is incompatible with the incentive to come up with timely
negative rating. At the same time, prudential regulators should reconsider
the role of sovereign ratings that they stipulate when institutional
investors hold emerging-market assets. The removal of investment grading
requirements for institutional portfolios might attenuate the boom-bust
cycle in emerging-market assets. Unless sovereign ratings can be turned
into proper early warning systems, they will continue adding to the
instability of international capital flows, make returns to investors more
volatile than they need be and reduce the benefits of capital markets to
*Merging Market Risk and Sovereign Credit Ratings, by G. Larrain, H.
Reisen, and J. von Maltzan, 1997, OECD Development Centre, technical paper
The author is head of research at the OECD Development Centre