CREDIT RATING AGENCIES

Private credit rating agencies provide another way of assessing country vulnerability. There are three major international firms: Standard & Poor's, Moody's and Fitch IBCA, as well as some more regional or domestic ones, such as the Japan Bond Research Institute, which rates bond issues in Asia. These provide assessments of both sovereign (government) and private sector credit risk. These agencies rate credit risk on a wide variety of credit instruments and issuers (both public and private sector) of bonds, debt etc. The process of establishing these ratings is in the spirit of monitoring and surveillance operations. While there is some question of their use as early warnings, the ratings should certainly be useful as inputs into monitoring and surveillance activities.

The rating agencies failed to predict the approaching problems in the Asian banking and financial sectors. Although their misinterpretation of signals³⁶ might have weakened their credibility, in fact their potential influence was increased to an almost quasi-official standing in the proposed revision of the Basle Capital Adequacy Rules released in June 1999. According to the new proposal, credit rating agencies were to be granted a dominant role in banks' internal credit risk evaluation processes. While this proposal has not been welcomed by many, including the rating agencies themselves, it justifies a closer look at the early warning capabilities of credit rating agencies.

In principle, rating agencies have some important advantages over IMF. While they may have less access to data and engage in less intensive discussion with governments, they have the advantage that they can reflect market perceptions about government policies and credibility to a much greater extent. Rating agency reports are updated more frequently to reflect sudden developments and provide a more continuous flow of information in a fast-changing world. Finally, rating agency reports grade countries on an ordinal scale that enables frequent adjustment to reflect marginal changes in the assessment of risk factors, even when the change is small. This is a potentially important advantage, and there are likely to be more frequent adjustments as the rating agencies gain experience.

It is generally not well perceived that sovereign ratings are a relatively recent phenomenon and in fact account for a minor portion of the ratings business income; most of their business remains in corporate ratings. This argues favourably for the objectivity of the rating agencies with respect to country risk. It suggests that there does not exist a significant incentive for rating agencies to either favour or be biased against a particular country. Moreover, an agency's reputation could suffer adversely if its ratings of a sovereign were to be frequently out of line with the market experience of either public or private creditors of that country.

There are quite a few regional or national ratings agencies.³⁷ In contrast with the three major international agencies mentioned earlier, many of these regional or national rating agencies have links with their respective governments (or may have had, in that they were set up or mandated by a government body). Thus the degree of independence of some of these may be suspect. This may account in part also for the gap between the ratings by regional/national agencies and those of the three majors for the same entities.

It is worthy of note that the members of ASEAN established the ASEAN Forum of Credit Rating Agencies in 1993 and the countries involved have been cooperating with each other to improve methodology and to harmonize standards.

Ratings as an early warning system

Any crisis is likely to impair a country's ability to service debt obligations, and this should be reflected in a deterioration of the country's sovereign rating. If the ratings agencies are quick to recognize the weakening in fundamentals, then the downgrading of credit rating might even precede the onset of crisis and serve as a signal. In practice, however, like most of the concerned institutions, the ratings agencies missed calling the Asian crisis. Ironically, they may have contributed to the crisis by maintaining high credit ratings which may have encouraged large capital inflows until the very last minute. Then, by announcing a sequence of quick downgrading within a very short time after the crisis broke, they may have signalled a continuous deterioration which likely added to the sense of panic. As shown in table V.3, Thailand and the Republic of Korea were still rated "Investment grade" in June 1997, the eve of the crisis. It was not until September-October 1997, when the crisis was already in full swing, that these countries were downgraded. The ratings agencies also seem not to have anticipated the severity of the crisis, downgrading these countries by the largest number of notches only in December 1997 or January 1998.

None of the major studies have yet tested the ratings agencies' performance as a leading indicator of a currency crisis. No doubt this is due in part to the ratings not being generally available except to subscribers of the ratings agencies. Therefore there is no empirical basis on which to judge their suitability for use in early warning systems. Nevertheless, they should be useful at least as a measure of an economy's vulnerability.

Standard & Poor's and Moody's have roughly corresponding ratings, though they differ in the symbols used. It has been found that they do not deviate too much from each other in their ratings.³⁸ Disagreements on a rating will be by a notch on the scale in most cases. The high degree of correlation found suggests that both agencies do in fact look at very similar macroeconomic factors (though they may weigh them differently) in coming up with a rating for a particular sovereign.

Standard & Poor's rating approach. In its sovereign credit ratings primer, Standard & Poor's confirms³⁹ these findings and notes that there is no exact formula for determining ratings. Moreover, Standard & Poor's readily admits that its procedure incorporates qualitative aspects as well. The broad categories in table V.4 show a close correspondence to the usual macroeconomic variables, with the additional category of "Political risk".

Moody's rating approach. Moody's tends to use a more general set of indicators. First, the qualitative aspect is underlined. While quantification is integral to Moody's rating analysis, particularly since it provides an objective and factual starting point for each rating committee's analytical discussion, ratings are not based on a defined set of financial ratios or a computer model.  Rather, they are the product of a comprehensive analysis of each individual bond/debt issue and issuer by experienced, well-informed credit analysts. Second, their analytical focus is on fundamental factors that will drive each issuer's long-term ability to meet debt payments, such as a change in management strategy or regulatory trends. Third, their analysis focuses on an assessment of the level and predictability of an issuer's future cash generation in relation to its commitments to repay debtholders. Their main emphasis throughout the rating analysis is on understanding strategic factors likely to support future cash flow, while identifying critical factors that will inhibit it. The issuer's capacity to respond favourably to uncertainty is also key. Generally, the greater the predictability of an issuer's cash flow and the larger the cushion supporting anticipated debt payments, the higher the rating will be. Fourth, Moody's ratings do not incorporate a single, internally consistent economic forecast but aim rather to measure the issuer's ability to meet debt obligations against economic scenarios which appear reasonably adverse to the issuer's specific circumstances. Last but not least, Moody's analysts take into account the different accounting systems which exist. In examining financial data, Moody's focuses on understanding both the economic reality of the underlying transactions and how differences in accounting conventions may or may not influence true economic values. However, it is important to recognize that Moody's ratings are intended only to measure risk of credit loss. They are not intended to measure other risks in fixed-income investment, such as market risk.

Fitch IBCA approach. The sovereign rating methodology of Fitch IBCA draws on the recent instances of default and near-default to establish a range of key leading indicators of distress. These are incorporated in a risk model that gives a percentage score to sovereign borrowers, which is then converted into long-term ratings. There is also a separate short-term risk model that analyses the prospects of timely repayment within the next year, which highlights the importance of liquidity factors.

Recent initiatives after the crisis

In the aftermath of the crisis, the ratings agencies have also done a considerable amount of self-examination. Sovereign ratings are relatively new and the demand for them did not really take off until the 1980s. Consequently, agencies are still building their capabilities in this area, and strengthening their personnel and data collection systems to better address the drawbacks noticed during the last two years.

In particular, Standard & Poor's has launched a new product that grew out of the Asian crisis: a financial system stress rating. The latest survey on financial system stress, published in May 1999,⁴⁰ covered 62 countries, 11 of which are in the ESCAP region. Basically, the survey tries to monitor the degree of leverage within an economy. It uses four leading indicators (level and rate of credit growth; level of private sector debt; level and rate of increase of asset prices; and level and rate of growth of net external liabilities) to predict the likelihood of coming credit disturbances. While these indicators emit signals on potential financial vulnerabilities, they do not measure the extent of the problem or the degree of stress a financial system is undergoing. In order to obtain some indication of the level of stress, Standard & Poor's uses estimates of the potential level of the gross problematic assets of a financial system (calculated at its worst-case scenario of recession), expressed as a percentage of domestic credit to the private sector and non-financial public enterprises. This indicator simply measures the extent of assets that can turn bad in the face of undesirable events such as a recession.

Next

Footnotes:

³⁶ Fitch IBCA admitted: "We used to think that a high proportion of short-term debt was a worry only with highly indebted sovereigns. We were wrong." (Financial Times, 14 January 1998).

³⁷ For example, India and the Republic of Korea have three each, Malaysia has two, and China, Indonesia, Pakistan, Philippines and Thailand have one rating agency each.   Meanwhile, Japan has had a 24-year record of experience in rating, the third longest following the United States and Canada.

³⁸ Richard Cantor and Frank Packer, "Determinants and impact of sovereign credit ratings", Economic Policy Review of the Federal Reserve Bank of New York (New York, October 1996). The explanatory variables were per capita income, GDP growth, inflation, fiscal balance, external balance, external debt, and economic development (proxied by indicator for whether or not a country is industrialized).

³⁹ Standard & Poor's, "Sovereign credit ratings: A primer", Sovereign Ratings Service (December 1998), p. 2.

⁴⁰ See Standard & Poor's, "Global financial system stress: 24 show adverse trends in credit quality", Sorvereign Ratings Service (May 1999).