Credit Ratings and Their Impact on Countries
The complex and interconnected world of international finance is heavily influenced by small, yet vital elements known as sovereign credit ratings. A credit rating involves an independent evaluation of the financial reliability of a corporation or governmental body. It is an evaluation of the credit risk of a prospective debtor, predicting their ability to repay the debt, and a forecast of the probability of the debtor defaulting. Credit rating agencies solve the problem of information asymmetry as they rate issuers of debt obligations, debt instruments, and sometimes governments and their securities. These ratings range from A to C or D, with A being the highest and C or D being the lowest. These cryptic letter grades, issued by agencies and wrapped in an air of objectivity, serve as financial indicators, supposedly forecasting the economic destinies of nations. Yet, upon closer inspection, their legitimacy becomes as opaque as their methodology.
The primary credit rating agencies are S&P Global Ratings, Moody's Investors Service, and Fitch Ratings.
Interpretation | Fitch and S&P | Moody's |
Highest quality | AAA | Aaa |
High quality | AA+ | Aa1 |
AA | Aa2 | |
AA- | Aa3 | |
Strong payment capacity | A+ | A1 |
A | A2 | |
A- | A3 | |
Adequate payment capacity | BBB+ | Baa1 |
BBB | Baa2 | |
BBB- | Baa3 | |
Likely to fulfill obligations, ongoing uncertainty | BB+ | Ba1 |
BB | Ba2 | |
BB- | Ba3 | |
High-risk obligations | B+ | B1 |
B | B2 | |
B- | B3 | |
Vulnerable to default | CCC+ | Caa1 |
CCC | Caa2 | |
CCC- | Caa3 | |
Near or in bankruptcy or default | CC | Ca |
C | C | |
D | D |
The impact of these ratings on countries is significant. They affect the interest rates on government bonds, and many countries place a high priority on maintaining a high sovereign credit rating. A high credit rating (AAA/Aaa) indicates a government has low credit risk, while a low rating (CC/Ca) suggests that the government might struggle to repay its debts. Subjective credit ratings can increase the cost of servicing debt for countries, and nonobjective credit ratings can reduce the amount of investment that countries receive, as they are perceived to be riskier than they are.
India's current credit rating: As per Standard & Poor's, DBRS, and Fitch India's credit rating stands at BBB- implying a stable outlook.
A Deep Dive into Credit Assessment Parameters
Credit rating agencies such as Moody's, Fitch Ratings, and Standard & Poor's significantly influence the financial world. These Nationally Recognized Statistical Rating Organizations, under the watchful eye of the U.S. Securities and Exchange Commission, evaluate credit risk based on several parameters:
1. Payment History: This includes any missed payments or past defaults.
2. Current Debt: The amount currently owed, and the types of debt held by the entity.
3. Current Cash Flows and Income: The entity’s ability to generate income and maintain positive cash flows.
4. Market or Economic Outlook: The overall economic conditions and market trends.
5. Unique Issues: Any specific issues that might prevent timely repayment of debts.
6. Asset Quality: The risk levels at which a bank or financial institution operates.
7. Capitalization: The cushion available to absorb potential losses that may arise due to the risks taken, and to ensure growth.
8. Earnings: The ability to appropriately price risks generate risk-adjusted returns and augment the capital base.
9. Resource Profile: Determined by the cost and stability of funds, which are key to smooth functioning and maintaining operational stability.
These parameters help the agencies assess the creditworthiness of an entity and predict its ability to pay back the debt, thereby providing an implicit forecast of the likelihood of the debtor defaulting. However, they often battle between objective data and subjective perception. Numbers can be debated, and their accuracy can be argued until the cows come home. But perceptions? Perceptions are shaped by personal experience and bias. Debate over perceptions is endless.
Reviewing the table detailing Moody’s assessment methodologies, out of the 18 parameters only 5 parameters can be measured quantitatively i.e. with statistics. 13 of the parameters are qualitative implying subjectivity in analysis and evaluation based on expert perception. The challenge arises when discussions center on subjective aspects such as perception, rendering debates futile. Out of the 18 parameters, 13 are notably influenced by judgment and perception, complicating the assessment process.
Similarly, Fitch’s sovereign credit rating model also provided a higher weightage to qualitative components. It stated that weights assigned to quantitative parameters like GDP per capita (12.4 points), government debt to GDP (4.5 points), etc., are merely for illustrative purposes. This indicates that while these parameters contribute to their grading system, Fitch allows discretion to adjust these weights as they deem appropriate. Furthermore, the Indian Finance Ministry highlighted that these agencies anticipate India to operate akin to Western nations. For instance, the ratings suggest that a country would receive higher points if it has more foreign investment in its banks, under the premise that public sector banks may have political ties. However, when considering India's case, public sector banks play a crucial role in serving the lower economic strata. Institutions like the State Bank of India and other public sector banks have been fundamental pillars of the Indian banking system. They are instrumental in the success of initiatives like the Jan Dhan Yojana, ensuring widespread access to banking services for every Indian. Lastly, these agencies do not disclose the criteria for selecting the experts for qualitative analysis. Countries across the world are expected to unconditionally accept the judgments of individuals appointed by these agencies.
Right alongside subjectivity, these companies have gained disrepute for their propensity to award top ratings to questionable loans (during 2008). This practice raises doubts about their reliability, especially when it comes to shaping the destiny of flourishing economies like India. Perhaps, in a twist of irony, India might be better off seeking the counsel of astrologers– at least their predictions wouldn't cost an arm and a leg, and their crystal balls wouldn't be fogged up by past financial blunders.
From AAA to Downgraded: The Story of Emerging Giant Economies
Imagine scaling Mount Everest, only to be judged unfit for the summit just because you didn't start from the same base camp as everyone else. That's the frustration facing emerging giants like China and India, whose ascendance to the fifth-largest economy position seems to trigger an automatic "downgrade button" on their credit ratings. It's intriguing how the credit rating of the fifth-largest economy has only slipped from AAA status when China and India joined the ranks. Both countries found themselves downgraded to the bargain bin of credit ratings.
A temporal correlation can be seen between China's entry into the top five economies in 2005 and its subsequent rating downgrade, similar trends are being followed in the case of India, and It doesn't paint a good look for the CRAs as it raises serious concerns about fairness and objectivity.
Debunking Credit Rating Claims: India's Strong Fundamentals
India has been assessed as below the trend line (a conventional measure indicating expected performance relative to its parameter level) in all the parameters. But turning the table, hard numbers and facts present a contrasting reality. Presented below are a handful of instances, accompanied with facts to counter the ratings provided by the CRAs.
CRAs: GDP growth is not up to the mark
Counter Argument: India is one of the fastest-growing GDPs in the world, 8.4% year-on-year in Q4 2023 (Trading Economics, 2023)
CRAs: Investor Protection (Business Extent of Disclosure Index) is not enough.
Counter Argument: India received a total of USD 70.97 billion as Foreign Direct Investment (FDI) in the fiscal year 2022-23, making it one of the top recipients globally (Department for Promotion of Industry and Internal Trade, Ministry of Commerce and Industry, Government of India, 2023). This suggests that investors have confidence in the Indian market and its regulatory framework.
CRAs: Political Stability is missing.
Counter Argument: Over the last 10 years, India has enjoyed relative political stability with consistent leadership and peaceful transitions of power (Eaton, 2023).
CRAs: Short Term External Debt (as percent of Reserves) is high.
Counter Argument: While India's short-term external debt may be higher than some developed nations, it is crucial to consider its low foreign currency-denominated sovereign debt and substantial foreign exchange reserves. These reserves can cover the short-term private sector debt and the total external debt, including private sector obligations (Reserve Bank of India, 2023).
CRAs: The Ease of Doing Business is rated as low.
Counter Argument: Since the 2016 launch of the "Start-up India" initiative, over 92,000 entities were recognized as start-ups by February 2023, marking a significant increase from 471 in 2016 to 72,993 in 2022 (Department for Promotion of Industry and Internal Trade, Ministry of Commerce and Industry, Government of India, 2023). This growth signifies improvements in the business environment and government support for entrepreneurship.
Does India still deserve a “Stable” Credit rating?
India’s economic trajectory over the past fifteen years has witnessed a remarkable transformation. Initially, the economy grew at a modest rate of three percent under the UPA-led government, facing challenges such as policy inertia, corruption, and a twin balance sheet problem. These factors contributed to global credit rating agencies assigning India the lowest investment credit rating.
Presently, India emerges as the world's fifth largest and fastest-growing economy. At Purchasing Power Parity, India would be the third-largest economy. India's consistent history of zero sovereign defaults reveals its willingness to fulfill its financial commitments. A report published by the finance ministry in 2020 cited, that India's forex reserves can cover an additional 2.8 standard deviation negative event, i.e. an event that can be expected to manifest with a probability of less than 0.1 percent after meeting all short-term debt. India's forex reserves stood at US$ 584.24 as of January 15, 2021, greater than India's total external debt (including that of the private sector) of US$ 556.2 bn as of September 2020. Moreover, in corporate finance terminology, India resembles a firm that has negative debt i.e. a firm whose probability of default is zero.
However, despite India’s economic resurgence, global rating agencies like S&P and Moody’s have maintained India’s rating merely at the cusp of investment grade (BBB- and Baa3, respectively). India’s substantial foreign exchange reserves, a well-capitalized banking system, and a profitable corporate sector serve as indicators of financial stability and creditworthiness. Moreover, India’s unique position of borrowing exclusively in its currency makes default virtually impossible.
Addressing Bias in Credit Rating Assessments
The late 1990s witnessed the seemingly invincible economies of Southeast Asia crumble in the Asian financial crisis, leaving a trail of economic devastation and unanswered questions. While the crisis had multiple triggers, the finger of blame soon pointed to the CRAs.
These supposedly impartial institutions, tasked with evaluating the creditworthiness of nations, were accused of playing a dubious role in exacerbating the crisis. Ferri, Liu, and Stiglitz (1999) argued that CRAs were complicit in the disaster. They initially failed to warn of the impending storm, leaving developing economies vulnerable. Then, as the crisis unfolded, they overreacted with excessive downgrades, triggering a domino effect of panic and capital flight. These downgrades, often based on subjective assessments, made it harder and more expensive for these nations to borrow, further hindering their ability to recover. Several authors have delved into this issue, highlighting different aspects of this complex problem:
• Gültekin-Karakaş, Hisarciklilar, and Öztürk (2010) found evidence that CRAs assign higher ratings to developed countries regardless of their fundamentals.
Subjectivity and Lack of Transparency
• Vernazza and Nielsen (2015) identified a "damaging bias" in the subjective component of sovereign credit ratings, leading to unfair downgrades like those during the Eurozone crisis. They advocate for stripping CRAs of regulatory powers and increasing transparency.
• De Moor, Luitel, Sercu, and Vanpée (2018) noted the large subjective component, especially for low-rated countries, highlighting the need for clearer breakdowns of objective and subjective elements.
Home Bias and Bias Against Poor Countries
• Fuchs and Gehring (2017) found evidence of "home bias," where CRAs favor their home countries or those with cultural/linguistic similarities.
• Tennant and Tracey (2016) demonstrated bias against poor countries, with S&P, Moody's, and Fitch making it harder for them to upgrade compared to richer counterparts.
The Bottom Line
Currently, sovereign credit ratings operate on a "who you know, not what you owe" system and it needs restructuring. After all, can we truly consider this an objective assessment when 13 out of 18 factors are based on subjective judgment which grants CRAs the authority to peer into the very soul of a nation, to judge its imponderables and intangibles as per their opinions? A one size-fits-all approach isn't cutting it anymore. Take India, for example – expecting them to meet the same standards as developed nations is unrealistic. We need a fairer, more tailored system that considers each country's unique situation. By doing so, we can ensure accuracy and fairness in credit assessments, paving the way for a more inclusive global financial landscape.
Bhavi Khanna is a Junior Analyst at IFSA Hansraj
Khushi Satwani is a Junior Analyst at IFSA Hansraj
Shresth Gupta is a Junior Analyst at IFSA Hansraj
Vanshika Soni is a Junior Analyst at IFSA Hansraj
References
S&P Global Ratings. (2019, February 15). How We Rate Sovereigns spglobal.com/ratings/_division-assets/pdfs/021519_howweratesovereigns.pdf
Indian Institute of Management Bangalore. (n.d.). Working Paper No. 134. https://repository.iimb.ac.in/bitstream/123456789/487/1/WP.IIMB.134.pdf
Amity Journal of Finance (2017, 09 May) Consistency in the Bond Rating Methodology – A Study of Indian Credit Rating Agencies https://amity.edu/UserFiles/admaa/90423Paper%203.pdf
Government of India (2020) Economic Survey, Volume 1, Chapter 3 [PDF document]. Ministry of Finance, India. https://www.indiabudget.gov.in/budget2021 22/economicsurvey/doc/vol1chapter/echap03_vol1.pdf
Gupta, Ms. Harshita, and Yadav, Dixit, Credit Rating Agencies - Risk and Regulations
(September 26, 2021).
Available at SSRN: https://ssrn.com/abstract=3930930 or http://dx.doi.org/10.2139/ssrn.3930930
Lad, Ramdas (2019,1 January) Credit Rating Agencies in India https://www.researchgate.net/publication/358021495_Credit_Rating_Agencies_in_Indi
Comments