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More standard ratings, less moody ones

By Jaimini Bhagwati
November 20, 2009 16:01 IST
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In the wake of the sharp downturn in the valuations of mortgage-backed securities last year, financial firms justified their investment in these non-transparent instruments on the triple ratings accorded to them, writes Jaimini Bhagwati.

Jaimini BhagwatiStandard and Poor's and Moody's continue to dominate the credit rating industry in terms of global reach and acceptance. Effectively, S&P and Moody's are a duopoly at an international level even though there are many regional and country-specific credit rating agencies.

Further, Moody's is the only publicly-held company among the larger CRAs and its high profit margins seem to indicate monopoly pricing power.

In the wake of the sharp downturn in the valuations of mortgage-backed securities last year, financial firms justified their investment in these non-transparent instruments on the triple ratings accorded to them.

Bear Stearns was rated single A till just days before its stock price collapsed at the end of March 2008. Similarly, AIG and Lehman Brothers were rated single A almost till they went bankrupt in mid-September 2008.

According to S&P and Moody's, the 'five year median default probability' of an institution rated single A is about 0.117 per cent.

This is a little more than a one in a thousand chance and incredibly, there were several cases of a drop from single A or even higher to bankruptcy in the six months from April to September 2008.

The dubious role played by CRAs in the financial sector meltdown has been extensively documented. For example, the Securities and Exchange Commission's 'Summary report of issues identified in the Commission Staff's examination of select Credit Rating Agencies, July 2008'.

Additionally, there is widespread agreement that there is an inherent conflict of interest in CRAs depending on the clients they rate for their revenues. Consequently, readers may wonder why this issue is being raked up once again.

However, as Dr YV Reddy had mentioned in his Justice KM Reddy Memorial Lecture in November 2009, one of the contemporary issues which deserves reflection relates to "infrastructural services for economic activity, such as credit rating services".

Corporate bond spreads to duration-matched US Treasuries
S&P credit ratings
31-May-2007 0.67% 0.86% 1.14%
01-Dec-2008 4.90% 5.94% 7.40%
09-Nov-2009 1.26% 1.84% 2.62%
Source: Barclays Capital US Corporates Index

The need for rating industry reform is relevant for India since there is a correlation between sovereign credit ratings and the cost of external commercial borrowings and non-resident Indian deposits.

The table above provides corporate bond cost spreads to US government securities depending on credit ratings. These are average spreads, over the maturity spectrum, and are weighted by the market values of outstanding bonds.

As of November 12, 2009, India was rated BBB– by S&P. It follows that for most Indian corporate houses and other sub-national entities, the BBB­– sovereign rating becomes a credit ceiling. As can be seen from the table, on November 9, 2009, a BBB corporate house's cost of borrowing was 0.78 percentage points higher than a single A rated entity.

Therefore, an Indian corporate house would probably access funds from international sources at a spread of at least 2 per cent or more compared to a single A.

At the end of March 2009, the outstanding volumes of long-term ECBs and NRI deposits were $62.7 billion and $41.6 billion, respectively. These two sub-categories added up to about 40 per cent of India's external debt.

Assuming that Indian ECBs and NRI deposits have been contracted at an additional cost of 2 per cent, due to India's relatively low sovereign credit rating, the extra interest outflow per annum is approximately $2 billion.

Let us also assume that India would be able to access debt funding from external sources for about 50 per cent of the $500 billion needed for infrastructure projects over the next decade.

If the cost of borrowing for this $250 billion is again higher than warranted by 2 per cent because India is under-rated, and the average modified duration of this pool of debt is five years, the present value of the additional cost would be about $25 billion.

As we know from the experience of Indian companies, smaller scale projects supported by ECB funding can easily tip from viable to non-viable based on cost of borrowing considerations.

If higher borrowing costs and, at the margin, non-viability of proposed ECB-funded projects are indeed due to an unduly low credit rating for India, a focused approach is needed to address this issue.

A November 7, 2009 Financial Stability Board report titled 'Progress since the Pittsburgh Summit in Implementing the G-20 Recommendations for Strengthening Financial Stability' includes national action taken in the US, the European Union, Japan and South Korea with respect to the rating industry.

This report also mentions that 'in response to the FSB and G-20 recommendation to review the use of ratings in the regulatory and supervisory framework, the Basel Committee on Banking Supervision will present concrete proposals in December 2009 to address a number of inappropriate incentives arising from the use of external ratings in the regulatory capital framework'.

It appears that issues such as possible misreading of sovereign credit ratings and consequences thereof are not part of the ongoing work at the FSB or the BCBS.

In this context, it is worth noting that developed countries with high credit ratings, which have borrowed heavily from external creditors, could de facto part default on their debt obligations through steady depreciation of their currencies while keeping interest rates close to zero.

Is it really credible that as of November 2009, the government of India has a higher probability of defaulting, over a five-year horizon, on its external debt obligations as compared to Enron four days before it went bankrupt or Lehman in the second week of September 2008?

Currently, the GoI's BBB– rating is the same as that of Iceland and the UK is rated triple A while China is placed at A+. Are countries rated higher if they impose fewer controls on their capital accounts?

Clearly, the answer is that CRAs do not have the answers. One way forward could be for India to push for discussions about perceived anomalies in sovereign ratings in FSB and BCBS forums.

Since rating agencies serve a quasi-regulatory function, we could seek the setting up of a multilateral CRA. Sovereign ratings are crucial benchmarks and a multilateral agency could concentrate exclusively on providing country ratings with its deliberations open to independent evaluation.

The author is the Ambassador of India to the European Union, Belgium and Luxembourg. Views expressed are personal

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