Sovereign rating services fail to get passing grade

Sovereign rating services fail to get passing grade

Fajar Hidayat, MBA Int'l Banking & Finance, Birmingham University, UK

Standard & Poor'S (S&P) Rating Services on Sept. 5 raised its
long and short-term foreign currency sovereign credit ratings on
Indonesia to triple C plus and C, respectively, from "SD"
(selective default) and assigned the foreign currency ratings a
stable outlook.

The upgrade followed the rescheduling of three syndicated
commercial loans as required by the Paris Club regarding
comparability of treatment. S&P also affirmed its long and short-
term local currency sovereign ratings at single B minus and C
respectively, and revised the outlook on the local currency
rating to stable from negative.

As an emerging market, Indonesia must still try to improve its
sovereign rating as assessed by S&P and other global rating
agencies (e.g. Moody's; Fitch IBCA; Duff & Phelps). But agencies
should also improve the accuracy of their ratings on emerging
markets.

The improvements by both parties could enhance capital flow
stability in emerging markets. Such stability is marked by the
following situations -- that in an economic boom the capital
inflow is not too excessive, while during an economic bust the
capital outflow is not too massive, which otherwise might dry up
a country's liquidity.

An emerging market is a country trying to improve its economy
to compete with nations with higher income. The World Bank
classifies economies with a gross national income per capita of
US$9,266 as high income countries. Emerging markets are the
recipients of capital inflow from various international financial
support programs.

Capital inflow also comes from global private investors who
favor emerging market securities (stocks and bonds) and currency
because of the potential for high abnormal return in a short
time. There is a great deal of risk involved because emerging
markets are in a state of transition.

Global credit rating agencies play a crucial role in smoothing
capital flow worldwide, particularly in emerging markets. Their
determination of the risk presented by loans to or investments in
securities of corporations, states, municipalities and other
public agencies is a major factor in the ability of these
entities to raise funds and to greatly influences the interest
rate they must pay to obtain credit.

In modern financial markets, corporations and sovereign
ratings have become essential to attract the broadest possible
class of investors and lenders.

Rating agencies could help countries to better understand how
their economies appear to outside investors and the possible
steps to improve that image. By enabling lenders and investors to
distinguish among markets, even a speculative rating can play an
important role in attracting capital to these countries. A
country with a rating is more on the right track for integration
into the global financial system than a country without one.

Rating agencies not only act as information providers, but
more so as arbiters of risk. The rating scale is an indicator of
a certain level of risk and places the loan borrowers or bond
issuers in a category of ability to pay interest rates of funds.
This interest is roughly proportionate to the risk -- or at least
the perceived risk -- of default.

It also reflects the length of time before repayment is due.
Assessing sovereign risk is based upon a number of macroeconomic
fundamental factors and some socio-political variables.

The highest rating is Aaa from Moody's and AAA from S&P,
indicating that a borrower or issuer offer, for instance,
"exceptional financial security". The critical range is between
investment grade (Baa/BBB or better from Moody's/S&P) and
speculative grade (Ba/BB or below from Moody's/S&P). Ratings by
Moody's and S&P become benchmark among market participants.
Ratings from Fitch IBCA or Duff & Phelps provide additional
perspective.

These agencies view their ratings as a forward-looking
indication of the relative risk for a debt issuer. They do not
regard their ratings as providing either a prediction of the
timing of a default or an indication of the absolute level of
risk associated with a financial obligation.

In 1987, only 30 sovereigns were rated; 18 were from developed
countries, and only 12 from emerging markets. By the end of 1996
74 sovereigns had obtained ratings, and the number of rated
emerging-markets sovereign more than quadrupled to 51. This came
with the massive growth of capital inflow to emerging markets. By
1997, annual financing (loans, bonds and equity) issued by
emerging market governments and firms totaled nearly US$200
billion, more than triple than some $60 billion five years
earlier.

While sovereign rating helps emerging markets to attract
capital inflow, rating agencies do not always determine the
ratings perfectly. Rating agencies did not do their job well in
rating some countries prior to and during Asia's financial
crisis. Instead of stabilizing, the ratings worsened the crisis.

As the crisis expanded, they lacked the ability to monitor and
understanding events. The agencies downgraded some East Asian
countries affected by the crisis to reflect what they saw as a
virtually bottomless risk. This reveals that the agencies acted
"pro-cyclically", adding momentum to the deeper down-turning of
the economy rather than stabilizing it. The downgrading caused
panic among market participants and exacerbated the crisis.

Even in October 1997, three months after the collapse of the
Baht, both Moody's and S&P ranked Thai government bonds as grade
A. Yet in December 1997, S&P suddenly downgraded South Korea's
sovereign ratings by three notches to BBB minus (almost "junk"
bond rating) leading to investor panic. In January 1998, the
downgrading of Indonesia's sovereign rating by S&P from BB+ to BB
hence became a speculative grade, contributing to the fall of the
rupiah to about 25 percent against the US dollar.

After the crisis, the sovereign ratings of borrowers from some
Asian countries affected by the crisis dropped to "junk status."
The downgradings reinforced the regional crisis in many ways:
Commercial banks could no longer issue international L/C for
local exporters and importers, institutional investors had to
divest those countries assets as they were required to maintain
portfolios only in investment grade securities, and foreign
creditors were encouraged to call in loans upon the downgrades.
The situation entrapped the countries in deeper crisis.

The Asian crisis was triggered by an economic boom with
excessive capital inflow mostly in speculative short-term funds
generated by euphoric expectations among investors. Upgrades of
sovereign ratings had strengthened euphoric expectations and
stimulated excessive capital inflow. When the economy went bust,
the speculative funds simultaneously flew away.

Both S&P and Moody's have pleaded not guilty. Only Fitch IBCA
issued a formal report analyzing the credit agencies' records.
Admitting mistakes, Fitch in 1998 noted that it incorrectly
assumed that: (a) a high proportion of short-term debt is
problematic for highly indebted countries only and (b) only
public sector debt impacts credit worthiness, and sovereign
crisis cannot emerge from difficulties in the private sector.

Ratings might thus be able to smooth boom-bust cycles in
emerging markets if they became proper early warning signals. In
a boom, early rating downgrades would help diminish expectations
and reduce private speculative short-term capital flows.

A sovereign rating change should occur before an economic
bust, since that would signal that the situation is not as good
as it used to be. If the bust does not significantly influence
economic fundamentals, the rating should remain the same unless
the long-term outlook has changed.

So unless sovereign ratings can be turned into proper early
warning signals, they will continue to add to the instability of
emerging markets.