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.