On the wrong side of a ratings bias

Lowy Interpreter

In a world where financial markets are supposed to be forward-looking, the most striking characteristic of the credit ratings agencies is their 'rear-vision' view of the world, making downgrades after the crisis has already arrived.

One other foible of the ratings agencies is that emerging countries are consistently marked more harshly than the mature economies. Greece was still rated as 'investment grade' by one of the agencies until early this year, while good credit risks in well-performing economies, such as Indonesia, are still not rated 'investment grade'.

The Institute for International Finance (the bankers' lobby group in New York) has confirmed this bias in a neat piece of formal econometric analysis. They developed a regression equation which mimics the rating process. The regression includes a 'dummy variable' for emerging countries – an additional variable introduced just for these countries, to see if this classification is, itself, an important explanation of the rating.

It is – the fact that a country is 'emerging' rather than 'mature' is not only statistically highly significant, the impact is also large: countries which fall into the emerging markets group are rated four 'notches' (four rating levels) lower than countries which have similar explanatory characteristics, but which are not in the category of 'emerging'.

This amazing bias might be explained as a legacy of the times when these countries were in fact intrinsically risky. But that reveals just one more example of the rear-vision view of the credit agencies, which have been slow to recognise the improved performance of the emerging countries, particularly in Asia, now the main source of world growth and whose modest volume of debt looks very secure.

The agencies have also been very slow to recognise that the sovereign debt of mature economies has become risky. Governments took over the debt of failing banks in 2008. As well, the specific European arrangements encouraged over-borrowing by the southern European members, making them poor credit risks.

To make sense of current risk realities, the ratings agencies need to shift drastically on both fronts, to upgrade the emerging countries and downgrade the mature.

Meanwhile, financial markets are way ahead of the ratings agencies, shifting their investments towards the high-yield countries such as Brazil and, in doing so, creating another problem: too much capital inflow and upward pressure on exchange rates. At the same time, markets have taken no notice of the Standard and Poor's downgrade of the US at the time of the debt ceiling impasse. A downgrade should have encouraged bond investors to demand a higher yield, but instead US yields have fallen sharply: investors, at least, still think the US is a safe bet.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.