Sovereign Credit Ratings Are Often Annoying; A Credible Indian Agency Can Change That

Sovereign ratings have almost been the exclusive domain of three US-based agencies—Fitch, Moody’s, and S&P. The sovereign credit rating assigned to India is presently BBB-/Baa3—the lowest of the investment grade. This is despite India, the fifth largest economy, having a zero sovereign default history.

S&P explains credit ratings as “forward-looking opinions” about the ability and willingness of debt issuers (corporations or governments) to meet their financial obligations on time and in full. They provide a common and transparent global language for investors and are one of many inputs they can consider as part of their decision-making processes.

The Securities and Exchange Board of India (Sebi) says it is an assessment of the probability of default on payment of interest and principal on a debt instrument. But it’s not a recommendation to buy, sell or hold a debt instrument.

Thus, ratings are of critical importance for companies seeking to raise funds from financial institutions.

The same logic holds true also for sovereign countries. Sovereign credit ratings are important for a country seeking to raise financial resources through international financial markets. These ratings are taken to be a credible indicator of the credit risk, implying thereby the ability of the sovereign to repay the loan.

The level of risk determines the risk premiums. A credit risk reflects the likelihood of a government being unable or unwilling to meet its debt obligations. It significantly affects access, timeliness, cost, and tenor of borrowings by the sovereigns.

Conversely, a good sovereign rating ensures access to easy funding in international bond markets. A good rating helps attract foreign direct investment—as it has become an important indicator of the country’s economic health.

As a World Bank paper states sovereign credit ratings play an important part in determining the countries’ access to international capital markets and the terms of that access.

The US-based agencies involved in sovereign ratings also rate securities whether stock or bond in the US and through their subsidiaries elsewhere across the globe. In the aftermath of the 2008 financial crisis in the US, several of them were castigated in the Financial Crisis Inquiry Report as being “essential cogs in the wheel of financial destruction-key enablers of the financial meltdown”.

Though there are some similarities between the sovereign rating process and rating process involving securities or bonds, there are also significant differences in that a sovereign’s governance and institutional qualities are assigned more importance than its capacity to pay (macroeconomic performance). This brings in a qualitative evaluation and a high degree of subjectivity.

Consequently, the task of agencies involved in sovereign ratings is challenging and casts a responsibility on them to ensure the process is transparent and rigorous.

Credibility Of Methodology

It is in this background that we will have to evaluate the essay dealing with credit rating methodologies in the ‘Re-examining Narratives’ report issued in December 2023 by the office of the Chief Economic Adviser (CEA). It has again sparked a much-needed debate on the role of the US-based rating agencies.

The CEA’s essay points out succinctly that the methodologies “utilised by credit rating agencies are opaque and appear to disadvantage developing economies in certain ways”. The descriptions and justifications for several parameters used in the methodology are not clear.

As pointed out in the report, “opaqueness and non-transparency in rating methodologies are fertile grounds for sowing suspicion about the discriminatory intent of CRAs, particularly when rating downgrades are mostly in respect to economically weaker nations”.

Thus, credit downgrades for developing countries make it difficult for them to access cheaper long-term funding from international capital markets.

Calls For Reform

International ratings agencies seem to make no distinction between the indicators used to assess ‘ability to pay’ and ‘willingness to pay’. They rely heavily on the Worldwide Governance Indicators (WGIs) of the World Bank which is admittedly perception based, details of which are not in the public domain.

A comparison, for instance, between the WGI of India and China is very revealing. The six aggregate governance indicators used in the WGI (all for 2022) and a comparison for instance between the ranking given for India and China are as under:

India has been given a sovereign rating of BBB-/Baa3, while China’s ranking is higher at A1.

The justification given by the agencies for India’s sovereign rating is the fiscal deficit, its extensive borrowings and its failure to maintain discipline as contemplated in the Fiscal Responsibility and Budget Management Act.

What has not been factored is that India has never defaulted. Ultimately, factors like willingness and ability to pay should be the determining parameters.

The arbitrariness of the sovereign rating process was earlier highlighted in The Economic Survey 2020-21. In it, a case was made that the ratings assigned to India failed to accurately depict the underlying economic fundamentals of the country.

While comparisons are odorous, let’s not forget the US has a debt more than USD 33.17 trillion. Moody’s still gives the US a AAA rating while Fitch and S&P have given it an AA+ rating. African nations have been particularly hard done by the sovereign rating assigned to them. It has made funding from abroad costly.

A United Nations Development Programme study has said that if the credit rating agencies employ less subjective assessments, a resulting revision in the ratings of African countries would save them up to US$ 74.5 billion in borrowing costs. African nations have often complained about the ‘institutionalised bias against African economies’ of the credit rating agencies.

Thus, there is an urgent need to reform the rating process. The time has indeed come for an independent rating agency without the burden of history.

An Indian Alternative?

An ORF research paper has suggested that the Brics nations ought to do something about this. Brics Summits have debated this issue, however, nothing concrete has emerged thus far. The London-headquartered ARC Ratings (a consortium of rating agencies from Asia, Africa, Europe, and South America), or the Malaysian, Russian, Hong Kong, Chinese, Japanese rating agencies have not made much headway in this area.

Given India’s growing importance, it is an opportune time for a domestic credit rating agency to move into this space. Such a move will resonate well with the African nations too. The process may take time, but it’s worth the effort.

However, for this to emerge as a credible alternative, key parameters like economic structure, fiscal strength, external linkages, monetary and financial stability and institutions and quality of governance will have to be examined.

It should be data driven with subjectivity kept to the minimum. The focus should be on actual risk rather than perceptions of risk. Hence, the process must be robust and transparent.

There must be close engagement with the International Monetary Fund, World Bank, the International Bank for Reconstruction and Development, Asian Development Bank, EXIM Bank and other financial institutions. The rating process must convince them to lend at lower cost to sovereign nations – not merely to repay loans but to rebuild capacity and become economically stable.

(Najib Shah is former chairman, Central Board of Indirect Taxes and Customs. Views expressed are personal)