Rating Agencies

News: Finance Secretary has accused rating agencies of “double standards” when assessing emerging markets and developing economies. Fitch, a rating agency, has termed India as the most indebted emerging market. It claimed that the latest budget did not provide clarity on fiscal consolidation plans.

What is a Rating Agency?

  • Rating agencies assess the creditworthiness or potential of an equity, debt or country. Their reports are read by investors to make an informed decision on whether or not to invest in a particular country or companies in that geography. They assess if a country, equity or debt is financially stable and whether it at a low/high default risk. In simpler terms, these reports help investors gauge if they would get a return on their investment.
  • The agencies periodically re-evaluate previously assigned ratings after new developments geopolitical events or a significant economic announcement by the concerned entity.
  • Their reports are sold and published in financial and daily newspapers.

Methodology:

  • The three prominent ratings agencies, viz., Standard & Poor’s, Moody’s and Fitch subscribe to largely similar grading patterns. Standard & Poor’s accord their highest grade, that is, AAA, to countries, equity or debt with the exceedingly high capacity to meet their financial commitments.
  • Its grading slab includes letters A, B and C with an addition a single or double letter denoting a higher grade.
  • Moody’s separates ratings into short and long-term definitions. Its longer-term grading ranges from Aaa to C, with Aaa being the highest. Fitch, too, rates from AAA to D, with D being the lowest. It follows the same succession scheme as Moody’s and Fitch.

Criticism:

  • Popular ratings agencies publicly reveal their methodology, which is based on macroeconomic data publicly made available by a country, to lend credibility to their inferences.
  • However, credit rating agencies were subjected to severe criticism for allegedly spurring the financial crisis in the United States, which began in 2017. The agencies underestimated the credit risk associated with structured credit products and failed to adjust their ratings quickly enough to deteriorating market conditions. They were charged for methodological errors and conflict of interest on multiple counts.

Implications:

  • Lowered rating of a country can potentially cause panic selling or offloading of investment by a foreign investor. In 2013, the European Union opted for regulating the agencies.
  • Over reliance on credit ratings may reduce incentives for investor to develop their own capacity for credit risk assessment. Ratings Agencies in the EU are now permitted to issue ratings for a country only thrice a year, and after close of trade in the entire Union.