Why has the Indian government criticised the methodologies of global credit rating agencies?

The essay seeks to flag issues with the methodology adopted by the three main global credit rating agencies, and to show, based on calculations by the Finance Ministry, how these gaps affect India adversely.

Why do sovereign ratings matter?

Sovereign ratings are about the creditworthiness of governments. They provide a marker for investors around the world about the ability and willingness of governments to pay back debt. Just as an individual’s credit rating is critical to whether she gets a loan and at what interest rate, sovereign ratings affect a country’s ability to borrow money from global investors.

Again, just as an individual or corporate borrower with a well documented history of paying back loans (showing willingness to pay back) and substantial assets or income streams (showing ability to pay back) gets a new loan (for a car/ house/ factory) at a cheaper interest rate than someone with no credit history or assured income streams or assets, governments with lower sovereign ratings have to pay higher interest rates when they borrow.

Sovereign ratings matter not just for the government but also for all businesses in that country. That’s because the government is considered to be the safest bet in a country. If the sovereign rating of a country’s government is low, the businesses of that country end up forking out an even higher interest rate when they borrow from global investors.

Most developing countries (such as India), while rich in either labour resources or land or mineral resources, suffer from a lack of capital (money available to put to use). In the absence of financial resources, developing countries struggle to make the best use of their natural strengths. A poor sovereign rating can inhibit the ability of these countries to borrow money from rich investors — just as a good rating can make it easier to become more productive and remove mass poverty.

Which are the main rating agencies?

Sovereign credit ratings predate the Bretton Woods institutions, i.e., the World Bank and the International Monetary Fund. There are three main globally recognised credit rating agencies: Moody’s, Standard & Poor’s and Fitch.

Moody’s is the oldest; it was established in 1900 and issued its first sovereign ratings just before World War I. In the 1920s, Poor’s Publishing and Standard Statistics, the predecessor of S&P, started rating government bonds.

While the US and European countries have enjoyed a good record, ratings have been affected by global events. For instance, according to an IMF research paper, sovereign defaults spiked during the 1930s Depression, and most ratings were downgraded. By 1939, all European sovereigns, barring the UK, were in the speculative grade.

What is the government’s criticism?

The Finance Ministry has pointed out three main issues with the methodologies used by the rating agencies.

First, they “are opaque and appear to disadvantage developing economies” in certain ways. “For instance,” the Ministry says, “the Fitch document mentions that the rating agency “takes comfort from high levels of foreign ownership” in the banking sector and that “public-owned banks have historically been subject to political interference”.”

“Such an assessment”, the government argues, “tends to discriminate against developing countries, where the banking sector is primarily run by the public sector”. According to the government, such an assessment also ignores the welfare and development functions that public sector banks have in a developing country, including playing an important role in promoting financial inclusion.

Second, the government says, “the experts generally consulted for the rating assessments are selected in a non-transparent manner, adding another layer of opaqueness to an already difficult-to-interpret methodology”.

Third, the rating agencies do not convey clearly the assigned weights for each parameter considered. “While Fitch does lay out some numerical weights for each parameter, they do go on to state that the weights are for illustrative purposes only,” the essay says.

To understand some of these points, look at the Table above. It details the Finance Ministry’s understanding of how Fitch goes about judging sovereign risk.

There are four main pillars — such as macroeconomic outlook, structural features, etc. — each with a specific weight. Within each of these pillars there are sub-components, again with individual weights. But apart from the quantitative variables, each vertical also has “Qualitative Overlay” variables.

The essential points of contention are, one, the use of the composite governance indicator (which has a weight of 21.4) is only based on the World Bank’s Worldwide Governance Indicators (WGI); and two, the use of Qualitative Overlay implies a subjective assessment.

The WGI uses a host of indices and reports such as the World Economic Forum Global Competitiveness Report, Economist Intelligence Unit, etc. to assess several aspects of a country that may not be captured by hard economic data. These include freedom of expression, freedom of media, rule of law, corruption, quality of regulation, etc.

The government argues that there is an excessive reliance on such subjective appraisals.

According to the government’s calculations, “…the influence of the composite governance indicator and perceived institutional strength surpasses the collective influence of all other macroeconomic fundamentals when it comes to the chances of earning India and other developing economies an upgrade.

“The effect is non-trivial… It implies that to earn a credit rating upgrade, developing economies need to demonstrate progress along arbitrary indicators, which are also criticised for being constructed from a set of several one-size-fits-all perception-based surveys.”