India's ratings plateau?

The S&P recently put India on the watchlist for a ratings revision downwards from its current investment grade. Without debating the merits of the downgrade, there is a troubling trend from this, especially when comparing our ratings trend to that of other emerging economies.

The graphic below, a composite measure of the ratings of all the three major rating agencies, shows that India moved up to investment grade rating in January 2007. However, unlike all its other partners, in a fairly accurate reflection of the political paralysis that has gripped the country, it has remained there for the past more than five years.
 

Oligopoly in the market for credit rating agencies

"At least one of the three biggest credit-rating companies was hired for 98 percent of municipal bonds bigger than $50 million this year, up from 94 percent in 2007, according to data compiled by Bloomberg. About 99 percent of U.S. corporate issues have a grade from one of the three, compared with 98 percent four years ago, the data show...

The three companies provide 97 percent of all credit ratings, the U.S. Securities and Exchange Commission said in a September report. S&P leads with a 42 percent share, Moody’s holds 37 percent and Fitch, majority-owned by Paris-based Fimalac SA, is at 18 percent...

It’s very hard to convince someone to stop using S&P and Moody’s ratings because they’re such a market norm... If you don’t have one, people will wonder what’s wrong with you."

See more on the distortions in the market for credit rating agencies in this excellent Bloomberg story.

Rating agencies are back in focus

Rating agencies continue to make news, for all the wrong reasons. Over the past few days, there have been three illustrations of how decisions of rating agencies have contributed towards their declining credibility.

Just before the market close on Thursday last week, the Standard & Poor’s (S&P) erroneously sent out an e-mail suggesting that it had lowered the rating on France’s sovereign debt. The mail shook the markets and forced up French bond yields,

"In a statement, S&P attributed the message to "a technical error" and affirmed that the rating was unchanged. But the yield for France’s 10-year benchmark bond jumped more than a quarter point, to 3.48 percent, and the spread between French and German bonds of that duration reached 1.7 percentage points, a euro-era record... The erroneous S.&P. message went out shortly before 4 p.m. Paris time, and the correction was issued almost two hours later, after most European markets had closed."

Simultaneously, in India, Moody's Investors Service revised its outlook for India's banking system to negative from stable. It attributed the downgrade to increasingly challenging operating environment that will adversely affect asset quality, capitalisation, and profitability of Indian banks; high inflation; monetary tightening and rising interest rates; and the crowding out effect of government's massive borrowing program.

Just a day after the Moody's downgrade, S&P went the opposite direction and upgraded the sector from group '6' to group '5', the same as the other similar economies. Its argument

"Dependence on stable bank deposits due to an extensive branch network and limited dependence on external borrowing made India's banking system low-risk on system-wide funding... In our view, banking regulations in India are in line with international standards and the regulator ( RBI) has a moderately successful track record".

So what do we make of these contrasting ratings signals? Do investors and financial market actors go by the fact that since S&P is larger entity, its ratings should be given greater credence? In this context, The Gold Standard has an excellent post where it compares the Moody's decision on India's banking sector with that on China's similarly troubled banking sector. He wrote,

"The price India has paid for its relative transparency on its problems is a negative outlook. The more opaque it is, the higher the rating. That is why these agencies gave AAA ratings to CDOs, CDO-squared and to CDOs on CDOs...

Its giant neighbour to the North has an entirely State dominated banking system and an economy with even greater financial repression. It systematically under-counts and under-reports its bad debts. Those who dare to raise their voice are forced to withdraw their reports.

Banks have large exposure to local governments who are dependent on land banks sales for their revenues. Banks have exposure to developers who want the prices of land banks to decline. Their apartment prices are dropping and transactions are plunging. So, we have no idea of the true health of Chinese banks or, for that matter, the whole economy. We will never have one. Yet, on November 8th, Moody’s reaffirmed its ‘stable’ outlook for Chinese banks."

It is hard not to be baffled by the clear inconsistency in these rating decisions. In fact, during the ongoing European debt crisis, on several occasions ratings downgrade decisions by one or the other of the three big rating agencies have triggered market downslides. There is a strong and credible enough view that the decisions of ratings agencies could contribute towards turning a liquidity crunch into a solvency crisis. It is therefore no surprise that a growing number of opinion makers hold the view that the ratings agencies hold disproportionate power, whose exercise has, as numerous events of the past four years have shown, been questionable.

The real meaning of US ratings downgrade

Since the dust has settled down on the decision by the Standard & Poor's to downgrade the rating on long-term US debt, it may be appropriate to dwell into its real meaning. Far from the dreaded scare scenarios, the impact appears to have been more benign.



If the bond markets are any indication, and they are arguably the best barometer of market perceptions, then the US ratings downgrade appears to either have had no impact or, perversely enough, made the US debt more attractive. Subsequent to the announcement, investors have been piling into US debt, not out of it, driving down yields on 10 year Tresuries to its lowest in two years.







This flight to US Treasuries in the aftermath of the market uncertainty created by ratings downgrade and the Eurozone debt-crisis, is to be expected given the natural investor reaction of fleeing to "safe havens". For all talk of Euro-assets and gold, US Treasuries and other highly rated American corporate securities remain the assets of choice for global investors seeking a "safe haven", and will continue to remain so for the foreseeable future. No other asset categories posses the level of "institutional strength, depth and liquidity of the market", besides lower risk.



This market response is also an accurate reflection of the reality underlying America's current debt "crisis". A simple arithmetic calculation of the US debt situation reveals that the relative magnitude of the short and medium-term US debt servicing burden is more easily manageable than imagined, especially at the prevailing interest rates. Paul Krugman calculates that an additional trillion dollars in debt with 30 year bonds (at a real interest rate of 1.25%) translates to $12.5 bn in additional real interest payments or 0.07% of GDP in future debt-service costs. In any case, in this time of deep debt over-hang, there are several countries with much higher debt-to-GDP ratios who continue to enjoy the triple-AAA rating.







Felix Salmon has an excellent post which adds a much needed sense of perspective to the S&P decision. The S&P, he writes, measures only the "probability of default", not the details of the default - the recovery value for investors (amount that will be left after default), time the issuer will remain in default, or the expected way in which the default will be resolved. In other words, the S&P rating decision does not convey any signal about what happens after the decision to default, on the ultimate losses that investors are likely to suffer.



This also brings us to the distinction between the S&P and other rating agencies. In keeping with the information failure that abounds in financial markets, the important fact that different rating agencies actually rate different things is not as widely known. The ratings of different agencies are most often used interchangably, atleast certainly in policy making circles. Unlike S&P's focus on default probability, Moody's is interested in expected losses.



A sovereign credit rating of the kind signalled by S&P's "is therefore primarily a function of a country’s willingness to pay, rather than its ability to pay". S&P's ratings are not investment-advice, but a rating of how likely a creditor will default. In contrast, Moody's rates specific instruments and the expected value of their losses if the issuers default. It assumes that people will use its ratings in the context of deciding which bonds to buy and which bonds to sell. In investment speak, a S&P downgrade is not a "sell" rating as is the case with a Moody's downgrade!



In the context of the US, this difference means a lot. It is politically possible that the US Government, driven by the Conservative push, could formally default. But nobody doubts that any such "legal default" will be only temporary, before sense kicks-in and bond holders are paid out in full. The expected losses being virtually nothing (except for the market determined losses), it is no surprise that Moody's retained its triple-A rating for the US debt. In other words, the S&P downgrade means that the political possibility of a US sovereign default has increased, though it tells little about whether investors should exit US Treasuries.



In simple terms, the S&P ratings downgrade is more a reflection of the market's perceptions of the crisis in American polity than problems with its short to medium-term fiscal balance. And academics and commentators would do well to confine themselves to this interpretation, as investors already appear to be following.



And for all those still sceptical, there is the example of Japan.







Japan lost its triple-A rating in 2002, and early this year S&P took a second shot, with another downgrade to double A minus. Japanese bond yields have continued to fall, with yields on 10 year bonds dipping below 1% briefly last week. The FT describes this as "the lowest level of interest rates anywhere since Babylonian times"!