In this week's FinMail we understand the role of Credit Rating Agencies in the Global Financial System. We also explore how they have the influence to make or break institutions and even worse, Nations.
Last week on Tuesday, 5th October 2021, Moody'supgraded its outlook on India from 'Negative' to 'Stable'. This comes almost after 2 years when Moody'sdowngraded India's Sovereign rating from Baa2 to Baa3 in early 2020. And if that was not bad enough, Moody's also changed its outlook on India from 'Stable' to 'Negative' citing that India's has been weak in the implementation of economic reforms from 2017 onwards, the GDP growth rate of India has been on a falling spree and hence they expected that the further economic growth of India is expected to remain moderate as a result.
And hence it changed its outlook on India from 'Stable' to 'Negative'. This downgrade was the first downgrade of India's sovereign rating after 22 years. Moody's also clarified that this downgrade was not because of the impact that the Covid-19 pandemic would have on the Indian economy, but it was as a result of the existing problems in the economy which were only going to amplify because of the pandemic. (Clearly, the officials of Moody's woke up that day & chose violence)
Now there were certain backlashes from the end of the Indian government criticising the particular downgrade from the Credit Rating Agency and stating it as a Biased downgrade. FM Nirmala Sitharaman also had criticised the Credit Rating Agency in a G20 meet of the nations stating that it would limit India's potential to reform the economy in the midst of a pandemic.
Fast forward to the present, Moody's upgraded its outlook on India from Negative to Stable while maintaining the lowest investment grade rating of Baa3. Changing the outlook Moody's mentioned that the downside risk is decreasing on the account of rampant growth in economic activities after the second wave and the GDP of India is also expected to get better; even higher than the GDP of 2019 and that too in the current year only. It agreed that it had over-estimated the limitations and the damages of the pandemic on the Indian economy and hence a change in the outlook.
(Indian Economy be like: Pichli baar kya bola tha? )
So this was basically the news. But hey, it was a big deal in terms of the impact that the downgrade in rating was going to have. And the upgrade in outlook will also impact positively for India.
And that is why we are here, to understand what is credit rating, who are these so-called entities — credit rating agencies (CRAs), how the ratings & outlook provided by them affect a nation. And is there a darker side to this story? All of this in this FinMail, let's go!
Credit Rating of Countries
You might be thinking why do countries have Credit Ratings? And what does it convey anyway?
Think of Credit Rating as a CIBIL/Credit Score of a Country/Institution. The higher the Credit Score of an individual, the higher the chances of getting a loan easily and at a relatively low rate of interest. In the same way, if a country has a higher credit rating (also known as Sovereign Rating for countries), the better & affordable it is for them to borrow internationally. Let us break it further down.
A low credit score suggests that you are not capable of paying back the loan & it is risky for a bank to grant you a loan. So, if your Credit Score is low but you need a loan anyways, in that case, the bank would give you a loan, but at a higher rate of interest as compared to an individual with a higher Credit Score. The bank is essentially taking more risk by lending you a loan and hence it would also seek high returns. (High Risk & High Returns; you know it)
In the same way, a country with a lower credit rating will have to pay the lenders a higher rate of interest to borrow money because a lower credit rating suggests that it is risky to lend money to the particular country in concern.
What are Credit Rating Agencies?
If the Credit Rating of a country is the Credit Score of the country then, Credit Rating Agencies function as the agencies that calculate/prepare the Credit Score. So CRAs are basically the CIBIL for the countries & institutions.
CRAs are those entities that do the job of assigning credit ratings to institutions/corporates/countries on the basis of how risky it would be for an Investor, based on their probability to default.
An individual has a Credit Score in numbers (from 300 to 900), while countries and institutions have letters instead of numbers. Credit Rating is given in the form of letters like AAA, AA, BBB, etc. So for instance AAA is the highest rating that can be assigned to any institution or economy and D is the lowest rating that essentially means that there is a high probability of default.
Coming back to our story, Moody's downgraded India's rating from Baa2 to Baa3 in 2020. Baa3 is the lowest ranking that a country can be on to be considered as Investment Worthy. One more downgrade and India would be considered in the categories of Junk Investments. For reference, Italy, Panama, Romania & Russia have Baa3 rating and obviously, No country would want to be at such a point.
But what is the case with the outlook? How is that different from a Credit Rating?
Ok, so when a CRA believes that it doesn't need to change its rating but also wants to acknowledge or warn the investors about their beliefs then they simply change their outlook on the Institution or Economy in concern. So for instance, if in the current story, Moody's were of the belief that India is going to progress despite the effects of the Pandemic, they might have changed their outlook to 'Positive' while keeping the sovereign rating of India intact at Baa3. And if the outlook is 'Negative' then we could say that they don't see any growth potential from the current situation. Hence in this way, they remain intact with their rating but also convey their stance via their outlook.
Now we know what are Credit Ratings and who are these CRAs, now is the time to look at how these ratings impact the country/institution in concern. (Abhi maja aayega na Bhidu)
What impact does a Credit Rating have?
Investors rely heavily on CRAs to know the inherent risk in any institution or nation. For instance, if you have to invest in a different nation, let's say Brazil, obviously, you'd not have any greater idea of their economy and the risk that you'd carry if you invest in the country. So you'd have to depend on such CRAs who give a Credit Rating to countries for taking an investment decision. So definitely credit rating impacts the country. Let's see how.
Ease of borrowing
As discussed, if the credit rating of a country goes down, it suggests that the probability of that country defaulting increases. So if a country with a low credit rating has to borrow funds from outside, the lender would demand more interest as the risk of default is now higher. So the cost of borrowing increases. In the same way, if the credit rating improves, the cost of borrowing would go down and it would be easier to borrow money.
Impact on the international fund flow
Foreign investors rely heavily on Credit Ratings for their investments decisions. If a country's credit rating is changed, it would definitely impact its economy. In India, Foreign Investors are considered as the whales because of the huge impact they have on the Financial Markets. And Credit Ratings have a huge impact on their behavior. Any positive developments in the ratings would mean that they would be encouraged to make more investments and any negative developments would mean a reduced flow of foreign investors' money.
Impact on Domestic Corporates
The Credit Rating of a country dictates how easy or difficult it would be for the corporates present in the country to borrow money from the International Markets. The Foreign Investors that invest in the domestic corporates would also check the country's Credit Rating before they invest their money. Would you be easily convinced to invest your money in a company that is based in a country with economic uncertainties? I guess not.
Whether the economy would get a push or a pullback depends on the Credit Rating. A good credit rating would mean more inflows, more investments, more liquidity in the financial markets, and thus better growth potential. And in the same way, a bad rating would create a chain reaction of limitations that would ultimately hamper the economy's growth. Credit Rating also affects the intrinsic value of the domestic currency as it would get stronger/weaker against international currencies depending on the rating.
So it might seem to you that a Credit Rating can make/break an economy. And if a Credit Rating Agency wants to do that, in that case, they definitely have the power to do so.
To the Dark side
If you're thinking that an 'institution' that holds the influence to either make or break not just the other institution and a country by simply providing its 'opinion', is way too powerful, then yes, you're absolutely correct. There lies the probability of power abuse as they are independent agencies. CRAs have been criticized from time to time for all the right reasons most of the time. The credibility of CRAs isquestionable.
"Do CRAs get paid by the bond issuers for rating their bonds?" asks a user to Dhirendra Kumar, CEO of Value Research. "Yes they do and this is the design of the Bond Market that lies all over the world" replies Dhirendra.
Institutions 'shop' Credit Ratings. If a particular CRA doesn't give the institution a required rating, they go to another vendor. And if that was not enough - Institutions buying the credit ratings, CRAs have a Sales Department. Sales Department for selling the Credit Ratings! Can it get more worrying?
That's not just it, they have been found biased according to some studies. (ofc you saw this coming)
The Economic Survey 2021 has explicitly expressed that foreign rating agencies like S&P, Fitch, and Moody's have remained biased when it comes to the sovereign credit ratings of India.
"Never in the history of sovereign credit ratings has the 5th largest economy been rated as the lowest rung of investment-grade (BBB -). India's fiscal policy must not remain beholden to a noisy, biased measure of India's fundamentals," the Survey said.
In 2018, India witnessed a collapse of the IL&FS group which had a total debt of ₹91000 crores. It was on the verge of defaulting, despite of this fact, the group was assigned a rating of as good as AAA just 13 days before it defaulted in its payments. This clearly raises the big '?' on the viability of CRAs. And a part of the blame also goes on to SEBI for not having stringent rules & regulations in place to prevent such incidents. SEBI fined the CRAs, ICRA & CARE with ₹25 lakhs each which was later increased to ₹1 Crore in September 2020. Defaults worth ₹1000s of Crores and penalties worth just ₹1 Crore. (Koi sense hai iss baat ki? SEBI ko to bohot lagti hai)
According to the Financial Crisis Inquiry Commission, credit rating agencies were “key enablers of the financial meltdown” in 2008. Yup! And the stories go on & on & on...
But the truth prevails which is that Credit Ratings don't show you the true picture. They can be bought, tampered with, opinionated, & misguiding. So let's end this particular FinMail with a question which is,
Should you as an Investor pay heed to such Credit Rating Agencies?
CRAs are not always right, so the obvious answer would be yes as well as no. (FinMail readers be like; Kuch Naya Batao). CRAs are not always neutral and not always biased so the diplomatic answer would be that to always invest in the safest bonds by factoring in the probability of it getting defaulted.
So the best thing to do here is to only invest in the bonds & debentures of those corporate groups which are preceded by their reputation, and not just by looking at the numbers that seem to be satisfactory on the balance sheet. Keep your pockets close to your heart coz CRAs aren't going anywhere. They will just change their opinion just before it's too late. And you know who is the last one in the sinking ship.
That is it for this week's FinMail, keep reading, stay vigilant and we will see you in the next week.
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