How Much Can Investors Rely on Sovereign Credit Ratings?Published: January 22, 2004 in Knowledge@Wharton
In a global economy, sovereign credit ratings are crucial to informing investors around the world of a country’s creditworthiness. Making investment grade signals that a country is viewed as nowhere near a default. Indeed, many institutional investors will not invest in a country that lacks the prestige of an investment grade rating.
Consider the case of Russia. In October, just weeks after Moody’s Investors Service accorded investment grade status to Russia, the country’s stock market took a dive, due in large part of the imprisonment of Yukos oil titan Mikhail Khodorkovsky. Though Russia’s stock market index has since bounced back, Khordorkovsky’s arrest led to a gush of capital outflows from Russia and showcased the fragility of its evolving economy.
“It’s still a very unstable country,” says Wharton finance professor Franklin Allen. “It hasn’t been such a long time since it defaulted,” he notes, referring to Russia’s 1998 default after it could no longer service its debts in the wake of a currency devaluation. Stephen Sammut, a senior fellow and lecturer with Wharton’s management department, notes that the volatile nature of an emerging market such as Russia’s complicates the call. “You have country risk, currency risk and sovereign risk,” he says, pointing to Russia’s lack of transparency as a problem for potential investors.
But others view Russia’s economy differently. Moody’s decision in October to raise the rating on Russia’s Eurobonds and foreign currency bonds and notes by two notches – to Baa3 (Moody’s minimal investment grade) – was made based on what it sees as Russia’s ability to service its debt. Standard & Poor’s, Moody’s competitor, declined to comment on Moody’s ratcheting up of Russia. But Helena Hessel, S&P’s director for Central and Eastern Europe, says Russia’s political world is still too risky to fetch an investment grade from S&P, which ranks Russia two notches below investment grade.
“For us, the country is still too vulnerable to changes in the price of oil and political issues,” Hessel says. “Only a few years ago it was in default.” In fact, as capital hightailed it out of Russia following the dive of its stock market, S&P indicated it was pondering a downgrade of Russia. (It didn’t.)
But Moody’s stuck to its script. While Russia naysayers slung arrows at the investment grade rating, John Rutherford Jr., Moody’s CEO and chairman, and John Schiffer, Moody’s top Russia analyst, flew to Moscow to hold a press conference and stand by their call. At the conference, Rutherford was quoted as saying: “If you look back five years from now you will find the market will have converged with the assessments we made.”
Was Moody’s investment grade rating a prudent one? During a phone interview in his New York office in November, Schiffer showed a trace of impatience on the subject of Russia – perhaps because he has been asked about his Russia upgrade nearly 60 times and has given several investor briefings and press conferences to discuss it.
“We’re not rating the whole country in some general sense,” Schiffer says. “This is not our job. This was an attempt to assess the risk of default on Eurobonds.” When one looks at what the government owes and what it has to pay it with, then Russia looks fit to service its debt. Payment of Russia’s Eurobonds will “only take between 3% and 6%” of the 2003 federal budget revenues, he predicts. “That’s very marginal,” and ought to be a strong cushion against default.
An Inexact Exercise
This year’s Russia ratings episode may say more about the different rating agencies than about Russia itself. As Schiffer concedes, “it’s a very inexact exercise.” But if “you are really doing your job,” then credit rating analysts must be forward-looking, he argues, “not ‘Gee, I don’t know, let’s wait a while.’”
When would one know if a call is wrong or not? In Schiffer’s view, “if a country defaulted within a year of investment grade, that would be viewed as a wrong call. You should be prescient by at least a year.” In early 1998, Moody’s downgraded Russia two times – just a few months before Russia crashed. “We moved before the others (S&P and Fitch’s),” he says.
Toby Nangle, director of fixed income and currency at Baring Asset Management and now on sabbatical at Cambridge University in England, offers an outsider’s perspective on credit ratings, suggesting that the introduction of ratings into international investment guidelines poses challenges for rating agencies – challenges which they have not met particularly well, he says. When the Bank for International Settlements, a bank for central banks around the world, called for rating agencies to play a higher profile in the draft of global banking regulations, rating agencies welcomed the move, Nangle recalls.
“Were these agencies blinded by dollar signs or did they truly believe that a more central role of ratings in regulation would not affect the link between observation and reality?” he asks. In other words, did the agencies not understand that by assigning a rating they would “be helping to prescribe credit quality as much as describe it?” If ratings agencies have failed to appreciate the link between their ratings and subsequent market reaction, “then the charge of irresponsibility in this respect is certainly warranted,” he says.
Moody’s vs. S&P
Sift through some sovereign ratings history and trends arise. Moody’s is often perceived as being more aggressive than S&P. “They are also more conscious of the market’s assessment of a given situation,” Nangle says, adding that Moody’s tends to be something of a trend-setter.
In a move that attracted disparagement and plenty of nay-saying, Moody’s raised Mexico to investment grade in March 2000. The upgrade, which capped six prior upgrades over an 18-month period, came four months before a crucial presidential election and shortly after Mexico had emerged from an acute recession.
At the time, Moody’s Mexico investment grade rating attracted criticism by well-regarded economists, brokerage firms and business journalists. Uncertain whether an historic and hotly contested presidential election would run smoothly, analysts said Moody’s investment grade rating came much too soon.
But a year later, Standard & Poor’s and Fitch Ratings followed suit, awarding Mexico investment grade on the grounds that Mexico’s economy was more wholly integrated with the U.S. economy and that Mexico’s governmental institutions were more stable – the same points Moody’s had made earlier.
Just last month Moody’s was again racing ahead. Benito Solis, head of Moody’s de Mexico, was recently quoted as saying that the agency planned to upgrade Mexico from Baa2 to Baa1. This move would accord Mexico the same investment grade as Chile, Latin America’s most highly rated country.
But if Moody’s can enjoy a bragging right or two on its ratings prescience in Mexico, it would be indecorous to mention the A-word, Argentina. There’s plenty of blame to go around on the botched and belated calls of Argentina and Uruguay. Credit rating agencies didn’t indicate Argentina was headed toward default until its government was within almost a month of declaring bankruptcy ahead of a peso devaluation. Credit rating agencies aim to not get caught out, as Allen puts it. Impending disaster is more evident with some countries, he says, adding that “they should have called Argentina much earlier than they did.”
Credit rating agencies were also caught out during Asia’s 1997 meltdown – a crisis that precipitated much hand-wringing among credit rating agencies for what was viewed as late calls. In addition, analysts still chortle at investment bank Duff & Phelps’ ill-timed assessment of Mexico as investment grade in 1994, months before the peso crumbled.
And just as they may have been caught out in Argentina, rating agencies were also caught short-footed by Uruguay’s upsets. “Uruguay was still rated investment grade as the Argentina debt crisis was climaxing and it was clear to all that default was imminent,” Nangle says. Standard & Poor’s, for example, didn’t downgrade Uruguay until January 2002, two months after its Argentina downgrade.
Uruguay’s dependence on Argentine-owned bank deposits was well-known and thus the likelihood of Uruguay suffering a sharp capital outflow was easy to anticipate, Nangle adds. “I honestly don’t know why rating agencies didn’t move earlier in tandem with Argentina ratings. Maybe they were conscious of the potential feedback and didn’t want to worsen the situation on the ground – in which case they were not fulfilling their [mandate] from their subscribers.”
Meanwhile, will Russia become a new emerging market darling with strong institutions and a stable economy? Will the investment grade rating on Russian debt go down as a ratings disgrace for Moody’s? Schiffer believes the likelihood that Russia will service its public debt is strong. S&P is unconvinced.
So what’s an investor to do? “I think that ratings should be used as one of several sources by investors,” says Nangle. “Having a rating agency worried about how far they are from consensus is not useful. Credit ratings would be most useful if they were accurate predictors of the probability of default and were a long way from market consensus.”
Adds Sammut: “In theory, it should ultimately be up to the investor (to decide) whether the ratings are accurate.”