Explained | What is a ratings agency and why do they matter?

Rating agencies help investors gauge if they would get a return on their investment.

Updated - February 11, 2022 05:45 pm IST

Published - February 10, 2022 04:09 pm IST

Finance Secretary T.V. Somanathan on Tuesday accused ratings agencies of “double standards” when assessing emerging markets and developing economies. He was responding to ratings agencies’ terming the country as the most indebted emerging market and the claim that the latest budget did not provide clarity on fiscal consolidation plans.

What did the rating agencies say?

Fitch, a rating agency, had stated that higher deficits and continued lack of clarity on medium-term consolidation plans in the recent Union Budget was its rationale for projecting of a downward trajectory in the country’s debt/GDP. The report concluded saying, “The government has little fiscal headroom at its current level to respond to possible shocks to growth.”

Another agency, Moody’s, said the Union Budget was growth-oriented, credit positive for many issuers but the budgetary provisions posed fiscal challenges. Focus on capital expenditure, it said, supported near-term growth but challenged long-term fiscal consolidation. Additionally, the budget projected only a slight narrowing in the central government deficit.

What is a rating agency?

Ratings agencies assess the credit worthiness 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 a previously assigned ratings after new developments (example, Coronavirus pandemic or a geography-specific climate change), geo-political events or a significant economic announcement by the concerned entity.

Their reports are sold and published in financial and daily newspapers.

What grading pattern do they follow?

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 lowest grade is ‘D’, accorded to entities with high probability of payment default or breach of an imputed promise. This is particularly accorded in case the concerned entity has filed for bankruptcy. 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. The former involves obligations maturing in thirteen months or less whereas the latter involves obligations maturing in eleven months or more. Its longer-term grading ranges from Aaa to C, with Aaa being the highest. The succession pattern is similar to S&P. The short-term ratings scale ranges from P-1 to NP, with P-1 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 of rating agencies

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. Asian Development Bank’s paper titled Financial Crisis and Regulation of Credit Rating Agencies: A European Banking Perspective points to this broad consensus. It explains, “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.

Do countries pay attention to ratings agencies?

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,” EU reasoned. 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. In order to discourage domination by three agencies (namely, Fitch, Moody’s and Standard & Poor’s), it further recommends use of smaller credit agencies. Back in September, Finance Ministry officials had pitched for an upgrade in India’s rating from Moody’s Investor Service. As per business news publication Bloomberg, the officials were to provide details on how India was to meet its budget targets for the fiscal year ending March 2022. Moody’s had downgraded the India’s rating to Baa3 in June 2020. The agency stated that the lowest investment grade was accorded because of a prolonged economic slowdown and deteriorating fiscal position.

In November, Fitch had affirmed India’s rating at BBB-.

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