Calling for urgent reforms and transparency in the process of sovereign credit rating, the office of the Chief Economic Advisor in the Union Ministry of Finance, has said that methodologies used by agencies Fitch, Moody’s and S&P, are heavily loaded against developing countries like India due to an “over-reliance” on non-transparent and subjective qualitative factors.
In an essay ‘Understanding a Sovereign’s Willingness to Pay Back: A Review of Credit Rating Methodologies’ — which is one of five essays in a book called Re-examining Narratives, the CEA’s office pointed out that perception and value judgements end up weighing much more than the countries’ actual macroeconomic fundamentals. The preface for the book has been written by V Anantha Nageswaran, Chief Economic Advisorand Rajiv Mishra, Senior Advisor, Ministry of Finance.
“The rating of India during the last 15 years remained static at BBB- during the last 15 years, despite it climbing the ladders from the 12th largest economy in the world in 2008 to the 5th largest in 2023, with the second-highest growth rate recorded during the period among all the comparator economies. Thereby, any improvement in macro-economic parameters may virtually mean nothing for a credit rating if qualitative parameters are judged to be in need of improvement. This has serious implications for developing sovereigns’ access to capital markets and ability to borrow at affordable rates,” the essay said.
The essay recommended relying mainly on a country’s debt repayment history to determine its ‘willingness to pay’, instead of “less-than-optimal” qualitative information. “…there cannot be any better-revealed preference for willingness and determination to pay back a country’s debt obligations than its repayment history itself. Thus, a nation that has not defaulted throughout its external debt history and through the vicissitudes of its socio-economic development should be taken as fool-proof in its ‘willingness to pay’ back,” it said.
Such a model, the essay suggests, will “do enormous good” to the credibility of the CRAs. It said that qualitative information and judgement can be the “last resort” when all other options for applying authentic, verifiable information are precluded.
According to the paper, the methodologies used by the rating agencies have an “enormous degree of opaqueness”, and called for far greater transparency and reforms in the ratings process. It claimed that the “qualitative” and subjective perceptions about governance and institutional strength surpass “the collective influence of all other macroeconomic fundamentals” when it comes to the chances of earning India and other developing economies a rating upgrade
The methodology used by the ratings agencies has been a persistent grouse in the North Block for a few years, with at least two former CEAs — Arvind Subramanian and Krishnamurthy Subramanian — having publicly slammed the agencies for their apparent reluctance to upgrade India’s ratings and for adopting “inconsistent” standards for different countries.
But this time around, the CEA’s office has systematically studied the complex rating methodology of each of the three agencies, to point out biases and highlighted that opaqueness in rating methodologies make for “fertile grounds for sowing suspicion about the discriminatory intent of CRAs”, given that economically weaker countries are usually at the receiving end of rating downgrades.
“There is a strong feeling among the developing countries that subjective assessments tilt, most often, in favour of the advanced economies, as developing countries have borne the brunt of over 95 per cent of all credit rating downgrades despite experiencing economic contractions which were milder than their advanced economy counterparts,” it said.
The CEA and his team raised a strong objection to the heavy reliance of the agencies on the World Bank’s Worldwide Governance Indicators (WGIs) for inferring governance and institutional quality of countries. “Institutional Quality, proxied mostly by the World Bank’s Worldwide Governance Indicators (WGIs), emerges as the foremost determinant of a developing economy’s credit rating, which presents a problem since these metrics tend to be non-transparent, perception-based, and derived from a small group of experts, and cannot represent the ‘willingness to pay’ of the sovereign,” it said.
Quoting estimates from counterfactual exercises conducted by the United Nations Development Programme, it said that if the agencies would employ less subjective assessments, a resulting revision in the ratings of African countries would save them up to $74.5 billion in borrowing costs.
“Even if governance indicators are to be relied upon, they must be based on clear, well-defined, measurable principles than subjective judgements by CRAs. Like all subjective qualifications, these judgments also suffer from heuristic and cognitive biases such as echo chambers, bandwagon effects, and difficult-to-change commitment and confirmation biases,” it said.
“Just as countries are obligated to be as transparent as possible with the rating agencies to be viewed favourably, the obligation must extend the other way around, too. CRAs tend to have a detailed database of best practices from around the world, which they apparently rely upon to form their judgements. This knowledge must be shared with the countries they rate so that appropriate action can be taken on a sovereign’s part to improve its creditworthiness,” the essay added.