Business

Saturday July 4, 2009

Sovereign ratings – the Asian perspective

By CECILIA KOK


OF late, international rating agencies have drawn flak from several Asian countries, including Malaysia, as they have downgraded some of the sovereign credit ratings in the region, but have continued to ascribe solid triple-A ratings to the United States and Britain.

It has been argued that western developed nations such as the United States and Britain have been among the worst affected by the global economic crisis and the weaknesses in their economies, fiscal positions and financial systems are apparent.

For instance, their banks are still known to be carrying toxic assets with values that have yet to be declared, their gross domestic products (GDPs) have fallen at unprecedented rates and their governments’ debts are growing by the record as they continue to spend their way out of recession. The United States’ fiscal deficit, for instance, are projected to reach US$1.75 trillion, or 12.3% of its GDP, this year.

This is in contrast to Asia, whose financial systems remain relatively strong and stable, although its economies have slipped because of the collapse in trade late last year. Undeniably, some governments’ fiscal positions have worsened as they also need to pump prime their weakening economies. But the fiscal deficits in most countries in Asia are not at alarming levels.

So, have the Big-3 international rating agencies, namely, Moody’s, Standard & Poor’s and Fitch, been fair in their assessments?

Malaysian Rating Corp Bhd (MARC) chief rating officer Milly Leong puts her view as such: “Rating is not an exact science, so the subjective part of the rating process is always open to debate.”

“However, as long as the basis is fairly transparent, which has been the case, investors can react in a manner which they see appropriate, notwithstanding the rating action. A rating remains an independent opinion and market participants are free to act as they please,” she adds.

Risk indicator

To be fair, however, Moody’s two weeks ago clarified that the solid triple-A ratings for the United States and Britain were not guaranteed forever. The agency said both countries’ credit ratings would be at risk should they fail to reduce their deficits once the recession was over.

A study done by the International Monetary Fund (IMF) in the early 2000s found a high correlation between the sovereign credit ratings assigned by the three international rating agencies. This is so because there is uniformity in their rating approach.

In assigning credit ratings to the various governments in the world, these agencies would incorporate factors such as political stability; economic prosperity and resilience as measured by GDP per capita and growth trends; the government’s fiscal balance and current account positions as well as its reserves; inflation; exchange rate policies; and the strength of the country’s financial system, among others.

Essentially, sovereign credit ratings are used to measure the capacity and willingness of the rated governments to repay their debt obligations in full and on time. These ratings are basic indicators of the risk of default faced by investors when investing in the bonds or securities issued by a particular government.

Generally, the better a credit rating, the easier it is for a country to attract foreign funds at more competitive rates. Conversely, poor credit ratings will make it harder for a country to attract foreign investments and it will have to pay higher rates to attract such funds.

Last month, Fitch revised its ratings for Malaysia’s long-term local currency debt a notch lower at “A”, compared with the previous “A+” on grounds that the country’s fiscal deficit was worsening. S&P and Moody’s have yet to change Malaysia’s local currency rating at “A+” and “A1”, respectively.

On the other hand, Malaysia’s long-term foreign currency debt is still rated at “A-”. So, on the overall, the country is still commanding pretty good ratings.

Barriers to entry

But the fact that most countries in Asia are still being assigned credit ratings that are lower than the United States and Britain has caused some dissatisfaction among Asian bankers. The most vocal about this issue has been CIMB group chief executive Datuk Seri Nazir Razak.

He pointed out that the Asian region, after all, was the main supplier of investment funds to the international markets. China and Japan, for instance, are the major holders of US treasury bills, accounting for 23% and 21%, respectively, of the total value.

So, a suggestion has been raised for Asia to develop its own rating agencies to rate countries from their own perspective instead of relying on western agencies to get fairer ratings.

But according to MARC’s Leong, the barriers to entry in the sovereign ratings business are significant for Asian rating agencies because they have limited brand recognition beyond their traditional shores.

Asian agencies need to first develop credibility with investors and the rated governments before they can gain grounds in the sovereign ratings business, she says.

Japan Credit Rating Agency Ltd, for one, conducts sovereign credit ratings, but it has yet to gain international recognition for its efforts.

The current market perception is that the US-based rating agencies (Moody’s, S&P’s and Fitch) have the analytical strength and political independence to assign reliable sovereign ratings. These agencies enjoy strong credibility among a broad range of international investors, so governments also seek the agencies’ seals of approval to establish risk benchmarks for their debt papers.

“An Asian-based rating agency involved in sovereign ratings can only become a reality and a practical element in the regional scene if there is a broad-based political will and support from the big Asian economies such as China, Japan and South Korea,” says RAM Ratings Services Bhd chief executive officer Liza Mohd Noor.

“We believe that the Asian rating agencies already have the technical expertise to rate sovereigns, but for them to grow in this area, there must be a concerted and sustained demand for their services by a significant number of institutional investors in the region,” she adds.

Currently, RAM and MARC are already involved in country risk assessments as they rate foreign debt issuers tapping the Malaysian bond market. These include banks from South Korea and construction companies from the Middle East.

“In any case, a sovereign rating will be just an extension of the country risk assessment which we are already undertaking in our ratings of foreign debt issuers,” explains Leong.

What’s the big deal?

Objective and justifiable ratings are important because any revision in sovereign credit ratings can have far-reaching implications on a country’s economy.

For instance, during the Asian financial crisis, Thailand, Indonesia, South Korea and Malaysia had their credit ratings adjusted more than three notches downwards between early 1997 and the middle of 1998. This resulted in the countries having to borrow at very high interest costs. The poor ratings also exacerbated the flight of capital from the region.

While the international rating agencies claimed that the downgrade of the sovereign credit ratings were due to the countries’ shrinking reserves and collapse of financial asset quality, some economists then suggested that the downgrade may have been more than what the countries’ then-worsening economic fundamentals would have justified. So, the ratings have been partly blamed for aggravating the economic pains of the region.

Nevertheless, despite the depth of the Asian financial crisis, none of the directly affected countries defaulted on their debts.

Some past defaults

Sovereign credit ratings have been about the fear of a country defaulting on its debts. There are two types of defaults as defined by the international agencies – “outright default” is defined as the failure to pay interests or the principal amount on due date, while “restructuring default” involves the rescheduling, exchanging or restructuring of the debt instrument by the government in a manner deemed coercive, involuntary and distressed.

Last year, there were two sovereign defaults reported by Moody’s – Ecuador and the Seychelles – when both the countries missed the interest payments on their global bonds in the second half of the year.

Usually, sovereign defaults will be negotiated and the country’s debts restructured to recover some value to investors even though full recovery of their investments is never expected. For instance, when Russia defaulted on US$73bil worth of debts in 1998, investors were estimated to have recovered about 60% of their investments following a restructuring of debts in 1999 and 2000. Russia’s default was a result of a financial crisis it encountered when crude oil prices collapsed in 1998.

The scale of the Russian default was surpassed by Argentina in 2001, when more than US$82bil worth of sovereign debts went into default. Investors suffered severe losses of up to 70% of their investments.

Sovereign defaults tend to result in huge losses to investors, sometimes to the point of causing financial instability in the investors’ country. Take the case of Mexico defaults in the early 1980s that almost threatened the stability of the US banking system. The bulk of the Mexican debts were held by American commercial banks that suffered losses as the value of their foreign currency investments were converted into pesos at an exchange rate about one-third below the market rate.

So, because of such crises in the past, sovereign credit ratings will continue to be an important element in the decision-making process of international investors, even though such ratings do not always tell the whole story of a country’s condition.

Perhaps in the near future, Asian agencies will play a big role in revolutionising the industry, as what RAM and MARC tells StarBizWeek – that they stand ready to provide full sovereign credit ratings services should the opportunity arise.

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