Recent events regarding the downgrade ratings verdict on the South African economy by Standard and Poor’s (S&P) have brought into sharp focus the need for alternative rating structures that would provide checks and balances on the operations of ‘Big Three’ global credit ratings agencies.
This, whilst watering down the monopoly of the ‘Big Three’ —U.S.-based S&P, Moody’s, and Fitch Ratings— to assess the capacity of sovereign states to meet their credit obligations.
The need to ensure an objective and truly credible sovereign debt assessment process could not be more pronounced than at a time when the private ratings agencies have come under intense scrutiny in the wake of the global financial crisis.
Meant to provide investors with reliable information on the riskiness of various kinds of debt, these agencies have instead been accused of exacerbating the financial crisis and defrauding investors by offering overly favorable evaluations of insolvent financial institutions and approving extremely risky mortgage-related securities.
Without going into the circumstances, merits or de-merits of the recent South Africa specific verdict, such a need for an alternative and improved professional credibility in the role of ratings agencies, is that it is the ordinary citizens that ultimately have to bear the brunt of the effects of a sovereign downgrade.
Suffice it to say the the BRICS Rating Agency is one such entity that seeks to weaken the monopoly of the ‘Big Three’ global credit rating agencies. At BRICS, similar concerns were raised with regard to problems related to the ‘Big Three’ Credit Rating Agencies. Consequently, BRICS countries have come up with the concept of an alternative credit rating agency – the BRICS RA.
The following historical background to the issues may assist the uninitiated.
In 2009, President Obama released a proposals to reform credit rating agencies and in particular, the “other services” considered key contributors to the financial crisis of 2008. The proposal sought to limit conflicts of interest by barring rating firms from consulting with companies they rate and requiring corporations to disclose ‘pre-ratings’ obtained from credit rating agencies before a rating firm is selected to conduct a rating.
As part of the approach, investors would have access to all the pre-ratings a corporation received for a particular security before a final rating firm is selected. That seeks to eliminate the problem of ‘ratings shopping’ in which a corporation solicits preliminary ratings from multiple agencies and only then pays for and discloses the highest rating it received. The White House also proposed to have the Securities and Exchange Commission set up a special office to watch over rating agencies.
In Europe, the ‘Big Three’ garnered further controversy over their sovereign debt ratings. While the public debt of crisis-hit countries like Greece, Portugal, and Ireland was relegated to ‘junk’ status, the agencies also downgraded the creditworthiness of France, Austria, and other major Eurozone economies. EU officials argued that these moves accelerated the Eurozone’s sovereign debt crisis, leading to calls for the creation of an independent European ratings agency.
Meanwhile, the BRICS RA first emerged during the 2015 BRICS summit held in Ufa in Bashkortostan, Russia. Following the summit, the concept was deliberated upon by the BRICS Business Council.
In 2016, under India’s chairmanship, the EXIM Bank of India appointed CRISIL Ltd, (Infrastructure Advisory division), to develop a research paper studying the modalities of such an alternative rating agency.
It found that emerging economies, including BRICS countries, have immense funding requirements, especially in core sectors such as infrastructure. The funding cannot be met by banks and multilateral agencies alone. Robust capital markets are critical for financing growth and bond markets are a key component of that imperative.
The BRICS Business Council concluded that the BRICS RA will aid the BRICS nations’ efforts to raise funds for such development from capital markets and develop their bond markets. The BRICS RA will offer an emerging markets-focused credit evaluation framework for investors to evaluate and compare the credit risk of projects across emerging markets. The BRICS RA will have a methodology that will not only incorporate existing methodologies employed by the other rating agencies but also be more comprehensive, and will include insights based on its analysts’ experience and knowledge of BRICS and emerging markets. Global investors will therefore be able to follow the rating scale offered by BRICS rating agency to get a finer distinction of credit quality on a much wider list of companies, banks, insurance companies and government owned entities within the emerging market space. This will enhance information availability of fixed income assets from these countries, thus providing issuers, investors and regulators a better appreciation of relevant risk factors and making the asset class a more attractive investment opportunity from a global perspective.
The need for the BRICS RA is further supported by the following factors:
- Sharper differentiation in credits across the emerging markets space is needed to facilitate flow of funds to these markets
- Will enable cross-border funding within the BRICS Countries
- Will add an emerging market lens in overall credit evaluation to facilitate flow of funds to these markets
- Will enable cross-border funding within the BRICS Countries
The initial conclusion is that the BRICS RA will initially offer ratings on foreign currency bonds issued by BRICS entities, foreign currency loans extended by multilaterals and development banks to projects in BRICS. Gradually, it will engage with banks and financial institutions to evaluate their foreign currency loans given to cross-border projects or for expansion in emerging markets. Over time, the BRICS RA will expand its operations to emerging markets outside of the BRICS, and add ratings of securitisation instruments of financial institutions, mutual funds, municipal bonds and claims-paying ability of insurance companies.
By facilitating inter-regional investments within the BRICS nations, the BRICS RRA will encourage the development of a common bond market for BRICS which will benefit all member countries by augmenting existing funding avenues for corporates and deepening their existing corporate bond markets.
The ratings methodology of the BRICS RA will focus on a comprehensive evaluation of credit risk profiles of the obligors/issuers that operate in emerging markets by benchmarking the risks and creditworthiness relative to the entire universe of issuers/obligors within the emerging market economies.
Some of its salient aspects are highlighted below:
- It will assign ratings on a standard rating scale i.e. ranging from AAA to D (followed by credit rating agencies across the world).
- Ratings will be assigned only at the request of the issuer so that the issuer has the desire and obligation to provide full information to the BRICS RA. The BRICS RA will allow the issuer to decide whether to use the rating or not.
- Country risk assessment will encompass an in-depth research of social and economic state, and political risks of the emerging market countries.
- Ratings for issuers would not be compulsorily constrained on account of the country risk but will have the flexibility to deviate from the overall country risk. This shall primarily depend upon issuer’s overall sensitivity to country risks and characteristics that demonstrate its ability to survive stress factors in event of sovereign default.
- Benchmarking of risks across emerging market economies would be comprehensive. These will be developed through comparison of historical default rates observed in similar rated issuers on local rating scale across all countries in emerging market economies. For instance: comparison of AAA default in China vs AAA defaults in Brazil or Indonesia.
In conclusion, critics of the ‘Big Three’ globally and in the emerging markets in particular have long voiced concern that the monopolisation of the sector by the ‘Big Three’ has created an uncompetitive environment that leaves investors with few alternatives. The BRICS RA seeks to decrease the dominant positions of the ‘Big Three.’
* Rasethaba is Chairman of the Black Business Council and serves on the Financial Services Working Group of the BRICS Business Council.