Euro crisis shows ratings agencies are a problem
26 July 2012
If every crisis requires a hero and a villain then where do ratings agencies fit on that scale, judging by their performance during Europe's sovereign debt disaster?
While it may be a sexier headline to call for political leaders' scalps or lay blanket blame on whole populations' work ethics, rating agencies have been complicit in compounding the turmoil and yet have largely escaped blame.
Plainly, ratings agencies have got it wrong in their evaluation of the crisis and have made battling economies' woes greater.
Firstly, their methodologies have failed to grasp how the distinction between internal and external public debt has narrowed in Europe as increasing amounts of debt have been issued in the same currency.
Consider Greek debt. According to the International Monetary Fund's Global Financial Stability Report published in April, Greece's general government debt is 153.2 percent, of which 87.5 percent is classified as external and 65.7 percent as internal.
If Greece had been issuing debt in its old currency the Greek government would have had the option of creating the means to service the debt. The ability of a sovereign to do this is what makes sovereign debt, issued in its domestic currency, nearly risk-free.
Euro zone countries lost this ability at the same time as they became able to issue both internal and external debt in their domestic and common currency. Further, the European Central Bank exacerbated the problem when treating sovereign debt issued by euro zone countries as the same regardless of the underlying fiscal positions and debt structures.
This "new look" debt should have been recognised by ratings agencies for what it was. However, ratings agencies have shown inflexibility in their ratings systems in separating debt used to help the bailout and troublesome debt.
Sovereign ratings are typically constructed by credit ratings agencies as "through-the-cycle", that is, they take a long-term view when evaluating a sovereign's ability and willingness to pay.
It is not surprising that rating agencies did not detect problems earlier, as their "through-the-cycle" methodology focuses on long-term performance. However, it ought to have been apparent to rating agencies that governments' balance sheets have been taking a hammering as a result of attempting to salvage the global financial system.
Rather than recognise this special situation and work more closely with international organisations, such as the IMF, to devise a strategy to not aggravate the situation, ratings agencies downgraded and generated even more instability.
Although this is not new behaviour from the rating agencies, it has slipped under the radar of the academic community, media, governments and other entities charged with safeguarding the public interest.
Moreover, the rating agencies' criteria for evaluating government economic management are strikingly similar to the policy recommendations of the Washington Consensus. For instance, the Washington Consensus recommends fiscal discipline through balanced budgets, freely floating currency regime, less trade restrictions, tax reform and market-determined interest rates, privatisation, deregulation of industries, and so on.
Standard & Poor's Financial Services' Sovereign Government Rating Methodology and Assumptions reveals that a strong sovereign rating is awarded to countries that demonstrate their governments are "able and willing to reduce general government expenditures in the near term despite economic, social or political effect (in other words, fiscal discipline), has a freely floating national exchange rate regime, is a market-oriented economy, has deep financial markets with market-determined interest rates, etc".
Conservative vested interests
From a political economic perspective the rating agencies have stepped into a role as whips on behalf of conservative interests who have long desired to reduce the ability of governments to influence the economy by severely curtailing expenditure and what is left of their social safety nets.
In this light, calls for regulation and oversight of the processes of ratings agencies appear superficial.
Even if national government agencies are created to oversee the ratings industry, and adequately funded to perform their tasks, simply monitoring the processes of the operations of rating agencies will not fully resolve the externalities caused by moral hazard and fee-based payment incentives.
Further, it is apparent that the policies the Washington Consensus supports, with the support of mainstream macro-economic theory, are not achieving the desired social outcomes. Hence, allowing rating agencies to act as whips for this program - instigating financial instability as they enforce short-sighted changes to fiscal policies at a time when economies need support - should not be tolerated by those charged with protecting the public interest.
Rather than simply increasing regulation and supervision of the agencies' processes, governments ought to create national public credit rating agencies which, among other functions, routinely validate the accuracy of sovereign ratings and, by doing so, maintain the focus of rating agencies on "through-the-cycle" assessments.
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