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India’s economic advisor pulls up Fitch, S&P, Moody’s over opaque rating metrics

Anantha Nageswaran calls for reforms in sovereign rating process, says rating agencies must be transparent, fair to developing nations

India’s economic advisor pulls up Fitch, S&P, Moody’s over opaque rating metrics
[Source photo: Chetan Jha/Press Insider]

Reforming the sovereign rating process of credit rating agencies to correctly reflect the default risk of developing economies will help save billions of dollars in funding costs, V. Anantha Nageswaran, the government chief economic advisor (CEA), said.

Such reforms will enhance developing countries’ ability to raise long-term financial resources from both domestic and global markets by significantly reducing funding costs, Nageswaran said in a document.

Titled Re-Examining Narratives: A Collection of Essays, and published by the CEA’s office, Nageswaran said a review of the credit rating methodologies shows that there is considerable reliance on qualitative variables to capture “willingness to pay”.

“Willingness to pay” encompasses a country’s commitment and ability to fulfill its debt obligations. It transcends mere capacity to pay, as typically gauged by quantitative factors such as gross domestic product, debt levels, and fiscal reserves, and includes the nation’s prioritization of debt repayment.

“The enormous degree of opaqueness in the methodology makes it challenging to quantify the impact of qualitative factors on credit ratings. The significant presence of qualitative factors in credit rating methodologies also gives rise to bandwagon effects and cognitive biases amply reflected in various studies, generating concerns about the credibility of credit ratings,” Nageswaran said.

In the context of credit ratings, the bandwagon effect is the tendency of agencies or investors to align their ratings or investment decisions with popular opinion, while cognitive biases are the systematic patterns of deviation from norm or rationality in judgment, influencing the objectivity of their assessments.

“From our quantitative analysis, we find that over half the credit rating is determined by the qualitative component. 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,” Nageswaran said.

“Their effect on the ratings is non-trivial since it implies that to earn a credit rating upgrade, developing economies must demonstrate progress along arbitrary indicators while simultaneously contending with the discriminations the ratings tend to carry,” he added.

In August, Sanjeev Sanyal, a member of the Prime Minister Economic Advisory Council, had questioned global rating agencies on India’s grades and said that the country should be placed at least a grade or two higher.

Sanyal questioned the need to adhere to the rules of the West that countries like India had no role in framing.

It is “utterly absurd” that India just about makes it past the investment grade in the ratings of agencies, Sanyal had said at an event.

“In terms of sovereign ratings, if India was fairly rated, it should be at least one, if not two, grades higher. There is no reason for India to be at the bottom of the investment grade,” Sanyal said.

The observations come as Fitch continues to retain India’s sovereign rating at the lowest investment grade of ‘BBB-’ for about two decades. Similarly, Standard & Poor’s and Moody’s also maintain ratings at ‘BBB-’ and ‘BAA3’ levels, respectively, with a ‘stable’ outlook.

The Big Three: Fitch, Moody’s, and S&P

Sovereign credit ratings, primarily by the big three credit rating agencies (Fitch, Moody’s, and Standard & Poor’s), are an important metric for a country looking to raise financial resources through domestic and international financial markets.  About 120 countries are rated by each of the big three.

The increase in the number of nations with sovereign credit ratings reflects an increasing reliance by countries on debt markets as a source of funding to meet their development financing requirements.

Credit rating agencies play a key role since their ratings are taken to be a credible metric of the credit risk associated with a sovereign. The level of risk, in turn, determines the risk premiums a sovereign would be expected to pay. Therefore, one would expect the credit rating process to be based on comprehensively developed criteria supported by hard data, Nageswaran said.

The Economic Survey of India 2020-21 had first argued that the sovereign credit ratings assigned to India by the big three agencies fail to accurately depict the underlying economic fundamentals of the country.

It had outlined India’s core strengths across macroeconomic fundamentals such as the country’s declining and now low external debt, comfortable foreign exchange reserves, low short-term general government debt, and high GDP growth.

With improvement in India’s business conditions, implementation of wide-ranging structural and governance reforms, and improvement in the quality of government expenditures, India’s ability to meet its debt obligations has improved substantially over the last decade, the survey had pointed out.

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