The Monopoly of Credit Rating Agencies

“After Fitch, Moody’s lowers India’s growth forecast” reads a headline in The Hindu on August 25. Who are these agencies? They are credit rating agencies responsible for assessing the creditworthiness of big borrowers – companies and governments. The market for credit rating is dominated by 3 big firms – Standard & Poor, Moody’s and Fitch. Basically, these credit rating agencies sell information about the debtors to the creditors.

How reliable are they? As the regulator of the Indian securities market, Securities and Exchange Board of India (SEBI) writes in its FAQ, ‘A credit rating is a professional opinion given after studying all available information at a particular point of time. Nevertheless, such opinions may prove wrong in the context of subsequent events. There is no contract between an investor and a rating agency and the investor is free to accept or reject the opinion of the agency.’ As a matter of fact, the credit ratings were proven to be completely wrong in the wake of the Great Recession because they grossly misrepresented the risk on the mortgage-backed securities. Joseph Stiglitz is quoted as saying: “I view the rating agencies as one of the key culprits.” And not surprisingly, between 2001 and 2007, the operating margins of Moody’s exceeded 50 per cent, three to four times those of Exxon Mobil Corp., the world’s biggest oil company. Also, as a CFR report states, the “EU governments and ECB policymakers accused the Big Three [S&P, Moody and Fitch] of being overly aggressive in rating eurozone countries’ creditworthiness, exacerbating the financial crisis”.

A financial market mediates between debtors and creditors through the buying and selling of financial instruments with varying risk and liquidity (to meet the different preferences and needs of the market participants). Unlike in a product market, say for tomatoes, it is difficult to assess the ‘value’ (let alone the quality) of a financial instrument. Suffice to note here that different financial theories exist which provide explanations for the ‘value’ of a financial instrument. The creditor needs to know whether the debtor is credit-worthy, i.e., whether the probability of the debtor to default is low. This information need is met by the credit rating agencies, of course, not very satisfactorily. For, they also seem to fall prey to the irrational exuberance characterizing the financial markets. More importantly, as during the Great Recession, evidence points to them as perpetrating a financial crime by aiding and abetting the housing bubble by issuing top ratings to bad mortgage-backed securities.

Global investors obtain information on investment avenues from multiple sources. And in the specific case of India, most of the financial savings are parked in time deposits, Post Office savings and with LIC and not in the stock market. Should a credit rating downgrade worry us? Are we worried because of how the stock market may react? Will it affect capital inflows? Rational investors make informed decisions by examining the macroeconomic situation, the ease of investing and the transparency and stability of macroeconomic policies. For example, any amount of mere rhetoric of ‘Make in India’ will not help – as seen by the exit of Jim Rogers, a global commodities trader and hedge fund manager, from India. As Rogers’ says, “one can’t invest just on hope.”

The argument of this blog post is not that all the assessments by credit rating agencies are incorrect. The argument is rather than we must critically appraise them and contextualize them. For instance, the lowering of Asia’s growth forecasts on account of slowing exports and subdued demand by Moody’s on 8th September 2015 should be a cause for concern. Why are we not focusing on policies which generate domestic demand?

I end with the financial commentator John Kay’s observation on the power of the bond markets in Britain. “So how do bond markets acquire their power to intimidate? Politicians spend too much time talking to people who take a daily interest in the bond market, and come to believe that their obsessions are important. Britain’s economic performance should be judged by benchmarks relating to employment, productivity, growth and innovation, not credit ratings.” This should be the case in India too.

Some Thoughts on Debt: The Indian Case

Any entity, private or public, needs to borrow if its expenditure exceeds its income. The difference between expenditure and income will then be the volume of debt. This post discusses the following: the meaning and role of debt, a brief overview of various kinds of debt, the fundamental difference between private and public debt, the structure of the Indian debt market, corporate debt and government debt in India. The post ends with some reflections and suggestions.

It is public or government debt which receives maximum attention in the media and rightly so.  Some of the other kinds of debt are external debt (the proportion of a country’s debt borrowed from foreign lenders), household debt and corporate debt. Households borrow money in order to meet various needs such as the purchase of assets, for purposes of education, for medical expenses, etc. Corporate debt refers to the excess of expenditure over income which is financed through borrowing (via issuance of bonds and debentures) by the private non-bank sector. In India, besides these different kinds of debt, agricultural indebtedness has received significant attention from academics, policy makers and political agents. A market for credit is important not just for long-term asset purchases or constructing plants but it is also important for daily business transactions, and today, also for usual consumption needs. One needs only to look at the booming credit card industry for confirmation.

There is an overwhelming tendency to impose rules of finance employed by households on the government. This is fallacious. As individuals, we try to live within our means; we borrow reluctantly. Agricultural farmers, industrial firms and service providers need to borrow too. For, it is unlikely that every person who wants to start an enterprise will possess the required funds. If that were so, the meaning of entrepreneurship would have been different from what we know it to be. Similarly, for a government (central, state or local), which is expected to conduct policies which have social and environmental benefits, it becomes necessary to borrow. Taxation incomes are seldom sufficient to meet the recurring and capital expenditure of the government. Moreover, social programmes relating to education, employment, environment, food and health have very long gestation periods. The point is that government bodies (Ministry of Consumer Affairs, Food and Public Distribution, Ministry of Agriculture and Ministry of Drinking Water Supply and Sanitation to name a few) are not profit-maximizing bodies; but, this does not imply that they can be inefficient or irresponsible. By virtue of the fact that they are democratic bodies and because their incomes and borrowing are mainly from households (the voters), it is imperative that their functioning is transparent and organizationally efficient. Government borrowing or public debt is not, or rather, should not be, synonymous with organizational inefficiency.

The sovereign debt in India is issued by the Central and State government. The instruments include Treasury bills, Index bonds and zero coupon bonds. Government agencies, public sector undertakings (PSUs) and government owned banks issue debt instruments – bonds, debentures, commercial paper (CP) and certificate of deposit (CD). The private sector comprising the non-bank corporate sector and private sector banks issue bonds, debentures, CPs and CDs. In advanced economies, the debt market is the preferred route for raising funds. However, in India, the equity market is more preferred than the debt market, and government securities dominate the Indian debt market. [For more details, see the 2004 SEBI working paper no. 9 titled ‘Corporate Debt Market in India: Key Issues and Some Policy Recommendations’. Conditions are changing and more corporate debt is being issued, as a more recent (2013) CRISIL document indicates.]

A 2013 Credit Suisse report on India’s financial sector pointed out the high growth in the debt levels of ten corporate groups – Lanco, Reliance ADA, GVK, Jaypee, Adani Enterprise, Essar, GMR, KSW and Vedanta. Despite profitability pressures, their debt levels rose between 2012 and 2013. Also, 40-70% of the loans are foreign currency denominated. Delays in their planned projects can cause further strain on their cash flows and therefore on their debt servicing ability. Some of them have undertaken asset sales, but they have proved insufficient. Indian banks need to be concerned as well; although, majority of the non-performing assets (NPAs) are from agriculture and small & medium enterprises (SMEs). In 2014, the International Monetary Fund sounded a warning too.

The debt-to-GDP ratio is more important than debt levels themselves. Why is this so? This is because an economy whose GDP is growing faster than its growth in debt will not face the problem of repayment. However, if the GDP grows at a smaller pace than debt growth, the economy will not have adequate surplus (aggregate output net of replacement) to repay the debt. This is what we mean by debt sustainability. In early 2014, the credit rating agency, Moody’s warned that India’s sovereign rating can be affected due to the slowdown in growth and high inflation. [In so far as public authorities, via the central bank, can create money ex nihilo, debt can always be repaid (referred to as monetising the debt). However, this is the case if and only if the public debt is denominated in the local currency. In India, most of the public debt accrues to Indians and is therefore denominated in Rupees.] The following chart compares debt-to-GDP ratio of India with three advanced economies – Australia, UK and US.


Data from World Bank

Clearly, advanced economies have different debt-to-GDP ratios (also see this link for data on OECD countries). In short, there is no economic reason why a high debt-to-GDP ratio is bad for the economy; it is the growth in the debt-to-GDP ratio that must be closely monitored and appropriate measures undertaken to ensure that the economy grows at a faster pace than the growth in debt. As previously noted, government expenditure on education, environment and health have long-term positive benefits (significant positive externalities). Over time, these expenditures will boost economic growth and will therefore aid in debt repayments. Of course, the returns from any investment – private or public, depend on the effectiveness of the project undertaken such that they generate the expected yields.

The financial liabilities of the household sector have also risen over time, due to the attractive home loans and increased ease of obtaining credit cards. All economic agents – be it households, corporate bodies or the government, often (and have to) resort to borrowing. This post has shown that the borrowings undertaken by the Indian household sector, the Indian corporate sector and the Indian government have grown over the years. This, per se, is, and should not be a cause of immediate concern. However, this does warrant a more detailed analysis of the ability of the Indian government to make debt repayments, which hinge crucially on the rate at which the Indian economy grows and its rate of inflation. A serious macroeconomic analysis, perhaps based on the economics of Domar, Keynes and Lerner is in order.