CREDIT RATING AGENCIES?WHAT ARE THEY AND WHY DO THE HOLD SO MUCH POWER?-LAURA RUBIDGE

Image: Adeolu Eletu (Unsplash)

Credit Rating Agencies (CRA) wield massive amounts of power and influence in the global political economy which allow them to shape the contours of a nations economic trustworthiness for either the betterment or detriment of the state. The recent downgrading of South Africa’s credit rating bears testament to this, with this news sending shockwaves and panic through the government, banking sectors and investors, and in turn further weakening the South Africa’s exchange rate. Little, however, is known about CRA to the ordinary citizen, yet a decision made by these CRA have a dramatic impact on those same citizens. This article aims to clarify the purpose and influence of CRA by discussing several key questions: What is a CRA? Why do they exist? What powers do they have? Are rating agencies still relevant?


What is a Credit Rating Agency?

CRA provide vital technical investment information to investors such political risk calculations and forecasting of exchange rates to name a few. The agencies assign letter grades to security issuers such as companies or countries. The ratings demonstrate how likely a security issuer is to meet their bond and debt obligations. Credit ratings are divided into three categories. The highest ratings are investment-grade ratings, these are the safest investments. The second category is speculative-grade, these investments would carry a higher risk but can yield a higher interest rate due to the increased risk. Any ratings below speculative-grade carry the highest risk of the debt being defaulted. Fitch Ratings, Moody’s Investors Service and Standard & Poor (S&P) are the most dominant CRA which control 95% of the credit rating industry globally. Each of these agencies bases their ratings on different methodologies of analysis and assign slightly different letter grades.


Why do they exist?

The ‘Big Three’ were formed in the early 1900’s. Initially, they were investment research firms who published research papers on various bonds available on the market which investors and fund managers bought. In the 1970’s, globalisation and the raise of economic liberalism which were spreading rapidly, catalysed by the policies adopted by Ronald Raegan and Margaret Thatcher helped institutionalise these institutions. The demand for investments both nationally and internationally grew simultaneously to the demand for CRA. New investors relied on these agencies for guidance and new companies as well as developing states relied on investors for funding. Subsequently, CRA adopted an ‘issuer-pay business model’: the institutions who are rated, pay the agency for the rating which the investors use as guidance for their investment decisions.


What powers do CRA have?

CRA have two main powers. They influence the type of investment a security issuer receives and the interest rate of repayment. Many large pension funds must put most of their money in investment-grade securities instead of speculative-grade securities. The downgrade of South Africa by Moody’s earlier this year meant that, from the opinion of Moody’s investments in South Africa would carry a higher risk, investors who are searching for long-term, low-risk investments such as pension funds, may be discouraged from investing in South Africa. However, investors looking for higher risk-higher reward investments would be attracted to South Africa, based on Moody’s downgrade and may reap the rewards of the higher interest rates associated with the higher risk.


Why does the type of investment and interest rate matter?

Governments raise money primarily from taxation and through government bonds to fund their budget for expenditure to improve the living conditions of its citizens. If the government receives fewer investments, at a higher interest rate, they have less money in their budget. This could lead to higher taxes to substitute the funds lost or a decrease in living conditions. In a developing state like South Africa, investments like these are extremely vital to the overall socio-economic development of the state and thus, the polarity held by CRA hold on the foundations upon which a nation economy could prosper or crumble.


Our CRA still relevant?

CRA have been influential in the global financial system, however, recent examples could demonstrate the diminishing influence of CRA. Fitch and S&P downgraded South Africa to sub-investment grade in 2017, this downgrade was expected to scare investors due to the higher perceived risk that South Africa was less likely to meet its debt obligations than when it was at investment grade. Contrastingly, Foreign Direct Investment (FDI) into South Africa increased by 446% from 2017 to 2018. This demonstrates that either foreign investors have a higher than expected appetite for South Africa’s risky, sub-investment grade investments or investors’ decisions were not influenced greatly by the CRA ratings.

Another recent South African example is the IMF Covid-19 Relief loan. The loan of R70 billion was approved in July 2020 with a mere 1.1% interest rate. This is much lower than the current comparable rate of 7%. Considering the recent downgrade of South Africa’s economy by Moody’s to sub-investment level, the interest rate could be much higher given the extra risks associated with the downgraded rating. According to Danny Bradlow, Professor of International Development Law and African Economic Relations, “investors may see this loan as ‘an expression of the IMF’s support’ and faith in South Africa to repay it, giving investors confidence to invest or maintain their investments in South Africa”. Additionally, in a letter addressed to the IMF, South Africa expressed their intentions to stabilise the country’s finances through cutting government spending and improving the governance of State-Owned Enterprises. The cheap IMF loan and increased investments could aid this endeavour. Furthermore, the stabilisation of South Africa’s finances could alter the CRA assessment of South Africa, possibly leading to an upgraded rating. This example essentially demonstrates that Credit Rating system work backwards. A large loan from the IMF catalyses other investment which could stabilise the economy and lead to a higher rating by the CRA.

Additionally, CRA have been accused of inaccuracy and bias and have come under criticism for contributing to the cause of events such as the Greece debt crisis in 2009 and the mortgage crisis in 2008.
Lastly, CRA issue pay business model creates a clear conflict of interest. This conflict of interest was evident in the 2019 case when the Fitch group were fined €5 132 000 in three European countries for failing to maintain independence and avoiding conflict of interest. Fitch clients in these countries issued ratings on three companies, including Renault. However, it was known that one of their shareholders was also a board member of the rated companies and indirectly owned 20% of shares in each of the Fitch companies.CRA have been institutionalised and have become increasingly influential in the global financial arena since the 1970’s. There have been recent movements from developing countries to reform the current global economic world order, which has proven to disadvantage the states most in need of development. The current system of CRA should be considered within this movement for reform bearing in mind the critiques of CRA for their flawed business model and inaccurate biased ratings, coupled with the recent examples which demonstrate the possible decrease of CRA influence.

By Laura Rubidge

Laura is in her final year of BPolSci International Studies degree at the University of Pretoria and is concurrently completing a level 4 NALP paralegal diploma. She hopes to complete her honors in International Relations in 2021 and pursue a career in the field of Public International Law and Human Rights. 

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