WASHINGTON, April 9 (UPI) -- A Financial Policy Forum study has examined the credit rating agencies and their effect on capital flows to emerging markets. Its conclusion: the agencies are somewhat pro-cyclical; they encourage emerging market investment when it is popular, and capital flight when it isn't.
The study was carried out by Gautum Setty of the FPF and introduced by the FPF's director Randall Dodd. It looked at the rise of the rating agencies in relation to emerging markets' bond investments, their ability to forecast financial difficulty, and possible reforms in their structure that could improve their performance.
Traditionally, emerging market bond issues weren't rated, because the rating agencies, which had existed since the 19th century in relation to corporate debt, were not felt to have any special ability in rating sovereign credits.
Their faux-pas in rating Venezuela AAA in the late 1970s, because of its oil revenues, was often used by non-U.S. bankers as an example of their relative naivete outside the United States.
Bond issues were marketed through a syndicate by the lead banker, and the banker's reputation was believed to be at stake in the event too many of its issues failed.
This system worked well before 1914, when in practice emerging markets such as those in Latin America were taken under the wing of one of the London or New York merchant bankers, and their economic policies were monitored in return for access to the international capital markets. In the stable pre-1914 economy, crises were manageable, and the emerging markets that cooperated with the merchant banks enjoyed relatively rapid economic growth, without excessive debt burdens.
In the 1920s, things went wrong. The London merchant banks, now short of capital and with an impoverished European investor base, were considerably less aggressive in their dealings with the emerging markets, and were consequently outbid for business by New York houses, not just JP Morgan, which was a traditional participant in the business, but other houses such as the National City Bank that were inexperienced in underwriting.
Consequently, when the 1929 crash hit, the level of defaults on emerging market debt was far higher than had ever been seen before 1914, and investors were appropriately deterred from further investment in this asset class. The problem was exacerbated by the Glass-Steagall Act, which separated commercial and investment banks, thus depriving potential emerging market bond underwriters of capital.
This was the background to Harry Dexter White and Maynard Keynes' 1944 creation, at Bretton Woods, of the World Bank and the International Monetary Fund. To them, in the international capital market as in so many other things, the private sector had failed and a monopoly public sector solution was necessary.
Rather than attempting to return to the stable and effective model of the pre-1914 world, Keynes and White created an autarkic financial model, that effectively prevented international bond financing to the developing world for 30 years.
A modest market remained in New York, but Securities and Exchange Commission regulations and the Interest Equalization Tax of 1964-74 meant that it was never a major source of money for developing countries or of revenue for the New York houses. Instead, the principal sources of development finance became the World Bank (and later the IMF), the national export credit banks, and the major international commercial banks through the syndicated loan market.
In the 1960s, with the emergence of the Euromarkets, the possibility opened again of a market for developing country debt. Nevertheless, it did not quickly re-emerge. The London merchant banks had lost most of their capability for advising and monitoring developing country credits, while the major international commercial banks, that had such a capability, were not heavily involved in underwriting.
It thus took the banking crisis of the 1980s and its aftermath for the international bond markets to reopen fully to emerging market credits.
At this point, a new mechanism was needed by which investors could assess the credit quality of the bonds they bought. The London merchant banks by now were a much smaller factor in international finance, were being bought out by large commercial banks, and in any case had oriented themselves primarily toward the equity markets, which they saw as most profitable.
The bond market had been commoditized, with issue spreads sharply reduced and the role of the lead manager reduced to a mere producer of legal documentation and launcher of the issue onto the world's trading desks. Into this vacuum stepped the rating agencies, selling their services to developing country borrowers at a suitably remunerative fee. Nobody thought the rating agencies particularly capable in rating emerging market credits, but they were the only game in town.
The FPF study demonstrated that the rating agencies have tended to lag reality in assessing developing country credit ratings, rating them above the level that would be indicated by purely statistical considerations in good times, and marking them down sharply, often by three or four rating levels, when things went wrong.
Rating agency down-gradings, in turn, are watched very closely by the market, and tend to be a signal for a tsunami of selling when they happen, thus exacerbating the problem that caused the downgrade and causing a liquidity crisis in the country's obligations just when it is most dangerous.
Indeed, there is a particular "insider trading problem" in the rating agencies' sale of some information to subscription-paying clients, and their frequent contact with Wall Street traders, both of which can provide indications of rating agency intentions to insiders before the investing public as a whole are aware of them.
The FPF study was also critical of the oligopolistic nature of the credit rating agencies -- only four are granted by the SEC the status of a Nationally Recognized Statistical Rating Organization, of which one, Dominion Bond Ratings, is primarily a Canadian national agency and another, Fitch, is considerably smaller than the two major agencies, Moody's and Standard and Poors.
The study suggested that if further agencies were granted NRSRO status, competition would be increased, rating agency fees reduced and the quality of debt ratings improved.
It is on this last point that I differ. Since rating agencies are paid by issuers, there would be a natural tendency for smaller agencies seeking business to shave their quality standards and grant higher ratings, thus reducing the information content of a debt rating to investors. Moreover, there seems no reason to suppose that the pro-cyclical nature of the ratings process would be improved by these means.
This may well indeed be a problem without a solution, so long as the present world financial architecture remains in place, with development finance dominated by a public sector monopoly cartel, and bond issuance being carried out through rapid-response trading desks.
It is however likely that, following the Argentina default, and possible further international bond defaults in Turkey and Brazil, the international bond market will effectively close to new borrowers for several years. At that point, if the hugely pro-cyclical nature of the international bond markets needs to be removed, it could be done -– by closing down the operations of the World Bank and IMF and allowing development finance to be returned to the competitive private sector, where it belongs.
If this were done, it would be likely that issuing banks, and not artificially established rating agencies, would once more govern investors' credit assessment process, to the great benefit of the developing world's economy.
