GS Paper III

News excerpt

The Chief Economic Adviser’s (CEA) office has published a report, titled “Re-examining Narratives - a Collection of Essays”, which has raised questions on narratives about the Indian economy.

•  The report questions the methodology of rating agencies Fitch, S&P, and Moody’s while rating a sovereign.

More details on the news:

• Comments of the Chief Economic Adviser coincide with India seeking an upgrade to its sovereign credit rating, currently at the lowest possible investment grade, as India has seen its economic metrics improve considerably since the pandemic.
•  The finance ministry officials have met representatives from the top three rating agencies–Fitch Ratings, Moody’s Investors Service and S&P Global Ratings–seeking an upgrade.
• Currently, S&P and Fitch rate India at BBB, and Moody’s rates it at Baa3, which is the lowest investment grade.
• The Chief Economic Adviser says that to get a better rating, developing countries have to show progress in areas that might not be important, which is not fair.

Issues with Present Rating System:

• Opaqueness in Methodologies: The credit rating process suffers from a significant degree of opaqueness in methodologies. This lack of transparency makes it challenging to assess and quantify the impact of qualitative factors on credit ratings.
•  Qualitative Factors and Cognitive Biases: The substantial presence of qualitative factors in credit rating methodologies leads to bandwagon effects and cognitive biases. 
• Studies reveal concerns about the credibility of credit ratings due to the influence of subjective elements on the assessment process.
• For example, between 2020 and 2022, over 56% of the African countries that are rated by at least one of the big three agencies were downgraded, compared with 9% of the European nations.

•  Dominance of Institutional Quality as a Determinant: Institutional quality, often measured by the World Bank’s Worldwide Governance Indicators, emerges as a crucial determinant. It creates a problem as these metrics are non-transparent, perception-based, and derived from a small group of experts, potentially leading to discriminatory outcomes.
• Arbitrary Indicators for Rating Upgrades: Developing economies may need to demonstrate progress along arbitrary indicators to earn a credit rating upgrade. It imposes challenges, as progress may be measured against non-transparent and perception-based metrics.
•   Non-Trivial Impact of Qualitative Component: Over half of the credit ratings are determined by the qualitative component. This reliance on qualitative factors complicates the process, making it less objective and potentially hindering accurate assessments.
• Increased cost of borrowing: Negative warning announcements by credit rating agencies are linked to increase in the cost of borrowing for developing countries.

The Economic Survey 2020-21 on sovereign credit ratings

• Call for Transparency and Objectivity: The Economic Survey has called for sovereign credit ratings methodology to be made more transparent, less subjective and better attuned to reflect an economy’s fundamentals.
•  Low Rating for Large Economies: The Survey noted that never in the history of sovereign credit ratings, has one of the largest economies in the world been rated at the lowest rung of the investment grade (BBB-/Baa3) except in the case of China and India.
•  Fundamentals Not Reflected: Further, it points out that India’s sovereign credit ratings do not reflect its fundamentals. Within its sovereign credit ratings cohort, India is a clear outlier on several parameters, i.e. it is rated significantly lower than mandated by the effect on the sovereign rating of the parameter.
• These include GDP growth rate, inflation, general government debt (as per cent of GDP), current account balance (as per cent of GDP), cyclically adjusted primary balance (as per cent of potential GDP), short-term external debt (as per cent of reserves), reserve adequacy ratio political stability, rule of law, control of corruption, investor protection, ease of doing business, and sovereign default history.
• This outlier status remains true not only for the current period but also during the last two decades. 

Significance of Reforming Sovereign Credit Rating Process:

Conclusion:

Thus, the rating mechanism followed by credit rating agencies for developing economies needs a serious reform focusing on well-defined, measurable principles rather than subjective judgments on ideas of governance.