Global sovereign credit rating needs an Indian lens

The essay dealing with credit rating methodologies in the compilation ‘Re-examining Narratives’ issued recently from the office of the Chief Economic Adviser (CEA) has again sparked a much-needed debate about the role of the US-based credit rating agencies (CRAs), which pronounce sovereign credit ratings. This was in the context of the sovereign credit rating of BBB-/Baa3 assigned to India, the lowest investment grade by the big three US-based CRAs (Fitch, Moody’s, and S&P). This despite India’s impeccable track record of having zero sovereign defaults, let alone the fact that it is the fifth largest economy.

Sovereign credit ratings are important for a country seeking to raise financial resources through international financial markets. These ratings serve as a reliable indicator of credit risk, implying, thereby, the ability of the sovereign to repay the loan. The level of credit risk determines the risk premiums. A credit risk reflects the likelihood of a government being unable or unwilling to meet its debt obligations. It significantly affects access, timeliness, cost, and tenor of borrowings by the sovereigns. Conversely, a good sovereign rating ensures access to easy funding in international bond markets. A good rating also helps attract Foreign Direct Investment (FDI); it has become an important indicator of the country’s economic health.

The US-based agencies, responsible for sovereign ratings, also assess securities, whether stock or bonds, both in the US and globally through their subsidiaries. (It is a different matter that CRAs have been severely castigated in The Financial Crisis Inquiry Report constituted after the 2008 US financial crisis as being ‘essential cogs in the wheel of financial destruction—key enablers of the financial meltdown’.) Though there are some similarities between the sovereign rating process and the rating process involving securities or bonds, there are also significant differences in that a sovereign’s governance and institutional qualities are assigned more importance than its capacity to pay (macroeconomic performance). This brings in a qualitative evaluation and a high degree of subjectivity. Consequently, the task of agencies involved in sovereign ratings is much more challenging, and it is their responsibility to ensure the process is transparent and rigorous.

The CEA’s essay points out succinctly that the methodologies ‘utilised by credit rating agencies are opaque and appear to disadvantage developing economies in certain ways ‘. The descriptions and justifications for several parameters used in the methodology are not clear. Again, as pointed out, ‘opaqueness in rating methodologies is fertile ground for sowing suspicion about the discriminatory intent of CRAs, particularly when rating downgrades are mostly in respect to economically weaker nations ‘. Credit downgrades for developing countries make it difficult for them to access cheaper long-term funding from international capital markets.

International rating agencies seem to make no distinction between the indicators used to assess ‘ability to pay’ and ‘willingness to pay’. The CRAs rely heavily on the Worldwide Governance Indicators (WGIs) of the World Bank, which are admittedly perception-based; what you hear will depend upon whom you ask, details of which are not in the public domain. The arbitrariness of the sovereign rating process adopted was earlier highlighted in The Economic Survey 2020–21, where a case was made that the sovereign credit ratings assigned to India failed to accurately depict the underlying economic fundamentals of the country.

African nations have been particularly hard-pressed by the sovereign rating assigned to them. It has made getting funding from abroad costly. As has been pointed out by the United Nations Development Programme (2023), if the CRAs employed less subjective assessments, a resulting revision in the ratings of African countries would save them up to $74.5 billion in borrowing costs. African nations have often complained of the ‘institutionalised bias against African economies’ of the CRAs. Thus, there is an urgent need to reform the rating process.

The time has indeed come for an independent rating agency without the burden of history to look afresh at the sovereign rating process. The BRICS Summits have debated this, but nothing concrete has emerged thus far. The London-head-quartered ARC Ratings (a consortium of rating agencies from Asia, Africa, Europe, and South America) or the Malaysian, Russian, Hong Kong, Chinese, and Japanese rating agencies have not made much headway in this area. Given India’s growing importance on the international stage, it is an opportune time for a domestic credit rating agency to move into this space.

The process will take time, but it is well worth the effort. Obviously, for this to emerge as a credible alternative, key parameters like economic structure, fiscal strength, external linkages, monetary and financial stability, institutions, and quality of governance will have to be examined. It should be data-driven, with subjectivity kept to a minimum. The focus should be on actual risk rather than perceptions of risk, which can be misleading. Hence, the process must be robust and transparent. There must be close engagement with the International Monetary Fund, the World Bank, the International Bank for Reconstruction and Development, the Asian Development Bank, and other financial institutions. Ultimately, they must be convinced that the process leading to a sovereign credit rating is such that it gives them confidence to lend money at low cost to sovereign nations—not merely to repay loans but to help them rebuild capacity and become economically stable.

(The writer is a former chairman of the Central Board of Indirect Taxes and Customs)