The Finance Ministry economists led by Chief Economic Advisor V Anantha Nageswaran have raised concerns about the opaque methodology employed by major credit rating agencies (CRAs)—Fitch, Moody’s, and S&P—adding that they need to enhance transparency by incorporating hard data, a move that could potentially lead to upgrades for several countries.
India’s rating has remained unchanged at the lowest investment grade even when it has become the fifth largest economy in the world.
“Our review of the credit rating methodologies reveals that there is considerable reliance on qualitative variables to capture ‘willingness to pay’. The enormous degree of opaqueness in the methodology makes it challenging to quantify the impact of qualitative factors on credit ratings. The significant presence of qualitative factors in credit rating methodologies also gives rise to bandwagon effects and cognitive biases amply reflected in various studies, generating concerns about the credibility of credit ratings,” a document titled ‘Re-examining Narratives: A Collection of Essays’ published by the office of Chief Economic Adviser said.
The contents of the publication do not necessarily reflect the views of the government or any of its ministries and departments.
The three rating agencies fail to clearly distinguish between the indicators used to assess ‘ability to pay’ and ‘willingness to pay’, making it complicated to evaluate the assigned credit ratings, it said.
The economists say that enhanced transparency is needed in the methodologies adopted by these CRAs, which will lead to credit rating upgradation for a number of countries saving them billions in funding costs.
The methodologies used by credit rating agencies are opaque and appear to disadvantage developing economies in certain ways. Fitch tends to ignore the welfare and development functions that public sector banks tend to play in a developing country, where government-owned banks have played an important role in promoting financial inclusion, it said.
“Reading through the methodology documents of the big three agencies, one would find that the descriptions and justifications for several parameters included in the methodology are not obvious. For instance, the Fitch document mentions that the rating agency “takes comfort from high levels of foreign ownership” in the banking sector and that “public-owned banks have historically been subject to political interference.” Such an assessment tends to discriminate against developing countries, where the banking sector is primarily run by the public sector,” the article said.
In contrast, the expansion of foreign owned banks in a developing country seems to target the already-banked middle class and does not appear to serve the unbanked low-income households.
Second, the experts generally consulted for the rating assessments are selected in a non-transparent manner, adding another layer of opaqueness to an already difficult-to-interpret methodology. Lastly, the rating agencies do not convey clearly the assigned weights for each parameter considered. While Fitch does lay out some numerical weights for each parameter, they do go on to state that the weights are for illustrative purposes only. Thus, it is left to the reader to make educated guesses on what the assigned weights could be for the qualitative and the quantitative factors, it read.
In the case of Moody’s, the finance ministry’s economists pointed out the opaqueness underlying the dynamic weights and its application to arrive at the rating outcomes. “Fitch mentions that weights used in their model are only for illustrative purposes.”
S&P
S&P combines the flexibility and performance profile with the institutional and economic profile to determine an "indicative rating level". The agency, for some assessment scores, gives higher weightage to flexibility and performance profiles compared to institutional and economic profiles and equal weightage otherwise. This adds to the lack of methodological clarity, the article said.
Reforms in credit rating process
Enhanced transparency in credit rating may compel the use of hard data and likely result in credit rating upgrades for a good number of sovereigns. This will help them access private capital, which has been assigned the central role by G-20 in addressing global challenges such as climate change and supporting the energy transition. Reforming the sovereign rating process will correctly reflect the default risk of developing economies, saving them billions in funding costs, the article read.
“As the rated sovereign is obligated to be completely transparent, establishing symmetry of obligations warrants that the rating agencies make their processes transparent and avoid employing untenable judgements,” it said.
Discover the latest Business News, Sensex, and Nifty updates. Obtain Personal Finance insights, tax queries, and expert opinions on Moneycontrol or download the Moneycontrol App to stay updated!
