Rating agencies and the debt crisis

29 June 2011. The study, entitled PIGS or Lambs? The European Sovereign Debt Crisis and the Role of Rating Agencies, shows that a country’s poor credit rating generally leads to higher interest rates on its sovereign debt even when a country's economic situation derived e.g. by its debt ratio, budget deficit, economic growth, etc. only partially justifies this assessment. The capital market, on which the interest rates for sovereign debt are determined, appears to accept the rating agency's judgment even when the fundamental data for a country disagree.

This can lead to a self fulfilling prophecy. If the capital market accepts the rating agency's judgment over the available data on the country's economy - even if the rating is not completely justified by fundamentals - the country is perceived to be at risk for future default on payments. It also means that the country has to pay higher interest on sovereign debt both now and in the future. This can create the environment for the original prediction from the rating agency to come true without anyone doing anything more about it.

The study also reveals that in the last two years rating agencies have indeed downgraded to an unjustifiably low level, the creditworthiness of Portugal, Ireland, Greece and Spain - the so-called PIGS countries. This means that countries with similar fundamental values as the PIGS, may have received significantly better ratings.

It is also worth noting that rating agencies themselves admit that it is extremely difficult to determine countries’ creditworthiness and caution investors against the accuracy of their judgements. One could be forgiven for believing that rating agencies pursue something that is purely an end in itself: they are unable to predict a national bankruptcy ex ante, but in certain situations they are able to induce, and thus also to forecast, one.

"This study concludes that taking into account the 'self-fulfilling prophecy' problem, the oligopoly of the three big rating agencies Moody's, Standard & Poor’s and Fitch, as well as their fatal misjudgement of numerous derivatives during the financial crisis, the question seems to arise," said Professor Manfred Gärtner, one of the autors of the study, "whether governments shouldn't enforce a higher degree of transparency and diversification in the rating agency market."

Copyright: photocase, checka