The partiality of rating agencies

Our IDR status from A- to BBB+ has attracted opprobrium and negative responses from government detractors who deem the downgrade to be a vindication of their critical stance all this while and are worried about the impact on foreign investment with implications for growth and jobs.

This reminds us of the prestige with which ratings agencies are accorded as gatekeeper to the capital markets (sovereign and corporate) as if their judgments are bestowed with almost infallible powers and that too in a semi-mystical sense, i.e. unquestionably so.

It also highlights the utter dependence and reliance on ratings agencies for the “indispensable” services they render – in providing expert and professional opinions that are neutrally-informed and objectively-based.

It’s a given recognition that ratings agencies do play a vital role and function in providing a third party and independent opinion concerning financial assets and, by extension and inclusion, the sovereign and corporate issuers themselves.

But it’s a different issue altogether from the question of whether ratings agencies really offer neutral and objective opinion.

The key ratings drivers or metrics employed by Fitch to determine their rating of our sovereign debt mainly in the form of the Malaysian Government Securities (MGS) are economic fundamentals/conditions, gross domestic product (GDP) growth, fiscal deficit, national debt-to-GDP ratio, governance reforms, political certainty, etc.

Sounds innocent, enough.

Of immediate concern, however, is the impact of the downgrade on the borrowing costs of our sovereign debt. Due to their status, ratings agencies exercise and wield enormous influence and clout. Ratings agencies – of which Fitch Ratings, Standards and Poor (S&P) and Moody’s comprise the troika of leading household names – are taken for granted to be neutral and objective in their evaluation of sovereign debt and corporate financial asset (also known as indexing).

Investors of both sovereign debt and corporate financial assets such as stocks and exchange-traded funds (ETFs) typically rely on ratings agencies for investment decisions. As such, the ratings agencies also exercise de facto decision-making power albeit indirectly as well as a semi-regulatory role (both front-end and back-end, i.e., influencing future expectations of the performance of sovereign and private financial assets as well as passing the verdict on past and current ones, respectively).

But are ratings agencies really that free from susceptibility and vulnerability to ulterior motives, hidden agendas or biases?

The question to be posed here, therefore, is why would Fitch (or other ratings agencies for that matter would) would want to purposely downgrade our sovereign bond status given the broader backdrop of the unprecedented global Covid-19 pandemic and crisis?

There’s some internal contradictory logic here.

Having recognised the impact of Covid-19 epidemic on our economy and the fact that fiscal deficit and debt levels would need to rise, why must Fitch then proceed to downgrade our sovereign debt from A- to BBB+ wherein the difference between the two is very minimal or that the boundary is blurred?

Having prejudice against higher borrowing and debt levels is a hangover from the neoliberal Washington Consensus that even the World Bank and International Monetary Fund (IMF) have moved on from since the days of the Asian Financial Crisis (AFC) of 1997/98 to cite Malaysia’s immediate and regional context.

Are ratings agencies in general behind the curve in this regard?

The fact that ratings agencies which are themselves ideologically enthralled to mainstream or orthodox macro-economic theories that couldn’t predict or anticipate the Great Recession of 2008 were quickly forgotten.

In other words, the fact that markets can and do systemically fail from time to time is overlooked and disconnected from the work that rating agencies do – based as it is on the assumption that there’s such a thing as the Symmetric Information and the Efficient Markets hypotheses.

As applied to the ratings agencies, they’re supposed to be in the position to access and possess complete and exhaustive information regarding the nature and value of the financial assets concerned – such that ergodicity can be deduced there. Ergodicity is simply the predictable and, therefore, linear pathway or trajectory of a statistical property such as a variable/determinant/factor like bond yields within a closed system.

As it is, ergodicity doesn’t account for “supervening” or external events such as central bank intervention in the form of quantitative easing (QE), for example or the Covid-19 outbreak.

It also doesn’t take into consideration the fact that systemic failures can result from the system being rigged – by insiders no less.

Take the infamous London Inter-Offered Bank Rate (Libor) scandal in the City of London that broke out in 2012. Although not a ratings agency as such, Libor – as a by-product of index providers – plays an analogous or parallel role in indexing and benchmarking global interest rates.

It’s later discovered that the markets in the form of commercial banks had very little to do with the benchmark setting via their submissions of the interest rates for the day. It’s already been pre-determined or manipulated by Libor insiders for a very long time with complicity by counterparts from outside the City.

Or more pertinently, what about the S&P rating of the credit default swaps (CDS) that finally exploded and crashed the Anglo-Saxon financial system in the Western hemisphere in 2008?

Is the ideological and policy hold of ratings agencies on governments the world over akin to a form of neo-colonialisation for those of us from the developing world?

Ratings agencies still do play an important role in fulfilling the criteria of “due process” in the realm of financial decision-making and ensuring that both governments and corporations adhere to good governance principles.

What is of concern here is there seems to be a tectonic shift that has fundamentally transformed capital markets globally by moving towards passive index investing and the concomitantly growing power of index providers, whereby the vast majority of actively managed funds have been incapable of beating broad market indices over longer periods of time but nonetheless charged high fees.

While this was not perceived as a major problem in the pre-crisis period of exorbitant asset returns, it became fundamental for investment decisions in a post-crisis, low yield environment – resulting in a money mass-migration from actively managed funds to much cheaper passive funds, that merely replicate financial indices throughout the 2010s.

By mid-2019, for the first time the assets of US equity index funds have exceeded the assets of actively managed equity funds – heralding the dawn of the new age of passive investing in which indices are front and centre.

One crucial characteristic of this new age is a redefinition of the relationship between the funds and the providers, whereby index funds in effect delegate their investment decisions to index providers. The latter are the companies that create and maintain the indices on which passive funds are built. They profit nicely from the new status quo, because asset managers have to pay fees if they replicate the indices.

As Howard Marks of Oaktree Capital stated: ‘somebody is making very active decisions about which stocks will be in each “passive” product. […] the people who create the indexes are deciding which stocks will be invested in’. Index investing thus represents a form of ‘delegated management’.

Of course, we are talking here about corporate indexing but if you replace a stock that will be invested in, with sovereign jurisdiction to be invested in, the effect will be the same – rating agencies have a bigger clout than necessary in determining which country/sovereign, investors should bet their monies on. Notwithstanding, perhaps it’s time for the existence ratings agencies backed by relevant institutions such as the Association of Southeast Asian Nations (Asean), related multilateral forums such as East Asian Summit (EAS) with the lead auspices of Japan, etc. under a sort of “ratings diplomacy” endeavour that are more suitable to the context of developing and emerging markets such as Malaysia.

Furthermore, the ratings agencies as a whole might need to rethink their approach by not flattening out the following relationships:

1. The differences between government/State and private budgets (i.e., the “household analogy is inapplicable to the former if and only if it’s a sovereign currency issuer and the currency is not pegged/fixed).

2. The stages of developmental growth between developed countries in the “Northern Hemisphere” as exemplified by the West and the rest of the world.

In conclusion, we still need the good services of the rating agencies (whether for sovereign or corporate financial assets). But their necessity has to be tempered with a different policy understanding these days which is anyhow already beginning to shift (tectonic or not is a different story altogether) with the emergence of a new consensus.

Perhaps, Covid-19 is that wake-up call after all for a revision in our macro-economic thinking.

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Jamari Mohtar & Jason Loh Seong Wei are part of the research team at EMIR Research.