Five year ago the Financial Crisis Enquiry Commission, set up by the US Congress following the Global Financial Crisis, described the rating agencies as ‘essential companies in the wheel of financial destruction’ and ‘key enablers of the financial meltdown’.
Closer to home, Stephen Grenville, a former Deputy Governor of the Reserve Bank of Australia, expressed similar reservations in this blog (see repost) John Menadue
REPOST of Stephen Grenville’s blog of 14 July 2016.
Standard & Poor’s (one of the ‘Big Three’ credit rating agencies) has put Australia on negative watch, with a one in three chance that our rating will be downgraded before long. On the face of it, this sounds like a big deal that can only be avoided by budget-tightening actions (which the close election result has made less likely). There would be knock-on effects from a rating downgrade, the banks, for instance, have the same threat hanging over them, as their rating can’t be higher than that of the government.
But hang on a moment! Aren’t these the same agencies that handed out AAA ratings to financiers that packaged up a bundle of dubious mortgages into a portfolio with fancy name (Collateralised Debt Obligations, or CDOs)? Wasn’t this endorsement provided by the credit rating agencies in exchange for fat payments from the CDO-promoters? The Standard & Poor’s character in The Big Short movie blurts out the rationale: ‘if we don’t give them the rating, they’ll go to Moodys.’Yes, these are exactly the same, although of course (just to confuse the investing public), those AAAs for CDOsweren’t exactly the same as AAAs for government debt. For government debt, the credit rating agencies’ record is, however, only marginally less misleading. S&P took away Greece’s investment-grade rating months after Greece’s budget cover-up (and inevitable debt disaster) became public in 2009.
So why would anyone take any notice of credit rating agencies? Despite the portentous reporting that always accompanies such announcements, in practice financial markets don’t take much notice. The US AAA downgrade in 2011 and Japan’s downgrade in 2002 were treated by financial markets with total equanimity, with no detectable change in financial prices. Similarly, the S&P announcement last week was greeted with calm composure by financial markets. The news media cited the exchange rate and weaker equity prices when reporting the downgrades, but any impact was indistinguishable from the normal daily fluctuations. Financial markets make their own judgments about risk, without help from the credit rating agencies.
Why do governments routinely take these announcements so seriously, and respond by confirming that they are doing exactly what the credit rating agency recommends? Usually, it is just part of the political parlour game. Treasurers wants to draw attention to how brilliantly they are steering their national economies in a tumultuous world. They can justify unpopular proposals by asserting they are necessary to avoid the threatened downgrades. It would take a brave government to tell these agencies that they were entitled to their opinion, but that the government will not take any notice.
If the clear experience is that rating downgrades have an imperceptible effect on market prices (bonds, shares and the exchange rate), maybe we should just ignore all this brouhaha. But the credit rating agencies have had some malign influences, both overseas and in Australia.
Future historians may well give a harsh judgment on the macro-policy response to the 2008 financial crisis. Policy responded appropriately to the sharp downturn by easing monetary policy and providing fiscal stimulus (endorsed by G20 in London in 2009). But by 2010, a debt-paranoia set in. This was turned into panic by the collapse of the European periphery (led by Greece). Even countries that had no pressing need to get their debt down were pressured by all the international agencies (including credit rating agencies) to rein in their budget deficits, even though this meant strong headwinds for the recovery. Over time, agencies such as the IMF came to see that the contractionary effect of this fiscal consolidation (also known as ‘austerity’) had been underestimated. The IMF reversed its advice for countries that can fund their deficits easily (as all the big countries can, in a world where governments can borrow long-term almost without cost).
Of course, the credit rating agencies were not single-handedly responsible for the 2008 crisis or the subsequent policy mistakes; they were just one cause and one voice among many. But they were on the wrong side of the argument then, and they may still be now. This debt fetish has produced nearly a decade of unbalanced macro-policy (monetary policy too loose, fiscal policy too tight). The result is a pathetically limp recovery in Europe, with unemployment still in double-digits today. Some countries realised the error after a few years (USA, Japan and UK) and quietly abandoned austerity. Their growth performance immediately improved.
You might wonder how Australia avoided this same mistake. After all, we’ve had the international agencies and the credit rating agencies telling us about debt and external deficit vulnerability forever. The secret of our comparative success is the bipartisan policy of promising to prioritise restoring the budget to surplus quickly, yet not actually doing it. The very characteristic that S&P complain about (failure to deliver on budget promises) is the masterstroke that allowed Australia to sail through the crisis without a recession and record a rate of growth twice that of the advanced economies. This higher GDP gives us capacity to shoulder the increased debt S&P frets about.
That said, there is a long-standing malign influence on Australia from the credit rating agencies’ debt fixation. For the past few decades, state governments have lived in fear of a downgrade. This is not because it would change borrowing costs much; the impact would be tiny. The fear is the damage to political reputations; such has been the focus on ratings that any state government that seemed indifferent to downgrade would be lucky to survive beyond the next election.
As a result, state governments have shifted to a form of infrastructure funding which is around twice as expensive as issuing their own bonds, without in any way making their underlying financial position any stronger. Sydney’s desalination plant illustrates the issue. This was funded by ‘selling’ the newly-completed plant to an offshore fund, involving a thirty-year take-or-pay contract which gives the investor the same sort of security and cash-flow that they would have from holding a government bond (although, admittedly, without the liquidity of a government bond), and twice the return. This contract is not counted as government debt although it has the same characteristics: an obligation by the government to make debt-like payments over a long term. The government’s financial position is actually weakened because of the higher funding cost.
Most financial institutions which were caught up in the blame-game of the post-2008 period have had to make painful changes since then. The credit rating agencies, however, seem to be Teflon-coated. Their opinion is still a central requirement of various official prudential processes; they still adjudicate on the critical distinction between funds which are ‘investment grade’ and those which are ‘junk’.
Assessing the full import of a country’s debt position is hugely complex. Australia currently holds an AAA rating because its performance (even with budget deficits and a perpetual substantial external deficit) has been consistently competent. Australian government debt is remarkably low by international standards (much lower than Canada, which is also rated AAA).
Of course Australia needs to live within its means, making sure that overseas borrowings increase our capacity to service those borrowings and putting in place measures which will strengthen the budget by removing anomalies. We can do this without the constant hectoring from agencies whose egregious misjudgments are still fresh in our memories.
It’s time to stop genuflecting at the ratings altar.
Stephen Grenville is a former Deputy Governor of the Reserve Bank of Australia. This article was first published in The Interpreter on 11 July 2006.