Flawed Credit Ratings In Latin America

By Claudio Loser
Forbes, July 7, 2009

Rating agencies' practices have been subject to scrutiny and open criticism since the onset of the financial crisis. The agencies have lost credibility in reaction to their poor performance in assessing financial markets risks throughout the current crisis, their poor timing, particularly ahead of a crisis, and a lack of transparency in assessing emerging market risk in the past.

Up until now, mainstream critics have paid little attention to the issue, because in the past there had not been a perceived problem in the assessment of companies in developed countries. But this is not a new phenomenon, and those that follow emerging economies had become disenchanted long ago.

Emerging countries, with limited access to capital markets, have benefited extensively from overstated ratings that were not warranted. We may be witnessing such developments in Mexico now.

Sovereign ratings for emerging countries were an offspring of the ratings of private companies, which constitute the bulk of the business of the main rating agencies: Fitch, Moody's, and Standard and Poor's, and the methodology they used, were likely not appropriate for sovereigns. Up to the early 2000s the re-grading of countries in the aftermath of a negative event or in the wake of debt-servicing problems was seen as a cause of a further aggravation of economic conditions for the borrowing countries even though conditions were clearly improving (Korea and Thailand, 1997; Uruguay, 2002).

After a period of calm in financial markets, conditions are deteriorating again. However, because the agencies maintain a relative ratings system rather than an absolute rating system, they have not made significant downgrades even in the current recession, making the system a poor tool for financial markets.

An analysis of Latin American investment-grade sovereigns shows that none has experienced a downgrade in the last six to seven years.

Rating changes would be dramatic for countries that have barely made it to the category, such as Brazil, Peru and Colombia. But sovereign credit ratings have remained stable for Chile (high in the ratings) and for Mexico (three notches into the category) to an extent that should be considered too high, in light of the impact of the crisis, even as governments have attempted to address fiscal challenges. This rating record is consistent with the evidence of the last quarter century, which suggests that downgrades have irresponsibly followed crises and not predicted them.

Of course, markets are far from clueless. For example, Mexico's stable ratings have not precluded increases in risk premiums on sovereign and corporate paper, even exceeding those of lower-ranked Brazil. The agencies are reviewing their outlook, and both Fitch and Standard and Poor's have moved to a negative outlook, which seems long overdue. Mexico is exposed to the U.S. economy and to the risks of the private sector, as some of the private liabilities are increasingly contingent liabilities of the government.

It is very likely that the agencies will downgrade Mexico's paper now that President Felipe Calderon's National Action Party (PAN) has suffered a serious setback at Congressional Elections on July 5. The rating agencies may want to wait to see the impact of reducing PAN's share of the vote to just over one-quarter--a much larger cut than expected. In particular, they may consider President Calderon's prospects to address Mexico's budget deficit and public sector reform challenges in determining any rating changes. Yet it would be a mistake to wait much further.

The authorities may consider that a downgrade is a serious setback. However, a belated announcement may inevitably create more damage on Mexico's sovereign than an adjustment in the next few weeks. While the rating agencies should take previous experience into account, they should take a clear and forward-looking view towards the difficulties that Mexico continues to face; including an assessment of actual measures, but also the general prospects of the Mexican economy, which currently remain clouded. A key issue is the methodology being used.

Rating agencies need to broaden the use of objective and reliable indicators, in addition to qualitative judgments in order to provide adequate and relevant indicators to the markets.

In the end, rating agencies need to provide an honest and forward-looking assessment, and not be bound by the present system of relative ratings and undue concerns on reactions to their changes. The agencies might be more useful if they made a more agile and clearer use of their ratings even as they take account of official efforts to correct imbalances with Latin American sovereigns. Thus, they would avoid further scrutiny of an already discredited industry badly in need of real reform.