Don’t shoot the rating agencies!

On Friday (27th March), the credit rating agency Fitch downgraded the UK’s sovereign credit rating by one notch, from AA to AA-, citing worries about the economy and a jump in government debt. Bond investors at least are shrugging this off. But the announcement has revived long-standing concerns about the role of rating agencies during crises, and whether they actually make things worse. Here’s my take.

It is important to understand first that, despite some hyperbolic headlines, Fitch’s announcement is unlikely to have any significant impact on the UK’s cost of borrowing. There is nothing surprising in the agency’s statement that might tell investors anything new about the prospects for the UK economy or public finances.

What’s more, the UK’s revised rating is still comfortably within the most valued category of ‘investment grade’. It is also still two notches above Fitch’s ‘A’ rating for Japan (where government bond yields have been low for decades) and five notches above the BBB awarded to Italy (partly reflecting the fact that Italy, unlike the UK, no longer has its own currency).

Nor is the UK being singled out. It is highly likely that other countries will be downgraded further too, continuing a trend in place since the global financial crisis. Indeed, South Africa’s sovereign credit rating has also just been downgraded by Moody’s, and Nigeria’s by S&P. Even the US is no longer rated AAA by all three major agencies, having been downgraded one notch by S&P in 2011.

Nonetheless, I get that the actions of the rating agencies make many people feel uncomfortable, especially when societies are struggling to cope with a global pandemic and health emergency. The reputation of the agencies had, of course, already been badly damaged by their role in contributing to the global financial crisis, when some had given what turned out to be hopelessly inflated ratings to mortgage-backed securities.

It has also been argued that the subsequent downgrades of sovereign debt added to the pressure on governments to implement ‘austerity’, especially in the eurozone. (The US Council of Foreign Relations provided a useful review of these controversies here.)

These concerns have surfaced again in the last few days. The respected economics commentator Frances Coppola (always worth reading) has even called for rating agencies to be ‘shut down’. In her view, their recent actions have simply made it more expensive for governments to finance the fiscal expansion needed to protect economies during the coronavirus crisis. Rating agencies are also busy downgrading corporate debt, including the debt of organisations running hospitals, which Frances understandably describes as ‘immoral’.

I would not go quite that far myself. For a start, we should always be wary of shooting the messenger. Rating agencies are only doing their job – as they see it – of providing an independent and objective assessment of the creditworthiness of particular borrowers.

For example, Fitch’s warnings about the impact of the coronavirus crisis on the UK economy and public finances are similar to those from many other organisations, including the Office for Budget Responsibility, Institute for Fiscal Studies and the Resolution Foundation.

It would also be odd if a rating agency did not take a view on the relative riskiness of lending to companies badly affected by the crisis, such as airlines, hotel chains, or high street retailers. After all, other market participants are doing so as well. Rating agencies are often just playing catch up with movements in share prices, corporate bond spreads, or credit default swaps.

What’s more, governments and investors are, for the most part, free to ignore what the rating agencies are saying. The main exception is when a downgrade takes the rating on a bond outside the ranges that particular investors are allowed to own, or requires them to hold additional security against it. This is most likely to be a problem for borrowers whose bonds are at, or near, the borderline between ‘investment’ and ‘non-investment’ grade (the latter are often known as ‘junk’). But most downgrades do not fall into this category.

To the extent that these constraints are set by regulators, the regulators themselves can also relax them during a crisis. Indeed, governments and central banks around the world are stepping in to guarantee corporate debt and to support credit markets with additional injections of liquidity.

Regulators could perhaps intervene directly by requiring agencies to freeze their ratings (or the agencies themselves could apply a temporary moratorium on downgrades). But I’d be against this, because the information in ratings still serves some useful purpose and because, like bans on ‘short selling’, it could backfire (‘what are the authorities trying to hide’?).

There is a separate debate about whether rating agencies are actually any good at their job. Olaf Storbeck reviewed some of the evidence back in 2012, notably a study by Hilscher and Wilson which found that a simple model based on publicly-available data predicted the default rate among US corporates rather better than the ratings produced by S&P.

Some other studies take a more positive view of the track record. For example, the IMF found that rating agencies have been pretty good at predicting sovereign defaults (albeit mostly in emerging markets with currency pegs). The agencies also perform socially useful functions in terms of providing ‘information, monitoring, and certification services’.

There are doubts too about the macroeconomics behind the rating of sovereigns in particular. Jonathan Portes is only one of many economists who has questioned whether it makes sense to have such a wide range of sovereign ratings for those advanced economies which do have the option of printing money to service their debts. The credit risk on lending to the UK government is surely miniscule, although ratings may still serve as a useful purpose as a proxy for other risks, such as being repaid in a devalued currency.

I’d add that, in the current circumstances, governments are right to let borrowing take the strain, and that the longer-term outlook would be much worse if they didn’t. Increased investor demand for government debt might actually make it less risky in the short term as well.

But these are all issues for another day. For now, I’ll just stress that most investors do not have the resources or expertise to do their own due diligence, and there is some value in independent benchmarks, particularly for less well-known borrowers. Beyond that, rating agencies no longer have the influence that many seem to assume.

In particular, I don’t think this crisis should, or will, be followed by ‘austerity mark II’, as some already fear. The consensus among policymakers has clearly moved on since the early 2010s. The UK public finances should also improve quickly anyway as the economy reboots. But if more borrowing now does require some retrenchment in future, I won’t be blaming the rating agencies.

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