The New Cold War
America, China, and the Echoes of History
For cash-strapped countries these days, credit is king. And sovereign credit ratings, or independent assessments of a state’s risk of default, are often helpful in accessing it.
The potential advantages of a strong rating are widely known: the ability to borrow more money, on better terms. And the downsides of a poor one—less credit, higher costs—are equally so. Yet the path to a top rating is less clear. Economists and political scientists have spent decades trying to understand how governments can secure better sovereign credit ratings, principally by focusing on a handful of economic indicators, such as a country’s GDP per capita, real GDP growth, default history, and the like. Such indicators, however, are incomplete guides on their own. The “big three” credit rating agencies—Fitch Ratings, Standard & Poor’s, and Moody’s Investors Service—rely on more than quantitative factors, which is why their conclusions about the same numbers sometimes differ.
Indeed, that fact, combined with some recent damaging downgrades, has led some experts, such as Daniel Vernazza and Jonathan Portes, to conclude that the rating process is too subjective or ill thought out and that political leaders should dismiss credit rating agencies as a result. But adopting such an approach risks missing a valuable opportunity. Subjectivity, after all, is a two-way street, since it can work in a country’s favor as well as to its disadvantage. Governments that understand how ratings are made can take steps to hold or improve their position; those that don’t may end up more vulnerable. And with new rating agencies now emerging alongside the old guard, knowing the rules of the game matters more than ever.
Rating agency critics often point to Standard & Poor’s decision to downgrade the United States’ credit rating from AAA (its highest) to AA+ (its second highest) in 2011. “It’s hard to think of anyone less qualified to pass judgment on America than the rating agencies,” the economist Paul Krugman argued in The New York Times after the downgrade. The agency, he said, was “just making stuff up.”
The move indeed came as a surprise: the world’s largest credit rating agency was asserting that the most powerful country on the planet was, for the first time in 70 years, no longer a risk-free borrower. However, Fitch and Moody’s disagreed. Where Standard & Poor’s saw a “rising public debt burden” and “greater policymaking uncertainty,” its peers apparently saw no cause for alarm. They may have been right. Over the next several quarters, U.S. Treasury yields—that is, the interest paid on bonds—remained stable and went on to reach historic lows.
This case wasn’t unique, even among states that have traditionally held a top rating. The largest agencies have recently split over the creditworthiness of Austria, Finland, New Zealand, and the United Kingdom. Qualitative judgments, whether of political uncertainty or a country’s apparent willingness to pay, often help explain such variations. They can also divide executives and analysts at the agencies themselves, during secretive meetings of their rating committees. As David Levey, a former managing director of Moody’s, told us, “Imagine a large group of people arguing strenuously with each other. It could sometimes get to that. These were very exciting meetings and often there were substantial disagreements. In every case, the ultimate decision was made by majority vote.”
Knowing this, senior government officials often work aggressively to prevent downgrades. U.S. Treasury Secretary Timothy Geithner, for example, reportedly sought to persuade Standard & Poor’s that Washington was an AAA borrower following a fierce political battle in Congress over statutory borrowing limits in 2011. Geithner appeared on television to stress his confidence in the American economy months before the downgrade. The Treasury secretary also allegedly warned Standard & Poor’s that it had made an error in its analysis after the downgrade. But Geithner’s appeals proved unsuccessful.
Such efforts have failed in large part because they didn’t leverage government’s greatest advantage, which usually lies at lower levels: in controlling the flow of information. At the end of the day, rating agencies rely heavily on the states they are assessing for raw data. And what governments choose to share—as well as how they present it—can make a crucial difference.
Curious as it may seem, rating agencies have always been heavily reliant on open-source information and on what governments have been willing to share. Take the United Kingdom, for example. In 1976, the British government was in enough economic trouble that it requested financial assistance from the International Monetary Fund, and in 1978, it decided to issue bonds in New York. In advance of the issue, records show, London decided to open negotiations with the rating agencies, which had not assessed London’s creditworthiness for decades. Although the United Kingdom did not need a rating to access the U.S. market, British officials believed that a strong endorsement from the agencies would build investor confidence and could significantly lower its cost of borrowing.
From the beginning, London was determined to strictly control the flow of information to the credit rating agencies. To that end, the Bank of England and the British Treasury, working with the U.S. investment bank Morgan Stanley, produced a document that theoretically provided the agencies with a comprehensive and wide-ranging survey of the national economy. Although they used accurate data, officials emphasized the United Kingdom’s strengths, stressing its commitment to growing revenues, reducing inflation, and profiting from recently discovered oil reserves in the North Sea. And they downplayed doubts about the economy. Tensions with trade unions—which would eventually culminate in the so-called winter of discontent—featured only briefly, as did some liabilities, such as the details surrounding the government’s default on debts incurred during World War I and owed to the United States.
By the end of the process, British officials believed they had provided most of the information the agencies used. As newly released British government documents show, officials made a concerted effort to tell as “good a story” as they could—to limit references to the debt without risking legal action concerning the “suppression of material information.”
The British government also worked to manage impressions through a series of visits from the rating agencies, during which government officials delivered presentations and held one-on-one meetings. As one internal document put it, “Impression of confidence, professionalism and personal commitment . . . cannot help but have a significant impact . . . [the rating agency’s] purpose in these meetings is to determine what to believe.” British officials believed such efforts to be crucial; the written report produced by the visiting country analysts from each credit rating agency served as the basis for discussions during rating committee meetings in New York.
Moody’s responded swiftly with an Aaa rating, but there was some delay in securing a final decision from Standard & Poor’s, which delivered the same verdict but suggested that the United Kingdom was not an “open and shut case” for a top rating. If the United Kingdom was not an “open and shut” case, then British efforts to inform and influence credit rating analysts during the review process may well have made the difference.
Despite the nearly four decades that have passed since the United Kingdom’s first contemporary sovereign credit rating, the agencies operate in similar ways today. To be sure, the industry has become more professional and data driven, and exchanges between governments and rating analysts occur on a more frequent basis. Yet agencies must still make subjective judgments. Reports in 2004 that Greece had disguised its deficit levels to secure admission into the eurozone came as a surprise to all the major rating agencies. But their responses ultimately varied. Standard & Poor’s cut Greece’s rating, but Moody’s kept the country’s rating intact.
To complicate things, some states have created, or are in the process of creating, their own global rating agencies, each of which will likely employ different qualitative assumptions about what constitutes creditworthiness. For example, Russia and China already operate their own rating agencies but now plan to join forces. The proposed organization will initially assess Russian-Chinese investment projects, but Russian Finance Minister Anton Siluanov has expressed hope that the agency will “rise to a level where its opinions will attract other countries.” The BRICS group of countries—Brazil, Russia, India, China, and South Africa—has also contemplated setting up its own rating agency. And some observers think the planned Russian-Chinese rating agency could broaden into a larger BRICS project.
These developments suggest a possible shift away from the big three, which could bring big changes. Siluanov has said that Moscow and Beijing would like their agency’s ratings to be “apolitical.” That outcome is unlikely; unless analysts adopt a mechanistic approach based on quantitative factors alone, qualitative elements will continue to influence the rating process. Dagong Global, China’s leading rating agency, already classifies some countries differently from the big three. In 2013, it downgraded the United States to A-, five notches below Standard & Poor’s already controversial AA+ foreign currency assessment. Earlier this year, Dagong Global gave Russia an A rating, thereby deeming it more creditworthy than the United States.
Sovereign borrowers need not worry about these foreign competitors just yet. The three largest rating agencies are thriving, with revenues surpassing pre-crisis levels in 2013. Dagong’s downgrade of the United States had little effect on international investment. In the not-so-distant future, however, states that want to borrow abroad may need to contend with new ratings criteria. This could certainly pose problems; critical judgments concerning a country’s willingness to repay, for instance, could become contentious and political. But if at least some governments strive to build credible rating institutions, there may also be new opportunities—and even more reason for governments to hone their pitch.