THE ABSURDITY OF INTERNATIONAL CREDIT RATING AGENCIES

News that Portugal’s credit rating has been downgraded from “AA” to “AA minus” has provoked a storm of criticism in Europe.  The downgrade will make it more difficult for Portugal to borrow on the international money markets because international banks use a country’s credit rating when assessing whether to lend to that country.  A country’s credit rating also determines the rate of interest it pays on any loans.  The decision to downgrade Portugal’s credit immediately after it has received a bailout is akin to pulling the rug from under Portugal’s feet.  It also negates the steps the European Union is taking to try to help Portugal.

Personally as someone who has had bitter experiences with credit rating agencies I think the whole practice needs to be outlawed.  Firstly there is no rhyme or reason to how credit rating agencies assess individual countries.  Portugal’s current rating of “AA minus” remains substantially higher than Russia’s junk bond “BBB” rating notwithstanding that Russia has paid off most of its debt, has the lowest debt to GDP ratio of any G20 economy, runs a substantial trade surplus, has a balanced budget and at around $500 billion possesses the world’s third biggest foreign currency reserves.  Portugal’s rating is only marginally lower than China’s, which is “AA3”, notwithstanding that China also runs a large trade surplus and at around $3 trillion possesses the world’s biggest foreign currency reserves.  As of 1st January 2011 Portugal’s credit rating at “AA” was actually higher than China’s, which was then “A1”.  That the credit rating agencies have assessed all three countries wrongly is shown by the fact that since the financial crisis hit in August 2007 it has been Portugal that has needed bailout support whilst Russia and China have not.  In the meantime the two countries whose economies stand at the epicentre of the world financial crisis, the US and Britain, and which continue to run massive trade and budget deficits and where government and private debt has exploded to many times the level of GDP, retain an “AAA” rating.

Secondly use of credit rating agencies means that banks instead of carrying out a proper investigation of a country’s fundamentals and exercising their own judgement in effect contract this function out to the credit rating agencies.  The whole financial disaster the world has experienced is to a large extent a direct consequence of the way in which banks have relied on credit rating agencies to make their decisions for them.

This is bad practice at many levels.  Firstly instead of making individual assessments credit rating agencies rely on mathematical formulae when deciding what ratings to set.  This reflects the fallacy, especially prevalent in the US, that results drawn from mathematics are somehow “objective” and “scientific” and therefore true.  In reality this results in absurd outcomes as I know from my own personal experience.  When I needed urgently to borrow some money some years ago I found that banks would not lend to me because my previous avoidance of debt meant that my credit rating as assessed by the credit rating agencies was poor.  The rationale was that as I had never taken on debt I had no previous credit history on which the credit agencies could assess me.  The result was that I was unable to borrow from the banks even though I had never defaulted on a loan and even though I possessed assets with a far higher value than the money I needed to borrow. 

Secondly, though the fact is never admitted, there is obvious political bias in the way the credit rating agencies do their work.  All three of the big credit rating agencies are American and are funded by US banks.  Not surprisingly they continued to give the big Anglo American banks the highest “AAA” ratings right up to the moment when they all crashed.  Similarly they continue to give the US and Britain “AAA” ratings even though the US’s and Britain’s exploding debt levels and systemic budget and trade deficits scarcely justify this.

In fact the true purpose of credit rating agencies is exposed by my last paragraph.  It is to ensure that international capital continues to flow into the US and Britain and specifically to the US and British governments and to US and British banks.  Given that this fact is so obvious it is difficult to understand why anyone else takes them seriously.

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