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AT present, there exist two opposing narratives of Pakistan’s economic performance. The rosier one, predicting great things to come, is perpetuated by the government’s economic managers. Any questions are quickly brushed aside by pointing out that credit rating agencies have given Pakistan’s economic management a thumbs up. But what exactly is this business of credit ratings, and should we take it seriously?
This takes us back to the US in the 19th century, when an expanding economy needed a complementing network of credit. Credit and economic activity have historically had a very close relationship, and the US in the 19th century was no exception to this rule. But there was one catch, as has always been the case with the provision of credit: the risk associated with a borrower. In the age of commercial and industrial expansion, the American economy faced the same dilemma of the borrower risk.
Enter Lewis Tappan, a dry goods and silk merchant in New York. One thing differentiated Tappan from other businessmen: he used to compile extensive records of creditworthiness of his customers throughout the US. In a time when economic activity was growing considerably, he was astute enough to recognise that this valuable information could be converted to monetary benefit. The result: the birth of a mercantile agency in 1841 that sold information on the creditworthiness of individuals and businesses within the US. The mercantile agency became R.G. Dun and Company in 1859. By 1870, its customers had grown to 7,000. The numbers rose precipitously to 40,000 by 1880. By 1900, it had more than a million customers.
How seriously should we take Pakistan’s recent positive credit ratings?
This incredible growth cannot be simply attributed to the growth of the US economy, which experienced turbulence in between those years (a civil war from 1861-1865, for example). Rather, it reflected a skyrocketing demand for information related to creditworthiness, plus the expanding credit business.
Following Tappan’s success, others followed suit. In the early 1900s, Henry Varnum Poor began publishing information on the assets and liabilities of railroad companies. In 1909, John Moody began rating railroad bonds. The former is today’s Standard and Poor’s (S&P) and the latter is Moody’s, two of today’s three leading rating agencies (Fitch Ratings Inc. is the third).
The story of leading rating agencies in the 20th century is a long one, and outside the scope of this article, but one striking development merits mention. In the 1970s, these rating agencies transformed their mode of business from ‘investor pays’ to ‘issuer pays’, implying that any government or entity issuing debt would pay the rating agencies for rating their debt. One can immediately see the ‘conflict of interest’ problem here. If I can pay a rating agency well, why would they rate me poorly? From a purely business point of view, it doesn’t make sense for a business to treat their prized customer poorly.
In 1981, the discussion of the business and logic of credit ratings took on an academic tone when two economists, Nobel Prize winner Joseph Stiglitz and Andrew Weiss, published a seminal paper about the economics of credit ratings. What they argued was that, in terms of credit lending, the lender faces substantial information asymmetries. These asymmetries prevent the supply and demand forces in credit markets from working smoothly. The lenders, instead of indulging in the cumbersome and challenging task of verifying a borrower’s potential to repay the loan, outsource this job to people or institutions who specialise in this work, ie the credit rating agencies.
Stiglitz co-authored another paper on the role of rating agencies leading up to the 1997 East Asian financial crisis. But this time the study brought to light a grave consequence of reliance on the credit rating agencies. This consequence, which our policymakers need to keep in perspective, has to do with capital flight when a change in credit ratings occurs. When credit rating agencies downgraded East Asian economies’ ratings, capital left these countries at lightning speed, putting their economic existence in peril.
Not surprisingly, the ‘issuer pays’ mode of conducting business has led to terms like ‘ratings shopping’, whereby issuers of debt shop for a rating agency that can give their debt a good rating. Late last year, Pakistanis woke up to a story about an ‘IMF publication’ that declared Pakistan’s finance minister and his team as outstanding performers. Within a day, however, not only did IMF angrily distance itself from any such publication, but it was also revealed that at least five Pakistani government departments had paid this ‘IMF publication’ handsomely (with taxpayer money) to publish some ads. Apparently, as a token of thanks for this generosity, adulation for the finance minister followed.
Perhaps nothing reflects the shortcomings of this credit rating system better than the great recession set in motion by the failure of Lehman Brothers and Bear Stearns in 2008. Their failure set off a chain of disasters from which the global economy has yet to fully recover. From 2006 to 2008, incidentally, the leading credit rating agencies gave these institutions an ‘A’. A report by a US government commission set up to investigate the reasons leading to the recession termed the three leading rating agencies as ‘key enablers of financial meltdown’. Other noticeable failures include the East Asian crisis (1997), the Enron and WorldCom scandals (early 2000s) and the ongoing Greek debt crisis.
In short, credit rating agencies do not necessarily factor on-ground economic realities when rating. What, then, should one make of the government’s economic managers parading the certification of these rating agencies as a proof of their good economic performance? The S&P website carries the following disclaimer: “Credit-related or other analyses … are not statements of fact … The Content should not be relied on and is not a substitute for the skill, judgement and experience of the user…”
Need I say more?
The writer is an economist.
Published in Dawn, March 27th, 2017
