No one said setting up an early warning system for a global financial storm was easy. Among those blamed for failing to spot the 2008 subprime crisis are senior politicians, the world’s biggest banks and several supranational institutions.
However, with the US Federal Reserve and Bank of England likely to raise interest rates, China’s growth slowing and commodity prices falling, we need an effective way to spot the gathering clouds now as much as ever. For many, that means turning to credit rating agencies — despite the fact that they failed to detect signs of crisis on the horizon in the last decade
Credit rating agencies matter. These private companies assess the ability of debtors, including countries, to repay. Because regulators often defer to their assessments of the risk inherent in holding a particular asset, they in effect dictate what investors can invest in, and how much.
They help to determine how much banks are willing to lend, and how much governments — and their citizens — must pay to borrow. They inform with whom corporations are willing to do business and on what terms.
In principle, credit ratings should be based on statistical models of past defaults. In practice, because there have been very few defaults, sovereign ratings are often a highly subjective affair. Analysts follow developments from London or New York, visiting only when it is deemed necessary because of a notable crisis or because the country pays to be rerated.
This means that ratings are often backward-looking and downgrades too late. Moreover, the agencies may lack the tools to track vital factors such as a country’s ability to innovate and the financial health of non-state actors.
Investors have tried to identify good alternatives to credit ratings. Market assessments of risk, such as sovereign yield spreads and credit default swaps, react fast (and often overreact) — but these are not systematic mechanisms for uncovering hidden risks and avoiding crisis.
In order to assess a country’s macroeconomic risk, one needs to look systematically at its entire balance sheet, including risk in the financial system and the wider private sector.
Consider the rating agencies’ optimism over China. Local governments, state-owned enterprises and the construction industry are horribly over-indebted. True, the national government has plenty of resources to bail them out. But Beijing will face a choice: reform, or take on further debt to stimulate the economy. Either way, I believe it will fail to achieve its 7 per cent growth target this year.
Brazil should have been downgraded to below investment grade last year as it struggled with a widening fiscal deficit, a growing debt burden in the wider economy and a weak and worsening business environment. Yet rating agencies are only now starting to look closely at the country, mainly because of a corruption scandal at Petrobras, the state-controlled oil company.
Meanwhile, investors are missing opportunities in Hungary, which should have been returned to investment grade as early as 2013. Since it lost the accolade two years earlier, the government has trimmed its deficit. Household balance sheets have also been improving. Ireland, too, deserves to be upgraded following fiscal consolidation.
Spotting risk is difficult, and it is tempting to let others do the hard work. But rating agencies follow an ad hoc and slow-moving approach. Market signals, such as the interest rates payable on sovereign bonds, are noisy and volatile. It takes systematic, data-driven analysis to understand the dangers hidden in a shifting global economic scene.
Nouriel Roubini is chairman of Roubini Global Economics and Professor of Economics at the Stern School of Business, NYU