South Africa is in panic mode about the looming threat of a rating downgrade by agencies such as Moody’s Investor Services.
This has even introduced us to a new lexicon that laymen like me had never heard: a nation status that is regarded as junk.
Read: Don't downgrade us, Solidarity urges Moody's
Once a beacon of hope for the whole continent, a fast-booming African economy and a miracle nation of Nelson Mandela is now regarded as “junk”.
I can’t believe this. I had to ask myself: Whose interests are these agencies serving?
My limited knowledge tells me an agent is in business to maximise earnings. Revenues have to be generated from somewhere.
Read: Moody's team set for SA mission
When agencies rate others for a fee, there is clearly a potential for conflict of interest. Isn’t that so?
Credit-rating agencies perform a valuable function for the financial market by producing and assembling information which many investors in less transparent markets would find prohibitive to develop on their own.
This information is shared with large numbers of creditors, each of which typically has a relatively small stake in the borrowing entity.
The information helps avoid Type I and Type II errors in the lending process; ie extending credit that in retrospect should not have been extended, and not doing so when in retrospect credit should have been given.
Read: Weak growth to trim SA revenue - Moody's
Their job can be divided into two main categories; signalling and certification. Signalling involves new information or interpretation provided to the market, which influences how a particular debt issue gets placed; it lowers the cost of capital for the issuer and simultaneously improves portfolio efficiency for the investor.
Certification involves the eligibility of a particular debt issue with regard to portfolio eligibility standards set by regulators, fund trustees, or boards of directors.
The rating agencies, in short, play a key role in the infrastructure of the modern financial system.
By reducing information costs, they dramatically boost both fixed and dynamic market efficiency, the results of which are widely spread among financial intermediaries and end-users of the financial system.
Wasn’t it the same “reputable” agencies, Moody’s and S&P, that were blamed in the aftermath of the Enron collapse - for lending their approval to dubious bonds and issuers? Yes, it was.
Their former employees captured the attention of a hearing in the US with stories of how large sums were being paid by banks to get high ratings.
Honestly; why should we place our faith in these over-rated market guardians, again?
The potential conflict of interest facing rating agencies is inherent and very clear. The question is not whether such conflicts of interest exist. They do.
Rather, what checks and balances are there which prevent the conflicts of interest from being exploited?
Just like the Structural Adjustment Programmes (SAPs) in Africa, the credit ratings are propagated as “economic divinities” to save us from our inevitable economic downfall. We won’t forget that the SAPs did not assist African development. “Assistance” was firstly formulated with reference to two parameters: the effectiveness and necessity of SAPs.
Standard & Poor’s credit rating for South Africa stands at BBB-. Moody’s rating for South Africa’s sovereign debt is BAA2.
Fitch’s credit rating for South Africa is BBB. In general, a credit rating is used by sovereign wealth funds, pension funds and other investors to gauge the credit worthiness of South Africa, thus having a big impact on the country’s borrowing costs, so they tell us.
What they don’t tell us about these agencies is that, firstly, the credit-rating agencies usually provide ratings at the request of the institutions themselves. Although they sometimes conduct unsolicited evaluations on companies and sell the ratings to investors, they usually are paid by the very same companies they are rating.
Since the company pays the ratings agency to determine its rating, that agency might be inclined to give the company a more favourable rating to retain their business. The US Department of Justice had started investigating the credit-rating agencies for their role in the mortgage-backed securities that collapsed in 2008.
Second: there are no standard formulas to establish an institution’s credit rating; instead, credit-rating agencies use their best judgement. Unfortunately, they often end up making inconsistent judgements, and the ratings between different credit rating agencies may vary as well.
Last: although credit rating agencies offer a consistent rating scale, that does not mean that companies are going to be rated accurately. For many years, the credit ratings of these agencies were rarely questioned.
However, after rating agencies provided AAA ratings for the worthless mortgage-backed securities that contributed to the recession, investors don’t have nearly as much faith in them.
Their ratings are still referenced by almost everyone, but their credibility has taken a serious hit.
Even though this is history, the SAPs were finally rejected: their “moral language” of development exposed as a smokescreen to obscure western self-interest.
Similarly; the credit ratings must be studied and their smokescreen credibility exposed in their conflict of interests with the Western financial markets.
The idea behind credit ratings assisting our creditworthiness is what remains of this smokescreen.
The man widely regarded as the father of economics, Adam Smith, famously said: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”
Self-interest is a most powerful trait in most human beings. Indeed, if the world were full of the self-seeking individuals found in economics textbooks, it would grind to a halt because we would be spending most of our time cheating, trying to catch the cheaters, and punishing the caught.
We need to design an economic system that, while acknowledging that people are often selfish, exploits other human motives to the full and gets the best out of people. The likelihood is that, if we assume the worst about people, we will get the worst out of them.
* Chris Maxon is a political commentator and public servant.
** The views expressed here do not necessarily reflect those of Independent Media.
*** Check out the print edition of Business Report tomorrow for further coverage.
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