The Impact of Credit Rating Agencies

Abstract

The purpose of this dissertation is to determine the effect of credit rating agencies (CRA) on the assessment of a countries' risk. CRAs have an important part in financial markets since they help reduce the misinformation between investors and lending institutions, on one side, as well as the credit worthiness of companies as issuers on the other side. Specifically, I will endeavor to determine the country risk and to what extent it might affect foreign direct investment decisions (FDI). In this analysis, I will focus on a set of variables in selected countries that have a significant effect on credit rating. These variables include; GDP per capita, Real GDP growth per capita, the consumer price index (CPI), The ration of government fiscal balance to GDP and  the government debt to GDP. In addition, I will endeavor to analyze the FDI inflows of these countries for the period 2005-2010 in order to determine the effectiveness of CRAs in determining country risks. The assumption in using FDI is that countries with high risks will attract less FDI.

Introduction

Credit rating agencies (CRAs) analyze and assess the level of creditworthiness of corporate and sovereign issuers of debt securities. In recent times they are expected to become an integral part in the management of both the corporate and sovereign credit risk.

According to Damodaran (2003), the logic that forms the basis of the existence of CRAs is to bridge the gap between the informational asymmetry between the providers of capital and borrowers regarding the creditworthiness of the latter. The borrowers with a low credit rating usually pay high rates of interest than highly rated issuers. In addition, credit rating determines the eligibility of debt and other financial instruments. The rating agencies are categorized into two; recognized and non-recognized. The first one is recognized by supervisors in each country for purposes of regulation. However, a majority of CRAs are 'non-recognized'. These include the Economist Intelligence Unit (EIU), Institutional Investor (II), and the Euromoney.

There is a big difference that exists among CRA, which could be as a result of size and scope of coverage, that is, geographical or sectoral. In addition, there are also several differences in their methods of operations as well as how they define risk. This makes their comparison to be quite difficult. There has been an outcry from legislators and other players concerning the effectiveness of CRAs in determining country risks. This has been fuelled by the failure of the agencies in predicting the 1997-1998 Asian crisis, bankruptcies of WorldCom, Parmalat, and Enron. Therefore, questions have been asked concerning the rating process and the accountability of the agencies.

In order to evaluate the effectiveness of CRAs, I will examine the effect of country risk on FDI inflows of selected countries. FDI is the long-term flow of investments that have a significant influence on the investing enterprise. Selected variables will also be evaluated to gauge their impact on credit rating of these countries.

According to Hauser (2005) the major difference between FDI and other forms of investments is that FDI aim is to acquire long-term interest outside of the country of the investor. Indeed, Shaheen (2005), and Jensen (2003) define FDI as the investment of privately owned capital in a foreign country. There are several definitions of country risk. According to Meldrum (2000), country risk can be attributed to uncertainties rather than well established statistical risks. White and Fan (2006) define country risk as the unanticipated downside variability in a key performance indicator. Hoti and McLeer (2002) define it as the likelihood that a state may be unable to fulfill their obligations to a foreign lender.

According to Gertchev (2006) CRAs use public and non-public data and information about economic and political factors that have the potential to affect the willingness of a government or firm to meet their debt obligation in a timely manner. However, CRAs do not have transparency and have no clear information concerning their methodologies. As Shaheen (2005), observes, ratings are sticky and tend to overreact when there are changes in the markets. This behavior could be the result of recent financial crisis, which contributed to instability in many countries. According to Hoti & McLeer (2002), the actions of countries to retain their ratings though tough macroeconomic policies could be counter productive for long-term growth and investment.

An important model that must be taken into consideration when determining country risk is the Basel II model. The purpose of the model is to create an international standard to be used by banks when formulating regulations on how capital banks can guard against inherent risks when lending to foreigners. Changes in banking rules under Basel II have led to new roles to credit rating. Rating can be used to provide risk weights determining minimum capital charges for several types of borrowers.

Methodology

The processes and methods that are used to establish credit rating vary significantly among CRAs. Credit rating agencies have traditionally relied on a process based on qualitative and quantitative assessment that is reviewed by a rating committee. In this analysis, I will heavily rely on quantitative statistical models based on publicly available data because the process is more mechanical and involves less reliance on confidential data. I will use regression analysis to determine variables that greatly increase a country's risk. The key measure in my analysis would be the measure of probability of default, PD, but exposure is also evaluated by expected timing and the recovery rate, RE after default has been experienced.

2.0.1. The Variables that I Intent to Use:

For practical purposes I will use a limited set of variables that have a significant effect on credit rating

1. GDP per capita,

2. Real GDP growth per capita

3. The consumer price index (CPI)

4. The ration of government fiscal balance to GDP

5. The government debt to GDP

2.0.2. Expected Results

The expected results of my analysis is that higher GDP per capita led to higher ratings; higher CPI inflation to lower ratings, the lower the rating, the lower the government balance as a ration to GDP. The higher the fiscal deficit and government debt to GDP lead to lower ratings. In the analysis of FDI, it is expected that those countries that attract less FDI can be considered to be high risk countries.

3.0. Time Schedule

Week 1  Prepare research proposal

Week 2  complete literature review

Week 3  complete field work

Week 4  Complete analysis

Week 5  Give presentation

Week 6  Complete final report

3.1. Limitations of the study

1. Time constraints

2. Financial constraints

3. The scope of investigation is wide