There are some professions that really get all the flak. Who would want to be a traffic warden, a physics teacher or even a South American soccer referee? All you get is abuse. No one understands your decisions. And no one values your contribution to society.
Into this category of Professions People Abuse, I will add that of working for a rating agency. Rating agencies provide an essential service for the smooth flow of information on the capital markets. However, no one claims to understand their decision-making process, no one likes them, and everyone has a story moaning about what the rating agencies have done.
But rating agencies are a fact of life and their power is very, very real. Misunderstand them at your peril.
Take Donald Tsang, the financial secretary of Hong Kong. Yesterday he went cap in hand to New York, to ask rating agencies Moody's and Standard & Poor's to give Hong Kong an upgrade. "With our tested endurance, enhanced economic fundamentals and our unique position in tapping the opportunities arising out of China's accession to the World Trade Organization, I believe there is every reason for credit rating agencies to upgrade their assessment of Hong Kong," said dapper Donald.
Power plays
What is so telling about this statement is that Donald thinks the rating agencies' opinions are important enough to warrant this kind of hard sell. Unfortunately for Donald, he is right. Rating agencies are extraordinarily powerful.
When a rating agency downgrades a country, a company or a deal, the cost of borrowing for that entity can rise exponentially. Even though a certain amount of dislocation between ratings and secondary market spreads, the correlation is still there. And as borrowed money becomes harder to access for weaker credits, a bad assessment by the rating agencies can be the kiss of death.
Already powerful, the agencies are set to get more so. Proposals before the Bank for International Settlements (BIS) - a sort of central bank for all the world's central banks - state that changes should be made to the risk weighting of bank lending around the world. At present, banks risk weight their loan portfolios on where a bank's nationality sits in OECD rankings. The BIS wants this to change so that banks will have to risk weight their loans according to the ratings assigned to the borrower by the rating agencies. This will result in a huge increase in the already very powerful position of the rating agencies.
Clear up the criteria
Going back to Donald, if the rating agencies are as important as he thinks they are now, and they are going to get more so, then it is vitally important that the rating agencies have a clearly defined methodology and criteria for how they award the ratings. I have written before about how the agencies in Asia have shifted the goal posts for assessing sovereign ratings from being based on direct liabilities and export coverage ratios to include all possible contingent liabilities. This is the reason sovereign ratings plummeted in the financial crisis and then have languished only a notch or two above their lows ever since.
There needs to be a clear understanding about how the rating agencies work. Do they look at a borrower's ability to repay their debt? Do they look at contingent credit issues? Do they even look at whether lenders should extend more credit to the borrowers? Do they react to the markets? Or do they drive them?
The opacity in the process has led the financial secretary of Hong Kong into this unseemly positon and it needs to be addressed soon. His contention that Hong Kong is independent of China and has no contingent liabilities as a result may be true. But Hong Kong's unique position in the world as being run under the one country two systems formula just does not fit into the rating agencies scheme of how things are done. There needs to be more understanding by the rating agencies of how Hong Kong in particular and the rest of Asia work. And Asian leaders and company executives need to better understand how the rating agencies work. The lack of clarity by the raters and ratees can only result in more confusion. And confusion is something that is one of the most damaging forces for the international financal system.
