Page 108 - ES 2020-21_Volume-1-2 [28-01-21]

Does India’s Sovereign Credit Rating reflect its fundamentals No! 91

have a drastic impact on prices because these rating changes can affect the pool of investors.
These effects are not confined to the pool of investors acquiring sovereign debt. When a credit
rating agency downgrades a country’s sovereign debt, all debt instruments in that country may
have to be downgraded accordingly because of the sovereign ceiling doctrine. Commercial banks
downgraded to subinvestment grade will find it costly to issue internationally recognized letters of
credit for domestic exporters and importers, isolating the country from international capital markets.
Downgrading corporate debt to subinvestment grade means that firms will face difficulties issuing
debt on international capital markets”.

Gültekin-Karakaş, Hisarciklilar and Öztürk (2010) studied the sovereign credit ratings of 93 countries
from 1999-2010 and found evidence that CRAs give higher ratings to developed countries regardless
of their macroeconomic fundamentals. They suggested that macroeconomic fundamentals should be
of core importance in assigning sovereign credit ratings since they indicate the ability and willingness
to pay of countries.
Vernazza and Nielsen (2015) decomposed the sovereign credit ratings assigned by CRAs into objective
and subjective components. They found that the objective component has explanatory power to predict
defaults in the short and long run. However, they found that the “damaging bias” of sovereign credit

ratings lies in its ‘subjective’ component, which biases default predictions in the wrong direction,
with potentially dramatic consequences. Vernazza and Nielsen (2015) suggested that the “biggest
casualty of this was the Eurozone periphery, which was downgraded far too heavily during the 2009–
2011 sovereign debt crisis as the rating committees repeatedly overruled the signal coming from
fundamentals. In light of our findings, we suggest that credit rating agencies should be stripped of their
regulatory powers and these transferred to an international body. Failing that, the ratings agencies
should be forced to substantially increase transparency, including publishing a separate breakdown
of the ‘objective’ and ‘subjective’ components of ratings, the minutes of the rating committees, and
the voting records”.
De Moor, Luitel, Sercu and Vanpée (2018) found that the subjective component of S&P, Moody’s and
Fitch ratings tends to be large, especially for low-rated countries. Through their study of 23 developed
and 80 emerging economies during 1995-2014, they observed that for the lowest-rated countries, the
subjective component of sovereign credit ratings led to a downward adjustment of the objective
rating by up to five notches while for the highest-rated countries, it led to an upward adjustment by
one to four notches. They also found that this subjective component was uniform across credit rating
agencies and varied mildly over time without following clear trends.
Tennant and Tracey (2016) observed scope for bias in sovereign credit ratings regarding choice
of determinants and weights assigned to them, which is further enhanced given their opacity and
subjectivity. Their study of 132 countries during 1997-2011 highlighted distinctions between ratings
actions taken for high income and lower-middle and low income countries, as well as between
regional grouping of poor countries. Their results provided clear empirical indications of bias – “S&P,
Moody’s and Fitch all find it more difficult to upgrade poor countries relative to rich countries, for
any given improvement in ability and willingness to repay debts. S&P and Fitch are further shown to
find it more difficult to upgrade African countries relative to other developing countries, for any given
improvement in ability and willingness to repay debts. These results are taken as a strong indication
of bias, as they are highly significant even though we controlled for the key observed economic and