37 The Use of Ratings in the European Capital Markets by Kristian Sparre Andersen and Anders Matzen, Financial Markets Department Introduction Until now professional ratings of bond issues, etc. have been more widely used in the USA than in Europe. The size and diversity of the US capital market mean that in the USA ratings naturally play an important role in the assessment of the credit risk associated with placement of funds in the bonds of a certain issuer. The general integration of the European capital markets after the establishment of the Economic and Monetary Union (EMU) may entail that ratings acquire a more important role in Europe. This article describes several factors of significance to this development. Greater use of ratings within the EMU is also expected to influence the Danish capital market. In the light of this development it is important to understand the information value of ratings, including the pitfalls associated with their use, cf. Box 1 which describes the rating scale used by the rating agencies. In this connection the historical performance of the rating agencies is described. There is a clear relationship between the rating given to a bond and the probability of contractual default by the issuer of that bond. At the same time, however, the development in Asia in 1997 shows that there are situations where the ratings did not reflect the actual credit risks. This is probably due to the agencies' relatively recent experience of carrying out credit ratings in these markets. This article thus concludes by considering whether the experience from Asia can be applied to Europe, in a situation where ratings are used more widely. The use of ratings in the European capital markets By tradition, ratings have been used far more extensively in the USA than in Europe, cf. Box 2. Widespread use of ratings generally requires the following: Investors must find a need for information on counterparty risks. Experience from the USA shows that the use of ratings has declined in periods where investors have not found the bonds offered in the market to be associated with any significant credit risk.
38 The use of ratings must be efficient in the sense that alternative ways of obtaining equivalent information must be more expensive or less convenient. Financial companies with credit extension as a core activity, e.g. banks, need ratings less than other investors who do not share their expertise in credit assessment. Investors must therefore believe that the application of ratings will reduce the uncertainty concerning the credit risk on investment in bonds. Ratings must be perceived on the one hand as fair by the issuers and on the other hand as reliable by the investors. A precondition for more widespread use in Europe is that rating agencies are recognized by the market participants. The agencies rely on issuers' fees for ratings as their primary source of income. This entails a risk of excessively generous ratings. However, the credibility of the rating agencies depends on investors' confidence that the actual credit risk associated with a given issuer/borrower is reflected in the rating given. If this is not the case, bond issuers/borrowers will no longer be interested in having their debt rated. A rating must enhance the issuer's opportunities to market its debt. Non-rated debt is often impossible to market to many investors. This is particularly true when the bond issuer and investor are far apart, either due to the considerable size of the domestic capital market (as in the USA) or because issuer and investor are domiciled in two different countries. Danish investors' purchases of Danish mortgagecredit bonds thus do not depend on the rating of the bonds, whereas it has proved considerably easier to sell rated mortgage-credit bonds to non-resident investors. The aforementioned factors entail that ratings are used primarily in connection with bonds and other negotiable debt securities. The combined bond markets of Europe are approximately the size of the US bond market, cf. Table 1. However, several factors have contributed to the less extensive use of ratings in Europe. A significant difference between the capital markets of the USA and Europe is the widespread use of financing by issue of debt securities by non-financial companies in the USA. In the period 1992-97 non-financial companies' average annual bond issues on domestic markets were the equivalent of $0.5 billion in Germany, $1.5 billion in the UK and $8 billion in
39 Table 1 Outstanding negotiable debt securities Public sector 1996 1997 Private sector USD billion Public sector Private sector EU-15... 4,974.4 4,045.4 4,545.5 3,926.8 Japan..... 3,302.1 1,787.5 3,140.7 1,612.0 USA... 7,107.7 4,902.3 7,386.5 5,583.5 Source: Bank for International Settlements, International Banking and Financial Market Developments. France. For comparison, bond issues by non-financial companies in the USA amounted to $178 billion. 1) The European capital markets generally adhere to national borders and resident investors often obtain information concerning the creditworthiness of issuers via other channels than rating agencies. Ratings normally play a less significant role for government bonds than for other bonds since the former are associated with an insignificant credit risk. This applies especially to issues in domestic currency where the central government's repayment ability is strong as a consequence of its access to levy taxes and in certain countries (outside the EU) also to undertake monetary financing, i.e. to repay the loan by borrowing from the national central bank. Therefore most central-government issuers have traditionally had only their foreign debt rated, whereas the rating of domestic central-government debt has only become common in recent years, in order to make domestic government securities attractive to international investors. In the light of the growing internationalization of financial markets in Europe it is becoming more likely that European market participants will use ratings as much as their American counterparts. In this connection nonfinancial companies' greater use of debt securities issues to raise capital and investors' preference for a geographical spread of their placements in order to diversify the market and credit risks, are key factors. The establishment of the EU single market for financial services, with the liberalization of capital flows across national borders, has been a significant force driving this development. The internationalization of the European capital markets is also apparent in Denmark. It can thus be observed that ratings are increasingly used by 1) OECD, Monthly Financial Statistics.
40 Box 1 The rating scale used by the rating agencies Rating of a bond issuer/borrower should be interpreted solely as an evaluation of the credit risk assumed by the investor on acquiring a claim on the issuer/borrower. Evaluation of other risks entailed by the asset, e.g. interest rate and currency risks, is not included in the rating. A rating never constitutes a recommendation of the liabilities of a given issuer or borrower and ratings should always be used subject to the investor or borrower's own liability and risk. The rating scales for long-term debt used by Moody's and Standard & Poor's are shown below with a summary definition of the interpretation of the individual grades. The rating agencies' "Long Term Debt Rating" is the original rating and the one which is normally considered most important. Today, there are also several other types of rating, including a "Short Term Debt Rating" and a number of special ratings applied to financial enterprises. This article is based on the long-term ratings. Moody's S & P Definition Investment grade Aaa AAA Best credit quality, extremely strong ability to repay debt Speculative grade B1 B+ Moderate security of payment. Ability to pay is B2 B present now, but great risk of problems B3 B- Aa1 AA+ Very high credit quality, very strong ability to Aa2 AA repay debt Aa3 AA- A1 A+ Credit quality above medium, strong ability to A2 A repay debt A3 A- Baa1 BBB+ Good credit quality, satisfactory ability to repay Baa2 BBB debt Baa3 BBB- Ba1 BB+ Speculative elements, considerable factors of Ba2 BB uncertainty Ba3 BB- Caa1 CCC+ Ability to pay threatened, very vulnerable to Caa2 CCC payment problems (at Moody's possibly also Caa3 CCC- defaulted) Ca CC Significant payment difficulties (at Moody's C C often defaulted) D D Defaulted
41 Box 2 Historical review of the activity of the rating agencies Already before World War I a number of agencies in the USA provided assessments and analyses of the credit risk on bonds issued by private enterprises. Initially, this solely concerned private railway companies which at that time were the largest borrowers in the USA, but gradually the activity was expanded to also include major manufacturing enterprises, public utilities and countries, municipalities and other regional authorities. In 1920 the number of enterprises with bonds carrying a Moody's rating exceeded 3,000. The number of rated enterprises then fell, among other things as a result of consolidation of US railways and public utilities and the depression in the 1930s. The number of rated enterprises reached its lowest level around 1950 when Moody's evaluated less than 700 business enterprises' long-term debt. Another factor contributing to the decline between 1920 and 1950 was that business enterprises mainly raised bank loans instead of issuing bonds. During the 1980s the use of ratings in the USA began to rise again. This was attributable to the development of the "junk bond" market, a market for high-yield, high-risk bonds. At the close of 1997 approximately 4,000 enterprises throughout the world were subject to rating. Use of ratings outside the USA has been far less prevalent. Non-American issuers' reasons for acquiring a rating have usually been motivated by a wish to market bonds to American investors. The number of non-american enterprises with a rating has risen strongly during the 1990s and constituted 38 per cent of the enterprises given a rating by Moody's at the close of 1997. The greater use of ratings in the USA is also attributable to the fact that since the 1930s US banks and insurance companies' placements of funds have been subject to restrictions applied as minimum requirements of the issuer's rating. The sectoral distribution of rated enterprises has not been constant over time. In the 1920s rated enterprises holding a rating were concentrated in the transport sector and public utilities. In the 1990s manufacturing enterprises and financial companies account for the majority of the enterprises rated by the agencies. Civic and other regional authorities today constitute a very large market for the rating agencies in the USA. This is not the case in Europe. The article therefore focuses solely on rating of business enterprises and countries. In addition to the two large agencies, Moody's Investors Service and Standard & Poor's, there are a number of smaller rating agencies which have specialized in credit assessments within one or more sectors, e.g. the financial sector, or a specific geographical area. Danish market participants. During the last few years five out of six mortgage-credit institutes have had their most frequently traded bonds rated. This is of relevance to international investors' interest in these bonds, since the proportion of rated mortgage-credit bond series held by non-residents is far greater than for non-rated bond series.
42 Over time EMU will probably lead to a merging of the capital markets of the 11 participating countries. 1) The irrevocable locking of the exchange rates of the EMU countries will eliminate the element of the interest-rate differentials among the participating countries attributable to the exchangerate risk. Investors' opportunities to achieve a higher return due to the volatility of the differential between government securities in the euro area will thus be reduced. Investors requiring higher yields than those available on the benchmark securities of the euro area are therefore expected to focus on issuer-specific factors related to credit risk, etc. 2) In this connection the rating of each issuer will draw more attention, as is the case in the USA. In the third stage of EMU the present segmentation according to national borders will disappear. Public regulation such as the requirement that institutional investors make placements in the national currency will no longer be relevant within the euro area. 3) Furthermore, the varying taxation of domestic and foreign assets will probably lapse in the slightly longer term, although it cannot be ruled out that in the short term certain tax-related factors will entail the continued segmentation of the bond markets within the euro area. Investors will face a far greater number of issuers, which will increase the need for information on the credit standing of the issuers. In this connection it is likely that investors to a greater degree will base their credit assessment of issuers on the agencies' ratings. At the same time, the more intense competition for investors arising from the increase in the range of placement opportunities for each investor will encourage issuers to submit to a rating. As Denmark is not a participant, the commencement of the third stage of EMU on January 1, 1999 will not immediately change conditions in the Danish capital market. However, the growing market integration within the euro area must also be expected to affect the Danish capital market. Greater use of ratings in the euro area will thus naturally make Danish market participants more aware of ratings. Rating agencies' view of the countries participating in the third stage of EMU On the commencement of the third stage of EMU the rating agencies' evaluation of the individual issuers will change. The changes will in par- 1) 2) 3) On May 1-3, 1998 the European Council nominated the countries to participate in the third stage of EMU as of January 1, 1999. They are: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain. Bertil From, "Yield Differentials in the Future EMU", Danmarks Nationalbank, Monetary Review, May 1997. For example, the third life assurance directive includes consistency rules to the effect that 80 per cent of the technical reserves must be in the same currency as the future payments.
43 ticular be a consequence of greater differentiation of the credit risk within the individual issuer groups, including central-government borrowers. This is expected to contribute further to greater focus on ratings in Europe. Moody's Investors Service and Standard & Poor's have adjusted their ratings of central-government issuers in several euro countries. However, the two agencies have taken different approaches to the consequences of EMU for the rating of central-government issuers in the participating countries. This is due to their differing assessments of the factors influencing whether a central-government borrower defaults on debt repayments. The relevant factors include: The debt ratio The central government's access to monetary financing Access to levy taxes The possibility of bail-out by other central governments or supranational institutions Domestic and foreign debt are normally assessed differently. The central government's access to monetary financing, i.e. its access to borrow from the central bank, is of significance only to the credit rating of the central government's domestic debt. Central governments levy taxes in domestic currency. A central-government borrower must obtain foreign currency to repay the government debt denominated in foreign currency. The risk of a central-government borrower's default on payments denominated in foreign currency is therefore considered to be greater. A central-government borrower's debt denominated in foreign currency is also subject to rating on the allocation of the sovereign ceiling. The sovereign ceiling indicates the highest rating possible for a country's issuers of debt denominated in foreign currency. 1) It is assumed that if the centralgovernment borrower cannot obtain foreign currency to service the external government debt, the other borrowers will not be able to do so either. The shortage of currency experienced by other borrowers may be due either to a general flight of capital or to various capital restrictions introduced to prevent this flight. The probability of a currency shortage is evaluated to be greatest in countries with a net foreign debt. The foreign debt is therefore an important parameter in the agencies' rating of a central government's foreign debt. 1) There are a few examples of issuers of debt in foreign currency having a higher rating than indicated by the sovereign ceiling. Usually this is related to special circumstances concerning the borrower. For example, Øresundskonsortiet A/S has an AAA rating at Standard & Poor's, while the sovereign ceiling for both Sweden and Denmark is AA+.
44 In its rating of domestic central-government debt Standard & Poor's attaches great importance to whether the central government has access to monetary financing. Repayment of the central-government debt by means of monetary financing does entail a risk of inflation eroding the real value of the debt, but it should be noted in this connection that a rating solely expresses the credit risk on a given asset, but not any other risks associated with the bond, such as interest, foreign-exchange or inflation risks. Standard & Poor's finds that the lack of access to monetary financing will diminish the creditworthiness of central-government issuers. As a consequence, in May 1998 the rating of the domestic central-government debt of countries participating in EMU was downgraded to the rating applied to the central-government issuer's debt denominated in foreign currency, even though no EU member state has had access to monetary financing since the transition to the second stage of EMU in January 1994. It should be noted that the downgrading by Standard & Poor's applies only to central-government issuers in countries participating in the third stage of EMU. The rating of Denmark's domestic central-government debt (AAA) was therefore not lowered to the level for Denmark's foreign debt (AA+). In contrast, Moody's Investors Service believes that the access to levy taxes is of vital significance to the creditworthiness of a central-government borrower. This access is not affected by EMU. In this respect EMU differs from a federal structure since there is no supranational authority which imposes practical or legal limitations on the ability of each participating country to regulate direct and indirect taxation. In the short term, Table 2 Changes in the rating of central-government borrowers as a consequence of EMU Moody's Standard & Poor's Domestic debt Foreign debt Domestic debt Foreign debt Belgium..... Aa1 Aa1 AA+ AA+ Finland..... Aaa Aaa AA AA Ireland..... Aaa Aaa AA+ AA+ Italy..... Aa3 Aa3 AA AA Portugal..... Aa2 Aa2 AA- AA- Spain..... Aa2 Aa2 AA AA Denmark..... Aaa Aa1 AAA AA+ Note: Rating in bold indicates change. indicates direction of change. Domestic debt of all EMU countries was rated AAA by Standard & Poor's prior to their EMU nomination. The rating of the other EU member states has not changed in connection with the commencement of EMU.
45 Moody's will therefore maintain the present ratings of the domestic centralgovernment debt of the participating countries. Since the euro area is a net creditor vis-à-vis the rest of the world, Moody's Investors Service has given all EMU countries the highest sovereign ceiling (AAA). To the extent that the rating of the central-government borrower's debt denominated in foreign currency was previously lower than the rating of the central-government borrower's debt denominated in domestic currency Moody's has upgraded the rating of the central government's foreign debt. Standard & Poor's has also raised the sovereign ceiling of the EMU countries to AAA, but as stated this has not entailed upgrading of central-government borrowers' rating. Table 2 shows the two agencies' rating of the domestic and foreign central-government debt of selected EMU countries. For non-central government borrowers located in one of the participating countries the common sovereign ceiling for the euro area entails that a higher rating can be obtained for borrowing in foreign currency than that applying to the external debt of the central government in the relevant country. This may stimulate issuing activity in the international bond markets. The quality of the ratings by rating agencies It is relevant to investigate whether the agencies' assessments of the credit risk associated with the bond issuers are in accordance with the actual conditions. Table 3 Default rates of bond issuers, 1970-97 Initial rating Defaulted after: 1 year 3 years 5 years 7 years 10 years 15 years Per cent Aaa... 0.00 0.00 0.14 0.37 0.82 1.71 Aa... 0.03 0.10 0.39 0.70 1.07 1.79 A... 0.01 0.21 0.54 0.92 1.65 3.06 Baa... 0.12 0.75 1.70 2.74 4.53 7.98 Ba... 1.34 6.21 11.44 15.53 20.88 30.42 B... 6.78 19.13 28.59 35.91 43.85 49.41 Caa-C..... 20.51 34.10 41.44 51.52 63.13 65.96 Investment grade.. 0.05 0.34 0.84 1.40 2.40 4.35 Speculative grade.. 3.86 11.32 17.68 22.52 28.27 36.73 Source: Moody's Investors Service, "Historical Default Rates of Corporate Bond Issuers, 1920-97", February 1998. Note: Differentiation of ratings by numerical suffixes is omitted from the table.
46 Table 4 Average annual change in ratings, 1981-97 To From AAA AA A BBB BB B CCC Defaulted Rating discontinued 1) AAA.. 88.77 7.80 0.68 0.05 0.10 0.00 0.00 0.00 2.60 100 AA.... 0.68 88.28 7.24 0.55 0.05 0.15 0.02 0.00 3.03 100 A..... 0.07 2.25 87.88 4.88 0.61 0.25 0.01 0.05 4.01 100 BBB... 0.03 0.28 5.33 83.01 4.44 0.99 0.10 0.18 5.63 100 BB.... 0.02 0.10 0.53 7.07 74.44 7.27 0.79 0.91 8.87 100 B..... 0.00 0.08 0.25 0.41 6.12 73.03 3.32 4.74 12.06 100 CCC... 0.16 0.00 0.32 0.97 2.26 9.86 53.15 18.90 14.38 100 Total Source: Standard & Poor's, "Rating Performance 1997", January 1998. Note: Differentiation of ratings by addition of + or - is omitted from the table. 1) In most cases discontinuation of a rating is due to the fact that the debt covered by the issuer's rating was redeemed in full without difficulties. The rating of a bond issue must take into account both the probability of default and the size of the loss in the event of default. The principle of the higher the rating, the lower the credit risk, must apply. The use of ratings is thus based on the fact that they provide a consistent ranking of the credit risk on liabilities. In this connection the level of the credit risk at the individual grades of the rating scale is less important. For several years Moody's and Standard & Poor's have published historical data to illustrate the probability of default by rated issuers within various timeframes. Table 3 1) presents data for private business enterprises and central governments which have issued bonds or raised loans rated by Moody's. The Table clearly shows that the lower the rating of the enterprise, the greater the risk of default. However, the average values in Table 3 conceal that the risk of default varies considerably in both the short and medium term. 2) This variation can be attributed to such factors as the effect of the business cycle on the issuer's ability to repay the loan. In principle, ratings do take into account the expected impact of present and future cyclical fluctuations on the ability to repay, but often any problems will only become significant in a recession. 1) 2) The table must be interpreted to show that in the period 1970-97 for example 1.70 per cent of all business enterprises with debt rated Baa have defaulted on their debt obligations within a 5-year timespan. To illustrate this it can be stated that the average risk of 1.70 per cent of default over a 5-year period for debt issued by business enterprieses rated Baa varied between 0.56 per cent and 5.25 per cent in the period 1970-97.
47 It is important that the rating agencies pursue a reasonably consistent rating policy which is not subject to frequent changes. For investors it is important that the meaning of a rating is as stable as possible over time. Investors and lenders who use ratings must likewise be aware that high ratings are changed less frequently than low ratings. If debt of high quality is subject to frequent changes, over a relatively short timespan this debt could shift from a very low risk of default to a position with a quite considerable risk. The value of a rating as a debt-ranking tool would thus be eroded. The stability requirement for high ratings in fact appears to be fulfilled, cf. Table 4, which shows the percentage annual change in Standard & Poor's rating of private business enterprises. Annual movements of more than one grade are rare. While it is easy to relate to the rating agencies' historical data on the risk of default it is considerably more difficult to evaluate whether a rating adequately reflects the expected loss in the event of default. Moody's has sought to solve this problem by setting the loss ratio as the difference between par and the price at which a defaulted liability was traded in the market one month after the default took place. However, this method is extremely sensitive to the development in interest rates and in the economy. Moody's indications of average loss ratios are also given with very broad confidence ranges. Chart 1 Basis points 400 Interest-rate differential between bonds issued by US manufacturing enterprises and US government bonds 400 350 350 300 300 250 250 200 200 150 150 100 100 50 50 0 0 0 5 10 15 20 25 30 Maturity in years AAA AA+ & AA A BBB BB B Source: Bloomberg, August 10, 1998.
48 On evaluating Tables 3 and 4 it is noteworthy that the data basis is dominated by US companies, so that the data cannot immediately be taken to express the rating agencies' ability to rate central governments or business enterprises established in countries whose institutional and legal systems deviate significantly from the conditions in the USA. Experience from the past year's financial and economic crisis in a number of East-Asian countries indicates that no universal interpretation can be applied to ratings by rating agencies. A clear positive correlation can be observed in the US capital market between an issuer's rating and the interest rate required of the issuer in conjunction with bond issues, measured by the interest-rate differential to US government bonds, cf. Chart 1 and Box 3. The ranking by credit risk undertaken by the rating agencies can thus also be observed in the market. It is important to understand that even if the rating scale comprises more than Box 3 The relationship between interest-rate differential and rating Differences in the rating of and the credit risk on bonds are naturally reflected in the interest-rate differentials observed in the market, cf. Chart 1. The widening of the differential between high- and low-rated issuers when the remaining maturity increases corresponds to the expectations of default over time shown in Tables 3 and 4. The marginal change in the interest-rate differential as a consequence of a rating adjustment by one grade is also greater for issuers with a "speculative grade" rating (BB+ or below) than for issuers of "investment grade". The chart also shows that the widening of the interest-rate differential between high- and low-rated issuers subsides after approximately 10 years. An interesting aspect of the default frequency is thus that while there is a growing risk of default over time for issuers with high ratings, the opposite is the case for issuers with low ratings, where the annual default frequency is declining. The explanation is that issuers with the lowest ratings either default (relatively early) or gradually move up the rating scale, whereas high-rated issuers tend to gradually slide down the rating scale, whereby the risk of default is increased. Finally, on determining the risk premium on an issuer with a low rating investors must take into account that an increase (drop) in an issuer's rating entails a capital gain (loss) on the issuer's bond debt. This will tend to make B-rated issues more interesting, since there is a chance of a higher rating despite the high risk of default. On the other hand, AAA issuers can only see their rating reduced. For 8-year periods starting in 1983-89 Moody's has calculated that only 53 per cent of the AAA issuers retained their rating throughout the period. With regard to B issuers, in the same period 27 per cent would have their rating upgraded, while only 12 per cent would see it downgraded.
49 Table 5 Development in Standard & Poor's ratings of Asian countries, 1997/98 Country Rating on June 30, 1997 Rating on June 30, 1998 Change in number of grades South Korea..... AA- BB+ - 7 Malaysia..... A+ A- - 2 Philippines..... BB+ BB+ 0 Singapore..... AAA AAA 0 Hong Kong..... A+ A+ 0 China..... BBB+ BBB+ 0 Thailand..... A BBB- - 4 Indonesia..... BBB CCC+ - 8 Source: Bloomberg. 20 grades, a rating is not an exact measure of the credit risk. For comparison, investors can adjust the required bond yield on a continuous scale. Irrespective of the aforementioned good general correlation between the rating and the yield on US issuers it is usually the case for the individual issuer that a rating is changed after the market has adjusted the yield in the same direction. This has often given rise to criticism. However, it should be stated that not only rating agencies, but also banks and supervisory authorities have often found it difficult to predict deterioration (or improvement) in the payment ability of an issuer/borrower in due time. The rating agencies and Asia The financial and economic crisis affecting a number of East-Asian countries over the last year has given rise to a lot of criticism of the rating agencies. 1) The following is a review of the most significant elements of this criticism. As previously stated, ratings must be perceived as long-term assessments of the issuers' ability to pay. The rating of a country or a business enterprise should therefore not be changed frequently. Moreover, the movement over a short period should only in exceptional cases exceed one grade up or down on the rating scale. In view of the repeated downgrading of certain Asian countries in 1997-98 the agencies cannot be said to have fulfilled their own objective in this area. In this connection South Korea is a particularly striking example. The country's sovereign ceiling had for many years been stable at A1/AA- at respectively Moody's and Standard & Poor's, but during the 4th quarter of 1) Cf. e.g. Euromoney, January 1998 and The Economist, December 13, 1997.
50 Chart 2 Price 120 Price development of South Korean bond (government guaranteed) compared with South Korea's rating and a US government bond Rating (right-hand axis) Rating Aa3 A1 110 A2 A3 100 Baa1 Baa2 90 Baa3 Ba1 80 Ba2 Ba3 70 1st qtr.1997 2nd qtr.1997 3rd qtr. 1997 4th qtr.1997 1st qtr.1998 2nd qtr.1998 3rd qtr.1998 US Treasury 7% 07/15/06 Korea Devel. Bank 7.25% 05/15/06 (government guaranteed) Korea's rating (Moody's) Source: Bloomberg, August 10, 1998. 1997 the sovereign ceiling was reduced by 6-7 grades to Ba1/BB+. The picture is the same for other countries, cf. Table 5. The development in the aforementioned country ratings was accompanied by equivalent lowering of other issuers' ratings of these countries. It has been stated that the agencies reacted too late to the development on the financial markets in Asia. In several cases the changes of the ratings were not announced until after the onset of the financial crisis and when the markets had already reacted by widening the credit differential. With regard to Korea this is illustrated in Chart 2. It should be noted that Moody's downward adjustment from A1 to A3 on November 27, 1997 occurred approximately 3 weeks after the price differential betweeen a South Korean dollar-denominated bond and an equivalent US government bond had widened by over 10 price points. It is likewise remarkable that during the first 9 months of 1997 the price differential between the two bonds widened gradually. This was in accordance with the growing concern at the development in Asia, including South Korea. The problems faced by the rating agencies in Asia are particularly attributed to a lack of insight into the fundamental political, cultural and eco-
51 nomic conditions in these countries. Among other reasons this may be due to a lack of reliable information on which the rating agencies can base their assessments. 1) For example, many market participants, including the agencies, were surprised that a significant part of South Korea's foreignexchange reserve was placed with domestic banks. In practice this impeded use of this part of the reserve. Equivalently, the problems in Thailand were not exactly reduced when it became clear that the published foreignexchange reserve had been eroded by the central-bank's forward purchases of Thai baht. Furthermore, the rating agencies' assessment of the banks in the Asian countries has been influenced by the fact that only relatively few banks in the area were assessed. This implies inadequate market familiarity. This familiarity is a requirement for evaluation of individual banks. As a consequence the agencies did not in time realize and make public the danger that the countries' banking sector as a whole would face difficulties. In their defence the rating agencies have stated that already before the downgrading of Asian ratings got under way they had in several cases issued assessments and analyses drawing attention to some of the conditions contributing to the development of the crisis 2), including the countries' large volume of short-term debt. The agencies have also stated that the plummeting prices for e.g. Korean bonds at the end of 1997 were excessive in relation to the credit risk on the bonds, cf. Chart 2. 3) The substantial movements in bond prices in relation to the agencies' perception of the credit risk can, however, also be taken to indicate that at the close of 1997 investors no longer found ratings in the East-Asian countries to be reliable. For this reason, since the end of 1997 investors have not found ratings to be of any great significance on evaluation of investments in East- Asian securities. It has also been argued that the rating agencies were excessively influenced by issuers and authorities in the relevant countries. For their part, the agencies have put forward examples of how critical statements concerning conditions in the Asian countries were counteracted in statements from e.g. major international investment banks which drew a considerably more optimistic picture of the situation. 1) 2) 3) Niels Peter Hahnemann and Lars Krogh Jessen, "The Currency Crisis in Southeast Asia", Danmarks Nationalbank, Quarterly Review, 4th Quarter 1997. Cf. e.g. Moody's report of May 1998, "White paper - Moody's Rating Record in the East Asian Financial Crisis". In a report from February 1998 "East Asia: A Retrospective", Moody's emphasized the problematic circumstance that many investors either of their own volition or as a consequence of requirements made by the supervisory authorities undertook massive sales of bonds in December 1997 solely on the grounds of the lower ratings.
52 Finally, it should be remarked that on starting up in a new market the quality of the rating agencies' work cannot really be evaluated until actual default frequencies can be compared with the ratings for a sufficiently large number of debtors in the relevant market, over a suitably long period. Since the agencies have only been active in Asia for a short time and cover relatively few issuers, this has so far not been possible. Conclusion The application of ratings to a capital market is closely associated with business enterprises' financing by issuing bonds. Several European capital markets are characterized by a close relationship between banks and business enterprises, where the enterprises by and large obtain financing only via banks and other financial institutions. This explains the so far relatively limited application of ratings in Europe. In step with the growing internationalization of the European capital markets, however, the conditions for the application of ratings appear to have changed. This tendency will presumably be amplified on the introduction of the third stage of EMU. However, a number of conditions must be fulfilled before the ratings can function as a valuable supplement to the investors' own assessment of the credit risk on bond issuers and borrowers: Publicly available information that forms the basis for ratings must be reliable. This has not been the case in Asia. The rating agencies must have in-depth knowledge of the market. This seems to be the case in the USA, but apparently not in Asia. Disregarding the greater similarity between US and European financial markets differing legislation and accounting practices between otherwise closely related countries should not be underestimated. If investors doubt the quality of the agencies' analyses and ratings, this will have a negative impact on the speed at which ratings are applied in Europe. With regard to Denmark, a business structure with many small companies makes an increase in demand for ratings from borrowers unlikely. Only very few business enterprises besides those already rated by the agencies have a borrowing requirement which makes the issue of rated bonds interesting. In this connection the mortgage-credit institutes' great significance to the long-term borrowing of business enterprises plays a central role. Not many Danish companies are likely to be able to improve
53 their terms of borrowing by issuing bonds directly in the market rather than by raising mortgage-credit loans. On the other hand, among for example institutional investors growing use of ratings may be expected, on approximately the same scale as in other European countries, when they invest in European bond issues, cf. the above reservations, however. Any introduction of requirements from the authorities regarding placement of assets by institutional investors, e.g. minimum requirements of the rating of the issuers, will naturally make a significant contribution to this development.