grading the credit rating agencies

image: Fitch’s stylized outline of its Sovereign Rating Criteria.

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August 2, 2023

Yesterday, the credit rating agency Fitch chose to downgrade the United States, mostly on the basis that the US government has a growing debt burden. The downgrade wasn’t large―AAA to AA+, on Fitch’s rating scale―but criticism was swift. 

Prominent economists and commentators immediately called bullshit. Jason Furman noted that the US debt-to-gdp ratio has not risen significantly since last year and that, in the meantime, the macroeconomic situation has substantially improved. Matt Yglesias highlighted that Fitch predicts a recession later this year, against all odds. Paul Krugman admitted that, while the US does have real governance issues with passing any kind of spending or tax bill, that’s never recently been a downgrade-worthy issue for Fitch. And Treasury Secretary Janet Yellen criticized Fitch for ignoring how Biden-era legislation reduces the federal deficit.

As the world’s leading economy (and also hegemon), the US won’t face real consequences for this downgrade: the dollar isn’t losing its reserve currency status anytime soon, nor will investors suddenly bet against today’s economic boom. Fitch is ignoring reality, and economists are rightly ridiculing its decision as farce. Not to be that guy, but it would be nice if they did this more often in support of Global South countries―where credit rating volatility is far more important and, when it comes to climate impacts, far more dangerous.

When the United States isn’t being downgraded, US policymakers (like those in Yellen’s Treasury Department) uncritically treat the credit rating agencies (CRAs) as legitimate judges of the financial responsibility of other governments and international institutions. In their view, a good credit rating from Moody’s, S&P, or Fitch―the three leading CRAs―reflects a country’s or institution’s apparent fiscal and macroeconomic prudence, thereby allowing it to raise debt more cheaply. (This fixation preoccupies the policymakers currently pushing to retool the World Bank and its sister institutions: under no circumstances should the World Bank’s spending plans cause it to lose its top-tier rating.)

In the abstract, there seems nothing wrong with governments demonstrating financial responsibility to external observers to secure lower borrowing costs. But CRAs’ ideas about “financial responsibility” are often more farce than fact. Not only are their ratings often at odds with reality, as the US downgrade exemplifies, but, across the Global South, their ratings make it actively more challenging for governments to undertake actually responsible macroeconomic policy. Leaving the rating agency oligopoly unchallenged all but ensures that Global South communities will never see the sustained investment push they deserve to fight climate change, industrialize, or achieve any sustainable development goals.

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The credit rating agency oligopoly systematically burdens Global South countries with lower ratings, exacerbates global financial volatility, and utilizes an approach to climate risk that will exacerbate finance gaps in vulnerable regions―undercutting just transition and adaptation investment goals worldwide.

UN researchers find that, although advanced economies contracted far faster than emerging markets (EMs) did during covid-19, CRAs gave EMs 125 credit rating downgrades in 2020 compared to just 6 in advanced economies. “S&P and Moody’s even had net positive rating actions for [advanced economies] during the most ferocious peacetime recession in living memory.” Meanwhile, downgrades to EMs decreased private capital inflows and investment, constraining their ability to meet development, health, and climate goals.

Indian economist Jayati Ghosh remarked in 2012 that CRAs had downgraded India for long-standing corruption and regulatory issues that they had never previously chosen to penalize India for. She argued that CRAs hypocritically weaponized these issues to push the Indian government into enacting reforms that their other clients desired. Mexican President Lopez Obrador accused CRAs of similar hypocrisy in their 2019 downgrade of state-owned oil major Pemex. Unlike Fitch’s downgrade of the US, these downgrades across the Global South have real consequences: they serve to threaten Global South governments into undertaking investor-friendly reforms, regardless of those reforms’ actual efficacy. 

Downgrades also kneecap those governments’ ability to spend on key social priorities. Indeed, Zsófia Barta and Alison Johnston find that CRAs systematically downgrade countries that undertake larger welfare commitments—and that downgrades push countries to cut welfare commitments.

Figure 1. Between March 2020 and January 2021, the first year of the covid-19-induced global recession, the lion’s share of downgrades went to Global South economies (UN DESA).

Figure 2. Most countries around the world saw a cumulative deterioration in credit ratings and a rise in borrowing costs between December 2019 and October 2022 (LSE – Songwe/Stern Report).

CRAs are so biased in part because they are for-profit, competitive firms. They charge countries and corporations alike for their credit rating services. But if they provide a bad rating, their client can take their money to one of the other CRAs in the hopes of a better rating. CRAs thus face systematic pressure to retain market share and not to lose client income. And because their main paying clients are investors, they end up supporting policies that investors support. 

This story is oversimplified for sure, but it helps explain the role they played in exacerbating the 2008 financial crisis. CRAs faced systematic market pressure to inflate their ratings of mortgage-backed securities as the housing bubble grew: “these agencies are roundly criticized for not only failing to warn investors of the dangers of investing in many of the mortgage-backed securities at the epicenter of the financial crisis, but benefiting by not pointing out deficiencies.” The crisis revealed that CRAs were neither independent nor unbiased.

Left unchecked, these patterns enhance market volatility. Nobel Laureate Joseph Stiglitz found in 1999 that CRAs aggravated the East Asian financial crisis by neglecting risk factors before the crisis and then, once the crisis hit, downgrading Asian governments more than macroeconomic fundamentals warranted—ultimately hampering their economic recovery by constraining investment. The fact that CRAs help build booms and prolong busts in both sovereign and private debt markets suggests that their for-profit, competitive incentive structure exhibits a dangerous procyclicality.

CRA downgrades are supposed to warn investors that default is more likely―but they’re more like a self-fulfilling prophecy. CRAs cannot maintain investment-grade ratings for governments that might default on their debt, because their reputations as accurate risk managers would suffer if their confidence is misplaced. But lowering those countries’ ratings in expectation that default is more likely could cause capital flight that ends up precipitating that default in the first place. Procyclicality like this is inherent to their business model. And, because previous downgrades will negatively bias future ratings, CRAs’ decisions can impose long-lasting negative effects on countries’ economic growth and development trajectories.

Even if CRAs weren’t so biased or procyclical, their methodologies for evaluating fiscal prudence would still hamstring the kind of long-term social and infrastructure spending that governments must urgently undertake in the face of climate catastrophe. Although major green transition investments are necessary and will likely be profitable over the long term, the fact that they will increase short term public and corporate debts is grounds for CRA downgrades under existing methodologies that prioritize short-term returns. It’s a vicious cycle: those downgrades would, in turn, hamper further green investment, worsening climate vulnerability.

Not only are CRA methodologies unable to accommodate this necessary long-term, climate-conscious perspective, but their methods for calculating climate risk also endanger public balance sheets. If global emissions continue at current levels, over 60 countries will face climate risk-related downgrades of more than one notch to their credit ratings by 2030, costing those governments anywhere from $137 billion to $205 billion in higher interest payments. Accounting for the risks climate change poses to investment sets in motion a “financial doom loop”―the vicious cycle mentioned above―where CRAs force downgrades onto often-poorer countries that need investment in adaptation and mitigation the most, while leaving wealthier countries untouched.

In November 2022, Fitch downgraded Pakistan’s credit rating in part due to a decline in foreign exchange reserves that they acknowledged was the impact of floods that submerged a third of the country. Fitch noted that the floods would “undermine Pakistan’s efforts to rein in twin fiscal and current account deficits.” Pakistan’s floods cost over $30 billion, and they’re hardly Pakistan’s fault, yet Fitch’s downgrade makes it harder for Pakistan to borrow cash for its still-pressing reconstruction and adaptation needs. Fitch’s downgrade exemplifies how climate disasters empower CRAs to prevent climate vulnerable countries from securing investment they need. For Fitch, exacerbating insecurity in Pakistan was just another Friday on Wall Street.

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Despite these flaws, however, major institutional investors must tailor their investment decisions to CRAs’ judgments about what assets or sovereigns are “investment grade.” Asset managers and pension funds are often required by their clients, fiduciary responsibility statutes, internal guidelines, and the Basel Accords to invest primarily or only in “investment-grade” assets—anything with a rating of BBB- (“triple-B-minus”) and above. Anything below is “junk-grade.” To be clear, CRAs did not create this distinction between investment- and junk-grade assets; investors did, and the Basel Accords endorsed it. CRAs that demote sovereign or corporate debt below investment grade will force many institutional investors to sell off their holdings of that debt, precipitating the financial distress that makes that initial downgrade a self-fulfilling prophecy. As Matt Levine nicely puts it, “credit ratings are not there to inform investment decisions, but to constrain them, to limit the universe of bonds that an investor is allowed to own.”

This distinction has taken on a life of its own within CRAs. While CRAs acknowledge the harm that the demotion to “junk” grade poses to their clients, their subsequent reluctance to cross that divide between investment and junk “blunts the ratings signal and can dilute the quality and objectivity of the rating, as well as potentially promoting pro-cyclicality of the ratings.” When CRAs do cross that divide for sovereign governments, they often do so in response to market panics incommensurate with countries’ economic fundamentals. 

Figure 3. Between 1975 and 2019, a lower percentage of both sovereign and corporate bonds were downgraded across the cliff between investment- and junk-grade compared to downgrades between A and BBB (both investment-grade ratings) and between BB and B (both junk-grade ratings) (UN DESA).

The endgame is bleak. Downgrading Global South countries in the wake of brittle macroeconomic conditions and climate disaster will push many EM governments and corporations below investment grade, triggering capital flight and making future investment more costly. The counterproductive tryst between institutional investors and CRAs sets a global constraint of sorts on policymaker efforts to mobilize private investment toward infrastructure in EMs.

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If CRAs can’t even treat the US in an unbiased, objective-seeming manner, why should we expect them to accurately judge Global South governments?

As they are currently constituted, credit rating agencies stand in the way of a just global green transition. Their bias against sovereigns that make welfare commitments means that high-emitting Global South governments undertaking just transition efforts―spending on job programs, minimum incomes, healthcare―might find themselves punished for prudent policymaking. The same goes for sovereigns that take on debt today to make substantial, necessary, long-term investments in climate mitigation and adaptation programs. And because CRAs exacerbate global booms and busts, they worsen the global financial instability that prevents green investment from rising to the levels needed to meet global Paris Agreement commitments. Ultimately, the credit rating agency oligopoly is an obstacle to policymakers’ attempts to close crucial global finance gaps in health, climate, poverty alleviation, and other SDGs.

There is one thing credit agencies do that we must give them credit for: they have created a common language of sorts for investors and financial market participants to evaluate creditworthiness. Given how large and complicated financial markets are, it seems useful, really, that firms like CRAs exist to evaluate other companies’ and governments’ financials. But their biases and for-profit business model compromise their role as information brokers. At the very least, then, CRAs should be nonprofit global public utilities. 

Global climate vulnerability only makes this task more urgent. A climate-conscious public rating agency must (1) ensure that the places most vulnerable to climate disasters do not receive the least investment, (2) insulate green investment flows from boom-bust financial cycles, and (3) positively rate investments for their long-term environmental and social impacts rather than penalizing short-term outlays. Today’s CRAs do none of these―but a public ratings agency cannot succeed here without support. To this end, Tim Sahay and Anusar Farooqui have proposed that this kind of public green credit rating agency must be paired with a public loan guarantee authority that can ensure that crucial green investments will always be investment-grade.

But getting to this point requires politicizing the role CRAs play in our economy and the consequences their actions have on people, firms, and whole countries―not continuing to assume that they’re a normal part of our financial plumbing. The good news is that we did this the last time the US government received a downgrade, in 2011, thanks to S&P. The Department of Justice sued in 2013 and S&P settled in 2015. Global South countries can’t exercise this kind of power under the current arrangement, or else CRAs might downgrade them and investors will get skittish, but the US government can wield this power at will.

US policymakers have challenged credit rating agencies’ nonsensical downgrades before. Fitch’s downgrade gives them the chance to do it again―and, this time, maybe they can take steps to change the credit rating agencies’ global footprint for the better along the way. Upgrading the global financial system to tackle shared global challenges requires downgrading the influence credit rating agencies exercise over it.