Rating the world’s economies – it’s a tricky business

Happy new year. It’s hard to believe that the first month of 2012 is over and we trust you had a safe and enjoyable break. Over the holiday break we saw the media talking about the ‘downgrading’ of country credit ratings. Announcements like this certainly make for an attention grabbing headline and can cause investor stress and uncertainty. So we thought it worthwhile to take a closer look at what country credit ratings are.

A sovereign credit rating is a measure of a country’s credit worthiness, or rather their ability to pay back the interest and the principal balance of a loan. Credit ratings are determined by credit rating agencies. These are research companies, not government agencies.  Standard & Poor’s (S&P), Moody’s Investor Service and Fitch Ratings are the ‘big three’ credit rating agencies usually quoted within the media. Credit ratings seek to provide investors and credit providers with an indication of financial risk.

The downgrade announcement in late January was made by Fitch Ratings. Interestingly, their website states: “As a result of regulatory changes, effective 1 January 2010, the publication of credit ratings will be characterised as financial product advice in Australia. From this date, Fitch Australia Pty Ltd will publish credit ratings under its Australian Financial Services Licence, but Fitch Australia is not licensed to disclose credit ratings to retail clients within the meaning of section 761G of the Corporations Act.”

One might be left wondering why our media is talking about this, given Fitch isn’t licensed to disclose credit ratings to retail clients in Australia?

In October 2010, the International Monetary Fund (IMF) published a document looking at the uses and abuses of credit ratings. They concluded that credit ratings play a positive role in providing cost effective information for investor and lender decision making. They also raised concerns about some of the rating systems and philosophies1. The International Monetary Fund (IMF) is an organisation with 187 member countries that seeks to promote stability and trade, and reduce poverty.

Unfortunately, their report didn’t consider how the media uses such information and the impact it can have on investor confidence. We guess that’s our role as your trusted adviser, to put these things into perspective for you.

Who was downgraded?

According to Australia’s ABC News website on 14 January 2012, S&P downgraded the credit ratings of nine eurozone countries – Italy, Spain, Portugal and Cyprus by two notches, and France, Austria, Malta, Slovakia and Slovenia by one notch each. And just recently on the 28 January 2012, ABC News reported that Fitch Ratings dealt downgrades to Italy, Spain, Belgium, Slovenia and Cyprus, and lowered its outlook on Ireland.

How are credit ratings determined?

You might expect that credit ratings are determined by mathematical formulas. This is not actually the case. Trying to determine exactly how the ratings are determined is a challenging exercise within itself, given the lack of information about the process available on credit rating websites. It’s fair to conclude though that credit rating agencies consider both numerical data like tax levels and inflows as well as qualitative measures, such as the likely affect of Government policies. It’s also fair to conclude the process to determining a credit rating is not an exact science, since each of the big three credit ratings agencies work in competition with each other and have different philosophies, processes and methodologies.

The woes of Europe were a regular feature of the nightly news in 2011 and one thing we can be sure of is that this trend looks set to continue in 2012 so be prepared.

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1. Source: http://www.imf.org/external/pubs/ft/gfsr/2010/02/pdf/chap3.pdf

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