T N Ninan: And Pigs do fly

Is this another case of mispricing risk or systemic bias against emerging markets?

In March this year, Spain had a AA+ foreign credit rating from Standard and Poor’s (S&P), signalling “very strong capacity” to meet its financial obligations. Portugal and Italy were at A+ (“strong capacity” to meet financial commitments). A year ago, Greece was there too. Southern Europe’s “Pigs” countries, as they are called, have a different story to tell today. Greece has been pushed down rapidly to junk bond status. The other three Pigs have also been downgraded, though they are still in investment grade (better than “speculative grade”).

But Spain, which has the best rating of the four, has a 19 per cent unemployment rate (the highest in Europe), and an 11.5 per cent fiscal deficit, while its economy shrank 4.9 per cent in 2009. The others have similar profiles: high unemployment, shrinking output, large budget deficit, big public debt overhang. For good measure, they also seem to have limited wiggle room.

Yet all of them have a better sovereign rating than India, which at BBB- just about makes it to investment grade. To be sure, India’s fiscal deficit and public debt are high, but an economy growing at 8 per cent can cope with these infinitely better than one that is shrinking. Unlike the Pigs, India’s current account deficit is more than matched by capital inflows, and foreign exchange reserves are more than foreign debt, while total government debt at 82 per cent of GDP is lower than two of the four Pigs countries (Italy and Greece are at 115 per cent of GDP), and the same as for Portugal. Yet S&P thinks that India deserves a lower rating than the Pigs.

Why, in early 2009, China and Greece actually were in the same ballpark rating bracket (A), while Spain was AAA! Even as recently as in March, S&P was “affirming” Greece’s BBB+ status (which, please note, was better than India’s). Only to reduce Greece to junk bond status a few short weeks later, when it was close to default. China, meanwhile, is still only at A+, although its vital statistics are better than the average for all AAA economies, be it economic growth, current account surplus, fiscal deficit, or the debt-GDP ratio. Not just China, the Bric countries on average have a lower debt-GDP ratio than many advanced economies, and lower fiscal deficits too. But does any of this reflect in the ratings? Not a chance.

Ratings are important because they influence the cost of the international capital that a country accesses. Typically, a BBB country has to pay about 1 percentage point more interest than a AAA country for five-year money. The gap shrinks dramatically if you are A and not BBB, but three of the Bric economies are BBB. If the ratings were accurate, the risk premium on insuring against default would be higher for countries with lower ratings. But China commands a much lower premium than any of the Pigs — which gives the lie to the ratings. Indeed, some Indian banks access money abroad at rates that they should not be getting, since India is BBB-. Perhaps India should be A.

The rating agencies argue that emerging markets have a higher political risk. Well, tell that to the Greeks, who are rioting in the streets of Athens! And Britain may well have to go to the IMF for a bailout, given a hung Parliament, and a debt-cum-deficit profile that mirrors the Pigs. Yet Britain is rated AAA. So, is this another case of mispricing risk (which after all caused the western financial crisis, with the rating agencies central to the problem) or systemic bias against emerging markets?