We already know that individuals get credit scores, while corporations and governments receive credit ratings. This is just the jargon. Governments of countries require ratings to borrow money. Credit ratings also reflect the quality of a country as an investment target, and a county’s credit rating depends on the economic and political state of the actual country. Why do countries need credit ratings?129
Many countries rely on foreign investors to purchase their debt, and these investors rely heavily on the credit ratings given by the credit rating agencies. The benefits for a country of a good credit rating include being able to access funds from outside their country, and the possession of a good
rating can attract other forms of financing to a country, such as foreign direct investment. For instance, a company looking to open a factory in a particular country may first look at the country’s credit rating to assess its stability before deciding to invest.
It is well known that the US leads the list of countries ranked according to external debt, followed by the United Kingdom. It is remarkable that Luxembourg has much larger debt per capita than any other countries (6 million per capita). Luxembourg is known as a major financial center, so presumably the country owns large deposits belonging to foreign people.
In principle, the rating process should give an objective and independent assessment. If the procedure were totally objective, it would be sufficient to have only one credit rating agency. But we have three big (Fitch, Moody’s and Standard & Poor), and many smaller, agencies, who might use different databases and (generally private) algorithms, and they therefore produce (slightly) different results,
Capsule history of the three famous credit rating agencies (CRAs)
In 1860, Henry Poor (18121905) published History of Railroads and Canals in the United States, an attempt to collect and provide comprehensive information about the financial state of such transportation companies. Standard Statistics started to published ratings of different bonds in 1906, and they merged in 1941 to form Standard and Poor’s Corporation. Their product, the S&P 500, became a stock market index, a measure of economic activity. John Knowles Fitch (1880 1943) founded the Fitch Publishing Company in 1913 to provide financial statistics for helping investors’ decision making. In 1924, they introduced the AAA through D rating system that has become the industry standard for bond ratings 130. John Moody (1868 1958) and his Company first published “Moody’s Manual” in 1900. Moody’s Investors Service has provided ratings for nearly all of the government bond markets and today is a full-scale rating agency.
There is a Latin phrase that goes: “Quis custodiet ipsos custodes?” It is literally translated as “Who will guard the guards themselves?” A natural question arises: Who rates the credit rating agencies?131 In 1975 nationally (US!) recognized statistical ratings organizations (NRSRO) were created. Investors simply needed more reliable information to help their decision making to allocate their resources, and this demand has led to enormous growth, expansion, and influence of the credit ratings industry. Three decades later, the Credit Rating Agency Reform Act of 2006 allows the main regulatory agency—the Securities and Exchange Commission (SEC)—to regulate internal credit-rating processes. CRAs had a critical role in the financial crisis of 2008, and the details are far beyond the scope of this book. The lesson I learned from Michael Lewis’s bestseller 132 was: “The line between gambling and investing is artificial and thin.”