Hamish McRae: The power of the rating agencies is in the spotlight

Economic Studies

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Why on earth are the credit rating agencies still so important? The debt of the Greek government has been downgraded to the worst rating of any country in the world by Standard & Poor's, just as the eurozone finance ministers were about to meet in Brussels on the terms under which it would be bailed out.

The downgrading does, I suppose, give a brisk two fingers to the finance ministers, showing where power in the world really resides. The financial markets now give Greece a three in four chance of defaulting in the next five years.

The markets do matter because they represent financial clout: where investors put their money. But it is inherently improbable that the agencies, whose spectacular mis-rating of the US mortgage market was a key element in the banking catastrophe, should still have any authority in the investment community. Why pay any attention to people who got it so wrong?

The answer comes in two stages. The first is that there is a quasi-legal status accorded to credit ratings that dates back to a time when bond markets were more stable. So some funds are obliged to hold only certain grades of investments, an indication to investors of the type of investment they were making. You could say this was lazy because it meant that buyers did not do their own research but merely based their investment decisions on the rather mechanical calculations of the agencies. But the system did work adequately enough for many years until it became corrupted ahead of the sub-prime crisis, with what we can now see as absurdly high ratings given to suspect bonds.

However, the structure remains in place. There will be some investors that are obliged to sell any Greek debt as a result of this downgrading because they are not allowed to hold such low-ranked investments. Actually they will probably have sold long ago in anticipation of the event. There will be other investors that cannot legally buy Irish or Portuguese bonds at the moment because they are ranked too lowly in the rating firmament. Now it would be possible for some bond funds to ignore the agencies, but it requires a certain self-confidence to stand up in front of an investment committee and say that you are going to put money into some country that everyone else thinks is going to default. As a result there is a self-fulfilling element to bond investment: a down-rating makes it harder to borrow, thereby increasing the chance of a further down-rating.

The second part of the answer is that competition is not working, or at least not yet. The two big US agencies, Moody's and S&P, plus the smaller French-owned (but New York and London-based) Fitch, have still a dominant position in this market. The Chinese have established a rating agency for sovereign debt, the Dagong Global Rating Agency (which incidentally has downgraded the debt of the US government twice this year and the UK once), but this does not at the moment seem to have much of a world-wide following.

At some stage other rating agencies will spring up and if they can do a better job than the present lot they will, after a while, start to influence where savers put their money. As Asian savings are going to become more important the hold of the present triumvirate will loosen, and I would expect the challenge to come from Asia: maybe Mumbai or Singapore. But it is not there yet.

Meanwhile the eurozone will become a test-bed for the three main ratings agencies, a chance to redeem themselves after the sub-prime debacle. If by some chance Greece (and Ireland and Portugal) were to pay their debts in full, then the gloom of the ratings agencies will look pretty soft. They will be seen to have made the reverse mistake of the sub-prime era: ranking a whole class of bonds too low instead of too high. If on the other hand they prove right and these countries do default, then their status will be enhanced, and it will be the eurozone politicians that will have made an ass of themselves. It is a high-stakes game in reputation as well as in money.

Jobs figures tell us most about growth

The inflation figures yesterday were suitably depressing, with the consumer price index stuck at 4.5 per cent and expected to rise further in the autumn. The retail price index is stuck at 5.2 per cent, and it more accurately represents most people's experience of inflation. But if you want to see some glimmer of hope, if you allow for the increase in VAT and other direct taxes, the retail price would "only" be up 3.9 per cent, shocking but not quite as shocking as the other measures.

The more important information for economy-watchers comes this morning in the unemployment and employment figures. The unemployment numbers tend to lag changes in the economy, and in any case are affected by the numbers of people entering the job market.

But the employment figures will be extremely interesting because they have been quite strong in recent months, suggesting that growth is faster than the official GDP figures report. In round numbers, three or four new jobs are being created in the private sector for every one lost in the public sector. If jobs overall are still being created, we can relax a little. If employment flags, or worse, falls back, then the nail-biting continues.


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