Outline where the sovereign rating systems used by rating agencies fall short.
The idea
Sovereign ratings from the agencies have five chief shortcomings. First, they lag the market, so spreads widen well before a downgrade, and when ratings do move they often move several notches at once, which can amplify a crisis. Second, they are ordinal letter grades, not default probabilities, and they say nothing about loss given default. Third, they rest heavily on reported, backward-looking data and can miss contingent liabilities such as bank guarantees. Fourth, different agencies may split on the same country, and judgement, not a published formula, closes the gap. Finally, a rating-based default spread table is an average over history, so the same rating can trade at very different spreads in calm and stressed markets. The exam point is that ratings are stable and informative about the long run, but slow.
A practice question
What is the most commonly cited shortcoming of sovereign ratings from rating agencies?
- Ratings change daily, so they are too volatile for long-term investors. In practice they change rarely and often after the market has moved.Why not: Reverses the problem: agencies change ratings infrequently.
- Ratings are based only on equity prices and so reflect market noise.Why not: Ratings are analyst-based and do not rely solely on equity prices.
- Ratings tend to lag market information, so spreads often widen before ratings change. - correct
- Ratings ignore the government's debt level.Why not: Debt burden is a core input into a sovereign rating.
Agencies aim for stable ratings, so they lag changes in market views. Spreads often move before a downgrade.
A harder one
A sovereign's reported government debt is 60 percent of GDP, but it has also guaranteed its banking sector, whose liabilities equal 250 percent of GDP, and these guarantees are not in the debt statistics. Which shortcoming does a rating based on reported debt illustrate?
- Ratings count all guarantees as debt, so they overstate default risk. The stem says the guarantees are missing from the statistics, so the opposite error occurs.Why not: Reverses the problem: reported debt excludes contingent liabilities and so understates risk.
- Ratings reflect only market prices, so they cannot see off-balance-sheet items.Why not: Ratings are analyst-based and are not market prices.
- Ratings rely on reported, backward-looking data and may miss contingent liabilities, understating default risk. - correct
- Ratings ignore the size of the economy in all calculations.Why not: Debt is typically judged against GDP; the problem is that contingent liabilities are missing from the numerator.
Off-balance-sheet guarantees can turn into government debt in a crisis. A rating built on reported figures can miss them.
The hardest tier
An agency rates sovereigns through the cycle, so that a rating changes only when it is confident the change is permanent. Which consequence follows?
- Ratings become more volatile, since they reflect every change in conditions.Why not: Through-the-cycle ratings aim to be stable and do not respond to every change in conditions.
- Ratings become more accurate over one-month horizons than market spreads.Why not: Slow-moving ratings are generally less informative than spreads at short horizons.
- Ratings eliminate the risk of procyclical downgrades.Why not: Sudden multi-notch downgrades after a delay are one result of through-the-cycle caution.
- Ratings are stable and have low turnover, but they react slowly to deterioration, which weakens them as short-horizon default predictors. - correct
Stability is bought at the price of timeliness. Ratings are slow to reflect new information and are weaker predictors over short horizons.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Country Risk: Determinants, Measures, and Implications
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- Account for what follows when a country defaults.
- Review how sovereign default risk is measured and outline what goes into a sovereign rating.
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