CREDIT RATING YARDSTICKS: TRUE MEASURE OF ECONOMIC HEALTH?

SHAMSUL GHANI, shams_ghani@hotmail.com
Oct 13 - 19, 2008

The downward journey of self-destruction is underway with no signs of a lucky halt - let alone the prospects of a reversal. Standard & Poor's second downgrade during the year didn't come as a shock. What really shocks is our economic managers' failure to show a sense of urgency. After cutting our foreign currency debt rating from B plus to B in June, 2008, S & P has applied another cut and placed us in CCC plus category. Pakistan's local currency debt rating has also been lowered from BB minus to B minus. Our dollar bonds are now in "junk" territory, and on foreign currency debt our default is a few steps away: CCC, CC plus, CC, C and finally D.

It sounds a bit horrific. Based on some statistical calculations, the yardsticks employed by the rating agencies are more of a panic button than a true measure of economies' health. Historic data suggests that only 1.21 per cent of economies/companies with Moody's rating of Ba actually went into default while the default percentage for those with B rating was 6.53. For three categories, Caa, Ca and C, the cumulative default rate was 24.73 per cent. Since Moody's Caa corresponds to Standard & Poorís CCC, we can say that in the most pessimistic scenario, we have a default probability of only 25 per cent. The reliability of the yardsticks employed becomes doubtful when seen in the light of empirical evidence.

The following table shows the modality of rating process.

CREDIT RATING HIERARCHY

CREDIT RISK

MOODY

STANDARD & POOR

FITCH IBCA

DUFF & PHELPS

INVESTMENT GRADE

Highest quality

Aaa

AAA

AAA

AAA

High quality (very strong)

Aa

AA

AA

AA

Upper medium grade (strong)

A

A

A

A

Medium grade

Baa

BBB

BBB

BBB

Not Investment Grade

Lower medium grade (somewhat speculative)

Ba

B

BB

BB

Medium grade (speculative)

B

B

B

B

Poor quality (may default)

Caa

CCC

CCC

CCC

Most speculative

Ca

CC

CC

CC

No Interest being paid or bankruptcy petition filed

C

C

C

C

In Default

D

D

D

D

The ratings from Aa to Ca by Moody's may be modified by the addition of 1,2 or 3 to show relative standing within the category

The ratings from AA to CC by S & P (and others) may be modified by the addition of a plus or minus sign to show relative standing within the category

STOCK EXCHANGE ADDS A DIMENSION TO DEFAULT PROSPECTS

With the State Bank having left with only $4.7 billion in its kitty and commercial banks holding as little as $3.7 billion to finance country's import and pay off $3 billion foreign currency debts/bonds maturing very shortly, the threat of default is real. What makes the picture bleaker is the prospect of a run on stock market after it is released from its position of limbo. Around $3 billion of portfolio investment have already found exit during the year. The remaining $2 billion are held up for want of floor removal. After August 27 when the KSE-100 index was frozen at 9,144 points, the stock market has gone through consecutive spells of historically low trade volume. With the foreign investors' insistence for de-freezing of index, it should not be difficult to foresee that $2 billion will vanish into thin air the moment floor condition is removed. Mr. Shaukat Tarin's advise to release the brake pedal to allow the market to find its own level is a bit intriguing, at least in the given scenario.

A sane proposal from certain quarters has popped up asking the government to give sovereign guarantee to the foreign investors to keep their money invested in stocks for a period of one year at a guaranteed return of 10 per cent. In case the market fails to pick up during that period, the foreign investors may be paid the existing floor prices together with the said return of 10 per cent. In case the economy picks up, the highly undervalued stocks might bring windfall for the foreign investors. This appears to be a win-win proposition for the two parties and therefore should be seriously taken up.

It is really unfortunate that following in the footsteps of politicians, our financial managers have developed the habit of fishing in troubled waters. The reported day-trading by the Mutual Funds and proposals asking to put a ban on such trading is a sad state of affairs. Certain fund managers are said to have involved in morning-time sell-off and repurchase at lower prices at the fag end of daily sessions. The view that the market has been brought to a standstill to save the skin of certain big brokers who find themselves in a tight corner also carries some weight. But this time our focus is on preventing the outflow of $2 billion (that will heighten the foreign liquidity crisis) rather than hunting the big fish of stock exchange.

With the political uncertainty still hovering around and the new government finding it difficult to simultaneously fight on extremism and economic fronts, the threat of a further downgrade is very much in the air. S &P has spelled this out in very clear terms. Coming few months is stern test of the democratic rule's sustaining capacity. It will have to produce something very positive out of nothing. The bigger the crisis, the greater would be the opportunities. What is required is an innovative approach with a will to emerge victorious.