Friday, August 12, 2011

A standard too poor to judge nations by

Sovereign ratings such as those awarded by Standard and Poor’s are deeply flawed.

The recent downgrade of the US sovereign debt by Standard & Poor’s has three intriguing implications. First, it sends the message that like mere individuals, companies and lesser states, the US government too cannot live beyond its means. Second, S&P’s action suggests that the US is no longer the world’s prime economic mover, a status it has enjoyed for well over a century.

The former message is welcome, but the latter is less so. Just as a bunch of unruly schoolkids needs a strong chaperone, the world’s nations need a strong and credible leader to play an anchor role, particularly in terms of crisis. Institutions such as G7, G20, the EU and the IMF are too weak, too decrepit or simply do not enjoy the widespread trust needed to play that leadership role credibly. An America, however weakened, is better than no leader at all. The world economy without a firm hand on the rudder is not a pleasant prospect.

The third interesting observation from the downgrade and the events that followed is that it’s possible for a private company to take a decision that shakes the world’s most powerful governments. Nations and governments have traditionally enjoyed huge power over the private sector, and until recently it would have been unthinkable that one private company could take one decision that reverberated thru the world economy and left the world’s most powerful government scrambling to salvage it’s reputation.

But just how reliable are the sovereign ratings, and do changes in those ratings merit such mayhem? To see the answer, one has to look no further than the list of S&P’s AAA rated countries. If you could invest a million bucks in Guernsey, Isle of Man or the US, would you choose either of the first two? Yet those countries continue to retain their AAA ratings! Austria, Australia, Liechtenstein, Luxembourg, France and the UK are well-run countries, but would you really choose all of those above the US for your investments?

The US is still the largest, most diversified and most vibrant economy in the world. Whatever it lacks in quality of political leadership, it makes up in terms of these factors. America also has the world's largest private sector (which as observed earlier is steadily gaining importance). Also, America’s political process is fairly transparent so the risk of idiosyncratic or whimsical policy making is low – during the recent debt ceiling negotiations, every move was ruthlessly scrutinized by the world’s media. Many of the countries in the AAA list above have policy-making that’s opaque, run by a few individuals such as a President, Prime Minister or Finance Minister or by coteries. In addition, the US dollar is the world’s reserve currency. So as long as Uncle Sam runs the world’s money printing press, the likelihood of its defaulting is virtually nil.

Let me hasten to add that I’m no fan of the US or any other nation’s economic management – hubris, maneuvering for narrow political ends, lobbying etc. are rampant in America as in most other places. All the horse sense view is saying is, if the US is demoted from the top trustworthiness rating, so should every other AAA country be. If that doesn’t happen soon we can safely conclude that the sovereign debt rating process lacks integrity.

And let’s not forget that these ratings are being awarded by agencies that played a starring role in the financial crisis - by awarding stellar ratings to mortgage-backed securities that nearly allowed financial institutions to bring down the entire financial system, they failed investors and the financial system at large.

So, particularly given the psychological impact of these ratings, it’s incumbent upon the rating agencies to devise much more sophisticated rating methodologies that span a much wider range of factors.