Arjoon Harripaul, Contributor
HARRIPAUL
INVESTMENT - BOTH private and public is the means by which an economy grows. The money to finance this investment comes from savings either domestic savings or foreign savings. While globalisation of capital markets is making it ever easier to access foreign savings, reliance on external financing may come with the risks of system-wide liquidity or solvency crisis that can be precipitated by a sudden cessation of external financing.
This is why most policy makers agree on the critical role that domestic capital markets play in both growing the domestic economy and in insulating it from global financial crises.
The year 2004 was a stark reminder of how a government's access to domestic savings could make or break a country's fiscal position. The Dominican Republic, whose external public debt to GDP was 22 per cent (total debt to GDP was 50 per cent which is considered moderate), was forced to default due to its lack of access to a vibrant domestic capital market.
On the other hand, Jamaica, whose external debt was in fact much higher at 75 per cent (total debt to GDP was 136 per cent) was able to avoid a default due to a vibrant domestic capital market, from which the government raised monies to meet maturing debt obligations, both local currency and foreign currency. It is precisely because of this flexibility a healthy domestic bond market gives to a government, that such a factor can improve its sovereign foreign currency credit rating.
DEFAULT PROBLEM
Savings have to be placed somewhere - either deposited into the banking system or invested in various tradable financial instruments in capital markets. Credit ratings, in estimating a probability of default, help savers (i.e. investors) to assess their options and rationally match their risk tolerance with their savings objectives. This use of credit ratings to pool risks results in a more efficient use of funds.
In the absence of analytical information about a company's financial position and corporate strategy, many would-be investors in capital markets stay within the confines of the relative comfort (and lower returns) of the banking system. Thus, by virtue of enabling investors to compare credit risk across companies, industries and countries, credit ratings deepen the capital market by attracting more investors.
From the perspective of those trying to raise funds, credit ratings enable them to access funds from a wider range of instruments (and not only bank loans) as well as reduce information risk, both of which should result in more efficient pricing. This reduces the cost of capital and allows a larger number of projects to be economically viable, thus increasing the rate at which the overall economy can grow.
On account of a greater number of projects being funded, credit ratings also improve the liquidity of a bond market. Inefficiencies typically inherent in any banking system such as high operating costs, the management of non-performing loans and the cost of maintaining high reserve requirements at the central bank are usually less prevalent in capital markets.
Credit ratings reduce informational asymmetry, not only via the information contained in the credit rating symbols assigned to various instrument, but also by supporting greater financial disclosure, better corporate governance and improved access to publicly available expert analysis.
Greater information disclosure and improved liquidity also deepen the market by attracting money that would otherwise have been placed off-shore or in real assets, which are not as productive to the economy as investments in real sector (manufacturing / services). While there is no reliably accurate compiled data on deposits from the Caribbean region held abroad, the persistent "bubble" in real estate prices evident in Jamaica, Barbados, and T&T is well known to us all. One estimate of the increase in real estate prices in T&T over the last 3 years is 150 per cent.
Greater participation overall in the financial markets enables a government to have more flexible and arguably more effective monetary policies. This is because it is more effective for governments to manage short-term interest rates by open market operations using government securities than by making direct loans or changing the repo rate.
We explained earlier in our series that regular issuance of government paper in different amounts and of varying tenors is necessary for the construction of a base yield curve which is fundamental to the development of a healthy domestic bond market. It must also be noted that it is impossible to construct any yield curve other than that of the government in the absence of credit ratings. Why? Because credit ratings give the independent measure by which to allocate various instruments into risk buckets (AAA, AA, A, etc.) for which a curve can be constructed. By enabling such construction, credit ratings cause inefficiencies in the bond markets to be glaringly obvious and thus allow for their correction.
In order to fully answer the question posed at the start of the article as to how a regional credit rating agency can help develop the region's capital market, it is necessary to note two things.
The first is that there are very few debt issues that have been rated in the English-speaking Caribbean, by global rating agencies. Therefore, global credit ratings obviously cannot provide all the benefits that are supposed to accrue to our capital markets according to the foregoing.
The reason that global credit ratings cannot provide significant benefit to our bond markets is because global credit ratings are not very relevant to domestic and regional investors. While they are necessary for those institutions who wish to raise funds in the international capital markets, global credit ratings do not help local investors in differentiating the credit quality of alternative investment options within the region.
The global scale credit ratings assigned to companies and other non-sovereign entities are typically capped by sovereign ratings. On their part, the sovereign ratings in this region tend to remain low in the global rating scale (BBB or below), reflecting the small size of the regional economies, moderate stage of development and relative lack of income diversity. This in turn leads to bunching of all credit ratings assigned in the lower end of the global scale. While this is not of material importance to a global investor who is deciding whether to place their funds in Eastern Europe or the Caribbean, it is of vital importance to the local or regional investor.
The second matter of note is that CariCRIS is based locally and will provide an estimate of the relative probability of default in the universe of debt issued in the Caribbean. Because they will provide far more relevant information to investors and enable useful differentiation of credit risk within the region, it is anticipated that CariCRIS's rating penetration will be far higher than that of the global rating agencies.
These two factors viz. a better differentiation of credit risk within the region and a greater penetration of credit ratings will go a long way in the development of our regional bond markets, as highlighted in this article.
CariCRIS is the Caribbean's Regional Credit Rating Agency. This article forms part of a series on issues surrounding capital markets and credit ratings. E-mail: info@caricris.com or call 868-627-8879.
