Sovereign Credit Ratings: EUC Report

Lord Eatwell Excerpts

Tuesday 15th November 2011 Lords Chamber

[Lord Eatwell]

My Lords, a great strength of this report, on which my noble friend Lord Harrison is to be congratulated, is that it distinguishes clearly between the role that rating agencies play in the markets for private securities and the role that they play in the sovereign debt markets. In private markets, rating agencies provide a relatively simple rating for what are often mathematically very complicated financial instruments. Without this sort of interpretation, the markets in complex products could not operate. The role of the rating agencies is to provide confidence to the buyers. Unfortunately, in the recent past that confidence was seriously misplaced, as my noble friends Lord Foulkes and Lord Monks both commented.

However, as the report makes clear, and as the noble Lord, Lord Kerr, pointed out, the task of rating agencies in respect of sovereign debt is quite different. Sovereign debt instruments are typically fairly simple; they are standard bonds of fixed duration. In this instance, the necessary rating skills are quite different from those needed in unpicking a complex statistical model. First, they consist of a devotion to whatever is the conventional economic wisdom of the time. It is convention, not good economics, that matters and often drives markets. Secondly, the sovereign appraisal should include an assessment of the political and economic controversy within and between sovereign states. Here, political fashion inevitably plays a role in determining whether any given package of economic policies is deemed sound or not. As we in this country know to our cost, the current fashion is for austerity—today’s cure for all economic ills.

It is not at all obvious, as the report acknowledges, that the rating agencies have any particular superiority in evaluating sovereign risks over any intelligent investor, as my noble friend Lord Myners emphasised. If the role of rating agencies is so straightforward, why are they of any importance at all in the discussion of sovereign debt? Neither the report nor, disappointingly, the Government’s response addresses this core question. If, as the report’s title suggests, rating agencies are but the messenger, what is the origin of the message that they bear? To put it another way, if they are but the symptom—distressing and perhaps worth treating in itself, but not fundamental—what is the nature of the disease? It is in the light of that more basic issue that we should judge the Government’s response.

The basic issue has two dimensions: the development of the international bond market over the past three or four decades and the particular design of the sovereign bond market in the eurozone. The current structure and scale of international bond markets are a relatively recent phenomenon. For example, today the annual value of cross-border transactions in UK sovereign bonds comfortably exceeds 1,000 per cent of UK GDP. In 1971, the comparable value was nil. A similar explosion of cross-border activity is to be found in the sovereign bond markets of all G7 countries other than Japan. Into this environment of huge cross-border flows is thrust the eurozone, an economic entity larger than the United States of America. The sheer scale of the eurozone economy ensures that any significant bond fund manager anywhere in the world who is seeking to diversify exposure must have major holdings of US dollar bonds and sovereign bonds denominated in euros. However, whereas exposure to the dollar may be obtained by investing in US treasuries, exposure to the euro may be obtained by investing in any of the various eurozone sovereign bonds. Investors have a choice as to which euro sovereign to hold—a choice that is likely to be informed by their estimate of risk and return, and influenced to a greater or lesser degree by the rating agencies. This is a perfect structure for costless speculation and costless hedging, leading to huge flows between euro sovereigns and exposing any given sovereign to almost unlimited speculative pressure via naked trades. This is the disease.

Let me put the matter another way. The state of California, comprising 13 per cent of the US economy, is bankrupt. This has no impact on the US bond market. Greece, comprising 2 per cent of the eurozone economy, is similarly compromised, with disastrous destabilising consequences for the eurozone as a whole. It is against this background of a huge international bond market and a serious design flaw in the eurozone that the Government’s response to the report should be judged.

Do the Government’s proposals, such as they are, help to suppress the symptoms, or do they provide a guide to tackling the disease? The Government rather downplay the report’s criticism of the rating agencies’ performance prior to the sovereign crisis in the eurozone. The report is forthright:

“The valid charge against the rating agencies … is ... that they failed … to identify risks in some Member States”.

The Government’s response ignores this conclusion altogether and focuses instead on the need to share “factually correct information”. Can the Minister explain why the Government do not share the committee’s views on the failings of the rating agencies prior to the crisis?

On the symptoms, the Government are surely right to support measures to reduce hard-wiring of ratings into legislation rules and guidance. Yet the Government’s statement that they believe that,

“the more sophisticated use of ratings by investors should be encouraged”,

is surely one of the more vacuous platitudes of recent times. The Government’s support for greater transparency in the methodologies of the rating agencies, mentioned by the noble Lord, Lord Vallance, is likely to make matters worse rather than better, by increasing volatility as traders, knowing the methodologies, anticipate ratings changes.

In contrast to the noble Baroness, Lady Noakes, the Government express enthusiasm for greater regulation of the ratings agencies. As was pointed out, the Government signed up to this at the G20. Will the Minister tell us what regulatory steps the Government propose and explain how these steps will enhance the smooth operation of sovereign bond markets? What is most striking about the Government’s response is that it makes no attempt whatever to locate the role of the rating agencies in the context of the overall operation of the eurozone sovereign debt market. That, after all, was the topic of the report. Mr Cameron and Mr Osborne have repeatedly urged the eurozone Governments towards action, without spelling out exactly what action they propose. Perhaps the Minister will help fill the void in government thinking this evening by telling us what steps the Government propose should be taken to stabilise the eurozone bond market and where the rating agencies fit in to the Government’s plans.