10/16/2009 12:51 pm ET Updated May 25, 2011

Are Sovereign Ratings a Legacy of Colonialism?

Over decades, the rating agencies have imposed their sovereign ratings as the yardstick for investors in securities issued by "sovereign" issuers, i.e. mostly issuers of bonds by Governments or guaranteed by those Governments. The history of these ratings is not pretty: initially, rating agencies approached European Governments and told them to either pay and cooperate...or face the risk of a rating issued unilaterally by the agency.

The intention was the same as for company ratings: give investors (and mostly traders and underwriters) a shortcut to the credit analysis. It is the pressure of the capital markets operators that embarked them on that dicey path.

A country rating is a complex affair: it involves the classical macro-economic indicators, but it also includes elements of judgment that are more difficult to quantify. Some of them are squarely in the political arena, such as reacting to an election, warning Governments on policies ... More importantly, the rating agencies all provide ratings that are biased against emerging markets. It is extremely difficult for an emerging country to get more than a BBB rating, the lowest possible "investment grade" rating. It is interesting to note that the entry into European Union provided new members with better ratings. The fact that China has become the largest lender to the United States might explain why their rating is A+.

As markets got increasingly sophisticated, companies had to face a new reality: their rating will never be higher than the rating of their country. That principle is hard to defend. It is convenient, but does not recognize the new reality of emerging markets corporations. Some emerging market companies have become global and compete fiercely in the global arena. Their financial structure is substantially the same, but their country of incorporation is different.

One example I came across lately is in the IT sector. Tata Consultancy Services (the largest IT Company in India) and Accenture each enjoy a market capitalization between $ 25 and 30 billion. They both operate globally. TCS has no debt and Accenture has little debt on their balance sheet. The first one is rated BBB because it is in India and India's rating is BBB- while Accenture enjoys an A+ rating.

This whole situation needs to be reconsidered.

Are we convinced that rating agencies should be in the business of sovereign ratings and should they be left alone? The International Monetary Fund is a very important analyst of sovereign risks for its members: without making it a rating agency, shouldn't there be a transparent way to involve the IMF in the analytical part of the ratings. Wouldn't it make sense to have the IMF, an independent lender to those countries, play a role as the authority on such matters? Aren't they slowly but surely becoming the lender of last resort of the world?

The second question is the connection between country and corporate ratings. Doesn't globalization require that we look at companies from emerging markets on their own merits, even if they eventually obtain a better rating than their Governments? As I was sitting through sessions of the Institute of International Finance during the IMF meetings in Istanbul, it occurred to me that this could create level playing fields between emerging market borrowers and their "emerged" counterparts. Isn't it a question of fairness? As we were looking at long term trends, the access of those countries ot international capital markets seems increasingly crucial.

This is not an academic debate: it has important consequences, making the cost of capital for emerging market companies more expensive than for their "Western" counterparts. Nobody has a magic solution, but this should be a priority in reviewing the methodology and the principles of these ratings. In the meantime, rating agencies might be well advised not to use their ratings as a mean of passing judgments on elections and other political developments.