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Box 2 Historical review of the activity of the rating agencies

Already before World War I a number of agencies in the USA provided assessments and analyses of the credit risk on bonds issued by private enterprises. Initially, this solely concerned private railway companies which at that time were the largest borrowers in the USA, but gradually the activity was expanded to also include major manufacturing enterprises, public utilities and countries, municipalities and other regional authorities. In 1920 the number of enterprises with bonds carrying a Moody's rating exceeded 3,000. The number of rated enterprises then fell, among other things as a result of consolidation of US railways and public utilities and the depression in the 1930s. The number of rated enterprises reached its lowest level around 1950 when Moody's evaluated less than 700 business enterprises' long-term debt. Another factor contributing to the decline between 1920 and 1950 was that business enterprises mainly raised bank loans instead of issuing bonds. During the 1980s the use of ratings in the USA began to rise again. This was attributable to the development of the "junk bond" market, a market for high-yield, high-risk bonds. At the close of 1997 approximately 4,000 enterprises throughout the world were subject to rating. Use of ratings outside the USA has been far less prevalent. Non-American issuers' reasons for acquiring a rating have usually been motivated by a wish to market bonds to American investors. The number of non-American enterprises with a rating has risen strongly during the 1990s and constituted 38 per cent of the enterprises given a rating by Moody's at the close of 1997. The greater use of ratings in the USA is also attributable to the fact that since the 1930s US banks and insurance companies' placements of funds have been subject to restrictions applied as minimum requirements of the issuer's rating. The sectoral distribution of rated enterprises has not been constant over time. In the 1920s rated enterprises holding a rating were concentrated in the transport sector and public utilities. In the 1990s manufacturing enterprises and financial companies account for the majority of the enterprises rated by the agencies. Civic and other regional authorities today constitute a very large market for the rating agencies in the USA. This is not the case in Europe. The article therefore focuses solely on rating of business enterprises and countries. In addition to the two large agencies, Moody's Investors Service and Standard & Poor's, there are a number of smaller rating agencies which have specialized in credit assessments within one or more sectors, e.g. the financial sector, or a specific geographical area.

Danish market participants. During the last few years five out of six mortgage-credit institutes have had their most frequently traded bonds rated. This is of relevance to international investors' interest in these bonds, since the proportion of rated mortgage-credit bond series held by non-residents is far greater than for non-rated bond series.

Over time EMU will probably lead to a merging of the capital markets of the 11 participating countries.²⁾ The irrevocable locking of the exchange rates of the EMU countries will eliminate the element of the interest-rate differentials among the participating countries attributable to the exchange-rate risk. Investors' opportunities to achieve a higher return due to the volatility of the differential between government securities in the euro area will thus be reduced. Investors requiring higher yields than those available on the benchmark securities of the euro area are therefore expected to focus on issuer-specific factors related to credit risk, etc.³⁾ In this connection the rating of each issuer will draw more attention, as is the case in the USA.

In the third stage of EMU the present segmentation according to national borders will disappear. Public regulation such as the requirement that institutional investors make placements in the national currency will no longer be relevant within the euro area.⁴⁾ Furthermore, the varying taxation of domestic and foreign assets will probably lapse in the slightly longer term, although it cannot be ruled out that in the short term certain tax-related factors will entail the continued segmentation of the bond markets within the euro area. Investors will face a far greater number of issuers, which will increase the need for information on the credit standing of the issuers. In this connection it is likely that investors to a greater degree will base their credit assessment of issuers on the agencies' ratings. At the same time, the more intense competition for investors arising from the increase in the range of placement opportunities for each investor will encourage issuers to submit to a rating.

As Denmark is not a participant, the commencement of the third stage of EMU on January 1, 1999 will not immediately change conditions in the Danish capital market. However, the growing market integration within the euro area must also be expected to affect the Danish capital market. Greater use of ratings in the euro area will thus naturally make Danish market participants more aware of ratings.

Rating agencies' view of the countries participating in the third stage of EMU

On the commencement of the third stage of EMU the rating agencies' evaluation of the individual issuers will change. The changes will in particular be a consequence of greater differentiation of the credit risk within the individual issuer groups, including central-government borrowers. This is expected to contribute further to greater focus on ratings in Europe.

Moody's Investors Service and Standard & Poor's have adjusted their ratings of central-government issuers in several euro countries. However, the two agencies have taken different approaches to the consequences of EMU for the rating of central-government issuers in the participating countries. This is due to their differing assessments of the factors influencing whether a central-government borrower defaults on debt repayments. The relevant factors include:

• The debt ratio
• The central government's access to monetary financing
• Access to levy taxes
• The possibility of bail-out by other central governments or supranational institutions

Domestic and foreign debt are normally assessed differently. The central government's access to monetary financing, i.e. its access to borrow from the central bank, is of significance only to the credit rating of the central government's domestic debt. Central governments levy taxes in domestic currency. A central-government borrower must obtain foreign currency to repay the government debt denominated in foreign currency. The risk of a central-government borrower's default on payments denominated in foreign currency is therefore considered to be greater.

A central-government borrower's debt denominated in foreign currency is also subject to rating on the allocation of the sovereign ceiling. The sovereign ceiling indicates the highest rating possible for a country's issuers of debt denominated in foreign currency.⁵⁾ It is assumed that if the central- government borrower cannot obtain foreign currency to service the external government debt, the other borrowers will not be able to do so either. The shortage of currency experienced by other borrowers may be due either to a general flight of capital or to various capital restrictions introduced to prevent this flight. The probability of a currency shortage is evaluated to be greatest in countries with a net foreign debt. The foreign debt is therefore an important parameter in the agencies' rating of a central government's foreign debt.

In its rating of domestic central-government debt Standard & Poor's attaches great importance to whether the central government has access to monetary financing. Repayment of the central-government debt by means of monetary financing does entail a risk of inflation eroding the real value of the debt, but it should be noted in this connection that a rating solely expresses the credit risk on a given asset, but not any other risks associated with the bond, such as interest, foreign-exchange or inflation risks.

Standard & Poor's finds that the lack of access to monetary financing will diminish the creditworthiness of central-government issuers. As a consequence, in May 1998 the rating of the domestic central-government debt of countries participating in EMU was downgraded to the rating applied to the central-government issuer's debt denominated in foreign currency, even though no EU member state has had access to monetary financing since the transition to the second stage of EMU in January 1994. It should be noted that the downgrading by Standard & Poor's applies only to central-government issuers in countries participating in the third stage of EMU. The rating of Denmark's domestic central-government debt (AAA) was therefore not lowered to the level for Denmark's foreign debt (AA+).

In contrast, Moody's Investors Service believes that the access to levy taxes is of vital significance to the creditworthiness of a central-government borrower. This access is not affected by EMU. In this respect EMU differs from a federal structure since there is no supranational authority which imposes practical or legal limitations on the ability of each participating country to regulate direct and indirect taxation. In the short term,

Moody's will therefore maintain the present ratings of the domestic central-government debt of the participating countries.

Since the euro area is a net creditor vis-à-vis the rest of the world, Moody's Investors Service has given all EMU countries the highest sovereign ceiling (AAA). To the extent that the rating of the central-government borrower's debt denominated in foreign currency was previously lower than the rating of the central-government borrower's debt denominated in domestic currency Moody's has upgraded the rating of the central government's foreign debt. Standard & Poor's has also raised the sovereign ceiling of the EMU countries to AAA, but as stated this has not entailed upgrading of central-government borrowers' rating. Table 2 shows the two agencies' rating of the domestic and foreign central-government debt of selected EMU countries.

For non-central government borrowers located in one of the participating countries the common sovereign ceiling for the euro area entails that a higher rating can be obtained for borrowing in foreign currency than that applying to the external debt of the central government in the relevant country. This may stimulate issuing activity in the international bond markets.

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