Why credit ratings matter

This article of mine originally appeared in the 4th Quarter 2014 edition of Personal Finance magazine under the title “Interest Rate Realities.”

Credit bureaus are companies that keep track of how well you handle credit and pass that information on to prospective lenders in the form of a personal credit score. They keep track of your loan repayment history, your debt and your pursuit of new debt and from this they calculate your creditworthiness – in other words, how risky a borrower you are.

Higher-risk borrowers are able to obtain only smaller, shorter-term loans at higher interest rates than usual to compensate the lender for taking more risk. When this system works properly and transparently, it helps regulate the credit markets and protects both lenders and borrowers from excessive risk-taking and indebtedness.

With this in mind, think of the international sovereign credit ratings agencies – such as Standard & Poor’s, Moody’s, Fitch, and China’s Dagong – as credit bureaus for countries. They keep track of the credit scores of governments from all over the world to inform lenders of the likelihood of a government defaulting on its debt repayments. These scores are called “credit ratings”.

Credit ratings are a big deal because governments the world over borrow a lot of money, usually from banks, large pension and insurance funds (i.e. your retirement money), and other governments. The combined size of all government bond markets in the world is $40 trillion, more than twice the size of America’s entire GDP. The South African government bond market is well over R1 trillion in size and in 2014 alone the government will borrow roughly another R150 billion. Because the SA government bond market is so big and attracts so many foreign lenders, the risk associated with SA government debt affects confidence in the currency and the debt risk profile of large and systemically important borrowers such as metropolitan municipalities, Eskom, Transnet, banks, and other big corporations.

This is why investors pay so much attention to credit ratings. Upgrades and downgrades, if arrived at intelligently and thoroughly, tell investors a lot about the fiscal responsibility of the government, the prospects for the currency, and the general cost of borrowing across the economy. When a government keeps getting into more and more debt, shows signs of distressed borrowing to meet expenses, or has problems raising enough income through taxes, its credit rating should fall.

Although it didn’t have an official credit rating at the time, Zimbabwe’s government experienced this loss of confidence among lenders in the late 1990s, when it began to borrow and spend recklessly and instituted policies that hurt its economy and depleted tax revenues. The result was that foreign lenders stopped lending and the currency weakened sharply. The government was forced to either live within its means or resort to printing money to fund its excessive spending. Unfortunately, it chose the latter due to political expediency, in the process destroying completely the value of the currency in hyperinflation and sending the country into complete economic ruin.

In June 2014, S&P downgraded the South African government’s sovereign credit rating for the second time since 2012. This tells lenders that the SA government’s credit risk has risen, so lenders need to consider making smaller, shorter-term loans and imposing higher interest rates if they choose to lend at all. The downgrade suggested that the currency might get weaker and that the costs of borrowing generally in the economy would rise. The latter was confirmed the following month, when the Reserve Bank raised the repo rate.

The S&P downgrade is bad news. It not only confirmed that South Africa’s government finances were being poorly managed, but it also took the credit rating to BBB-, which is only one ratings notch above “junk grade”. Most lenders consider junk grade – or more formally, speculative grade – a risk too far and head for the exit. If the South African government does not tighten its belt, sooner or later it will be forced to do so – or embark on a course of reckless borrowing and/or printing money to fund itself. The consequences of the latter choice, as Zimbabwe showed, can be dire. The former is the correct way to right the ship, but it entails some pain. Nobody wants a party to end. But it always does.

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