This is the original English version of a piece that appeared in LIMES, the Italian Journal of Geopolitics in the March 2017 edition. The link to the original is here. They asked for something on the rule of the ratings agencies in their “who rules the world” issue.

http://www.limesonline.com/cartaceo/legemonia-gramsciana-delle-agenzie-di-rating?prv=true



Posting now because it seemed of some interest given my persistent complaints about how local currency ratings work, but also because it also contains some thoughts on the application of ratings to the Eurozone. Fully prepared for tl;dr.





The Gramscian Hegemony of the Ratings Agencies

Karthik Sankaran





Historians have long understood that the link between the fiscal capacity of the state and its ability to engage in and sustain its position in interstate competition is an essential element in the sinews of power. Beginning with the early modern period, fiscal capacity went beyond just the ability to raise taxes but to include ability to issue debt to investors with those investors displaying the confidence that these debts would be repaid – a confidence that in turn was reflected in both the availability and the price of debt.

Fiscal sinews have historically meant the ability to raise money at home. But in a world marked by immense cross-border capital flows, the ability to deny rivals access to global capital or alternately to funnel global capital to allies becomes another aspect of power. As global capital is predominantly owned and mediated by private individuals and institutions, such an ability can take the form of state suasion targeted at investors or at the gatekeepers that influence the disposition and direction of private capital flows. In our world, the rating agencies play a critical role in this regard, insofar as their assessment and calibration of the risks faced by lenders influences not just private investors but also the behavior of regulators who use ratings as an input in determining the safety and soundness of financial institutions. Ratings agencies thus have enormous power. The question is whether this power is exercised as an overt geopolitical instrument, or whether the geopolitical consequences of ratings power reflect rather a Gramscian concept of hegemony, wherein purportedly neutral judgements in fact reflect deeply rooted values, ideologies and beliefs. I would suggest that the latter interpretation is more correct for most discussions of the geopolitical power of ratings agencies.

One of the oddities of this world is the extent to which ratings agencies are concentrated in the Anglo-American world despite the fact that both the US and the UK are actually a large net borrower from the rest of the world. By various calculations the “Big Three” dominant ratings agencies, Moodys and S&P (both headquartered in the US) and Fitch ((jointly headquartered in the US and UK), account for more than 95% of all global ratings activity, with the first two accounting for roughly 80%.

This in turn is the result of several historical factors. The first is that the US and UK experienced the disintermediation of finance earlier than and to a greater degree than other countries did—i.e., rather than banks channeling funds to companies that they understood well, US and UK financial intermediation were focused to a greater degree on the issuance of corporate bonds to a broader investor base. This in turn put a greater premium on the need for information for investors less familiar with underlying business models than closely linked banks might have been, allowing for the rise of the ratings agencies.

The information infrastructure that grew out of these factors became even more important as the US rose to global prominence in the post 1945 world. By the early 1970s, US financial predominance was reflected not in the US status as a creditor to the world (unlike the model of the UK before 1915), but rather as a large debtor, whose preeminence stemmed from an elaborate quid-pro-quo whereby dollars generated by US trade deficits were readily accepted overseas in exchange for the US provision of a defense umbrella and the US provision of ready markets to absorb excess global capacity. This in turn made the dollar the dominant currency of international finance, a status that it still occupies today, with roughly 60% of all cross-border lending conducted in US dollars (This figure does not count cross-border lending within the same currency area as is the case within the Eurozone). contracted in dollars. Globalized dollar lending made US based ratings agencies a central part of the global system of gatekeepers for finance.

What is interesting that Europe was the first (and only) large economic area to try to extricate itself from its dollar linkage when the collapse of the Bretton Woods system in 1971 led to excessive intra-European currency volatility. This in turn inaugurated a long series of arrangements to limit such volatility that culminated in the creation of the Euro. The deutsche Mark and eventually the Euro replaced the dollar has long replaced as the dominant invoice currency in the region. The Euro has also a moderately high degree of internationalization (albeit less than the dollar), with the Euro accounting for a bit more than 20 % of out of area international lending. Meanwhile, the sheer size of the banking sector means that European banks are dominant players in much of the world. As a region with large net savings, Europe is also a net provider of savings to the rest of the world via its private sector. Notwithstanding all of this, European (or more precisely Eurozone-based) ratings agencies have little influence in the world. The same is even more true of the other large suppliers of global savings –China and (until the Shale revolution in the US) the major oil exporters. It is a commonly pointed out as a flaw that the ratings agencies are compensated by issuers rather than by investors, which may in turn create conflicts of interest. There is also a less remarked meta-issue that the dominant suppliers of credit ratings are headquartered in the sinks for global savings rather than in their source.

Do these factors have geopolitical consequences? Undoubtedly yes, but in a less obvious way than might be believed. It is not too often the case that purely geopolitical calculations (or political pressure to consider the same) influence the extent to which agencies tailor their reviews. Like many modern professional cadres, ratings personnel adhere to a certain standard of technocratic autonomy that is governed by its own rules. They are largely recruited from the group of universities that the dominant institutions of globalized finance themselves patronize. This is an international fraternity (and sorority) largely schooled in orthodox economics (with the usual doctrinal schisms within that orthodoxy), and a set of substantially internalized beliefs on the interactions among institutions and economics.

There certainly are instances in which old-fashioned geopolitics plays a part. For example, sanctions meant that Iran was substantially excluded from ratings by the dominant agencies for several years (though there are reports it may seek to renew its ratings as attempts to access capital markets again following the conclusion of the nuclear deal). But even in the case of sanctions, market power matters. For example, the sheer size of Russian integration with global capital markets (with roughly 700 bio dollars owed to Western financial institutions) may have been one factor that meant sanctions after the invasion of Ukraine were calibrated in such a way as to fall well short of Iranian levels of exclusion from markets. Nevertheless, the experience did mean that Russia (like other countries) is trying to set up its own ratings agencies. It remains to be seen how much purchase some ratings will have with investors outside Russia where the advantages of incumbency will likely be very strong.

However, rather than considering ratings agencies through the prism of pure geopolitics, I would argue that it makes more sense to focus on the rules, ideologies, and beliefs that influence ratings, which then have geopolitical and geoeconomic consequences. It does some quite clear that there are issues of internal consistency across the ratings landscape that seem particularly problematic in the case of emerging markets ratings.

The basic metrics that inform creditworthiness include public sector debt to GDP ratios, the currency composition of debt, the extent of private indebtedness in the economy, particularly in the financial system (which in turn may swell sovereign contingent liabilities), and the extent of net overseas holdings of assets (which in turn may be drawn down by domestic citizens to fund their local government). The issue is that the interaction among these factors is somewhat opaque and not necessarily scaled. So some countries would seem to be unequivocally AAA credits, such as Norway with a debt/GDP ratio of 31% and a positive net international position of 170% of GDP. But so are Canada with a gov’t debt/GDP ratio of 92% and an NIIP that is essentially 0% of GDP, and Australia with a government debt/GDP ratio of 40% and an NIIP of -60% of GDP. Conversely, emerging markets sovereigns with much lower debt/GDP ratios and higher NIIPs are rated much lower – for example China’s gross general government debt is 42%, its NIIP is +15%, it has virtually no sovereign external debt owed to private creditors, and yet its rating is in the AA-/A+ area. While this might be justified by large increases in private sector indebtedness in the recent past, developed sovereigns with substantially higher government debt ratios, worse NIIPs, larger banking systems (implying a larger contingent liability problem), and possibly greater medium-term political uncertainty (such as the UK) are rated higher than China.

The overall impression is that a hegemonic ideal of high-income democratic neo-liberalism automatically qualifies a country for high creditworthiness despite numerical indicators to the country. The most clamorous example of this was the overrating of Iceland in the 2000s. A tiny country with an immense, internationally active and very risky banking system (whose assets were roughly 9 times GDP) not only achieved the highest rating from one of the agencies, but saw its banks also upgraded (on the assumption of sovereign support) despite the obvious fact that the sovereign was too far small to actually tender such support. Indeed as late as mid-2009, after a crisis had seen the failure of the entire Icelandic banking system and the imposition of capital controls, the country was still rated higher than Brazil by the same agency, though Brazil had largely weathered the2008-2009 crisis and still had ahead of it a few years of a tailwind from a commodity boom.

As stated before, I do not believe that this reflects geopolitical preferences or influences—that Iceland was a NATO member had to less to do with the decision than a more ideological disposition within international capital more broadly. This is the belief that capitalist democracies that respect neo-liberal tropes of “supply side efficiencies” are inherently likely to have better prospects for economic growth and political stability, which makes them better credit risks, even when the numerical indicators of creditworthiness point the other way. To reiterate, this suggests the operation of hegemony in a Gramscian sense as a set of highly influential beliefs (and rules flowing therefrom) that is both widely shared and rarely questioned, rather than in a more “political science” sense of an exercise of state power by a hegemon that seeks to push private entities in a favorable direction during the course of interstate competition.

Nevertheless, these factors can have political and geopolitical consequences. To return to the years before 2008, the major feature of that period was the sharp rise in so-called global imbalances, as current account deficits in both the US and in the Eurozone periphery exploded alongside large surpluses in the eurozone core, East Asia and among the oil exporters. Among the latter two, the task of accumulating and recycling these surpluses savings was undertaken more by the sovereign than by the private sector. The quest for high-quality assets that could absorb those savings led to the creation of synthetic securities grounded in the US real estate market whose putatively high credit ratings proved famously illusory. An important point here is that the effects on US labor of China’s epochal reentry into the circuits of the world capitalist economy were hidden for a while as US consumption levels were cushioned by increases in US household leverage enabled longer than they would otherwise have been by the operations of the ratings agencies. The broader geopolitical implications of this—the accommodation of China’s rise, the widening rift between globalized capital and national labor in the US and other developed markets (which in turn has led to the Trumpist retreat from globalism) are profound, but once again they seem to stem more from the operations of unconscious rules than from overt pressure to turn the ratings agencies into geopolitical instruments.

The other major node of global imbalances (between the surplus capital exporting core and the deficit capital importing periphery) was the Eurozone, and it is here that the interaction of politics, economics and geopolitics becomes most clear. The decisions of the ratings during the crisis reflected a procyclical pattern observed during the Asian crisis of 1997 of excessively high pre-crisis rating followed by excessively sharp downgrades once the crisis began, which in turn may have contributed to amplifying market responses that exacerbated the crisis. These patterns during the Eurozone crisis (as they did after the Asian crisis of 1997-98) have occasioned a great deal of criticism, but I would argue that that ambiguities in the economic and political governance of the Eurozone may well have heightened the procyclicality of ratings behavior.

As is well known, the central ambiguity of the Eurozone lies in the fact that it is a monetary union that is not also a fiscal union. This in turn creates questions about whether national debts in the Eurozone are contracted in a foreign currency or in a local currency, and simultaneously about the extent to which single countries in the Eurozone can be said to enjoy full monetary sovereignty. These facts have led many market observers to make analogies between the Eurozone and the classical gold standard and to countries that failed to maintain their currency boards (such as Argentina in 1998-2001). Yet even these analogies are in my view, very likely misplaced. The reason is that unlike the classical gold standard, the Eurozone has shared control of a fiat money producing central bank that is capable and substantially (but not unconditionally) willing to moderate the rises in credit risk premia that arise from downturns in the business cycle. The common payment system Target 2 provides unlimited absorption of very large drops in investor appetite for assets from troubled countries. The classical gold standard enjoyed neither of these features nor did hapless countries like Argentina.

At the heart of this difference is precisely the fact that the EU’s creation and evolution is a consequence of geopolitical imperatives. The evolution of the EU and the Eurozone reflects first a desire to escape a history of intra-European wars, then the desire to anchor a reunified Germany to its Western neighbors in 1990 and more recently the desire to create an economic and financial unit that gave Europe a semblance of geopolitical and geoeconomic parity with China and the US. These factors are very different from the highly asymmetric motivations that led Argentina for example to import credibility by its peg to the US dollar, even while there was correspondingly relatively little concern on the US side when Argentina finally exited it calamitously.

But what complicates matters further is these geopolitical desires at a pan-Eurozone level have to negotiated against a backdrop of national preferences where there are political constraints on pooling sovereignty (or at least at the pace of such pooling); protests against perceived transfers (whether overtly fiscal or resulting from central bank action) among some countries; and protests against the fact that such transfers are conditional (and consequently seen as a constraint on the exercise of democratic choice) in still others. Political ambiguity is compounded by legal ambiguity—the language of “irrevocable conversion parities” to the Euro is not compatible with Article 50, which explicitly recognizes a right to leave the EU (a right the UK has chosen to exercise). Periodic political messaging around the prospect that Greece might leave the Eurozone, but still stay in the EU clouds matters further.

Recent history suggests an interplay between domestic political constraints and a revealed preference of European leaders to keep the Eurozone alive for geopolitical and geoconomic reasons by agreeing in moments of crisis to hitherto unthinkable expedients such as the creation of fiscal backstop (EFSF and then the ESM,) and the creation of a conditional monetary financing tool (OMT). Against this backdrop, whatever their historic misjudgments it is probably harder for the ratings agencies to get the Eurozone “right” at all times precisely because the fundamental categories of sovereignty and local versus foreign currency debt are more politically fluid as a result of the unique construction (and the ongoing evolution) of the Eurozone. The dominance in the ratings markets of English speaking countries with a particular culture of political economy might well exacerbate ratings misjudgments in the case of the emerging markets. However in the case of the EU in particular, some portion of the blame ascribed to the ratings agencies must also fall on the fact that the financial and political architecture of the Eurozone is in itself a work in creation, with the maximum creativity displayed only in the moments of crisis.