by Sovereign credit ratings are meant to be independent measures of a country’s ability to pay its debts. Such ratings are important because they determine the interest rates a country faces in the global financial market and, therefore, its borrowing costs. Ratings also matter for attracting investments by international companies, so-called foreign direct investment (FDI).
Unfortunately, sovereign credit ratings are negatively biased towards the Global South. UNDP estimates that unequal country ratings have cost African states more than $24 billion in excess interest and over $46 billion in forgone lending. The African Union is currently spearheading a growing reform movement to establish alternative rating agencies to Fitch, Moody’s and Standard & Poor (S&P)—the three American firms completely dominating the sovereign ratings industry. Their power was cemented by law, as they were the only ratings agencies officially recognised by the United States between the mid 1990s and 2003.
DDRN has interviewed Dr. Ramya Vijaya, Professor of Economics and Global Studies at Stockton University, to discuss her recent article on sovereign credit ratings and financial subordination, as well as the wider implications of unequal access to finance for developing countries.
How Credit Ratings Constrain Developing Countries
On whether she thinks country credit ratings are understudied, Dr. Vijaya said: “Sovereign credit ratings come into focus when there are moments of crisis. So in 2008, for example, during the global financial crisis or the 2012 European debt crisis. Then again during COVID a little bit when credit ratings became this sort of doom loop. But once the spotlight of the crisis goes away, it is definitely an understudied field when we talk about making lasting changes.”
It is crucial to investigate the long-term effects of country ratings because they determine how much money governments—particularly Global South countries with lower tax revenues—can afford to spend on healthcare, education and other important areas for development.
For instance, Cameroon and Ethiopia’s credit ratings were slashed after they requested relief from the Debt Service Suspension Initiative (DSSI). The DSSI was created in 2020 to grant low-income countries temporary debt relief, allowing them to expand spending to recover from the pandemic. Instead, the rating downgrade increased the costs of Cameroon and Ethiopia’s debt, prolonging recovery by straining their budgets.
A report by the International Monetary Fund (IMF) shows that Global North countries averaged 12% of GDP on pandemic-related spending. The numbers for emerging market and low-income economies were 6% of GDP and 3% of GDP, respectively. Yet, emerging and developing states accounted for over 95% of sovereign rating downgrades in 2020.
These examples highlight how developed economies get additional leeway from rating agencies to pursue a countercyclical fiscal policy, meaning they can ramp up spending or cut taxes during downturns to stimulate growth. Consequently, these countries can recover more quickly from crises. Global South nations, meanwhile, cannot increase government expenditure due to the threat of rating downgrades. Such procyclical policies tend to exacerbate debt problems and prolong recessions.
Beyond intensifying economic crises in the short term, limited access to finance affects long-term development. “Development does not follow the business cycle. Development is more on a 10–15-year horizon. Right now, [long-term] financing at affordable rates almost does not exist. Health is a very good example. What happened during COVID was that for a very long time, when the main prescription you are getting is austerity, what falls off the radar are things like investment in health infrastructure and education,” Dr. Vijaya explained.
In her paper, she shows statistical evidence that improved country ratings lead to higher spending on health and education as a proportion of government expenditure and vice versa. A higher rating deems a country less risky, allowing them to spend more without the risk of higher borrowing costs and capital flight. Crucially, developing countries are subject to downgrades more often because of the methodology employed by credit rating agencies. As a result, a short-term fiscal horizon based on austerity is imposed on the Global South, worsening inequality in the global financial system.
Flawed Rating Methodology
Fitch, Moody’s and S&P all employ several quantitative and qualitative measures to shape a country’s credit rating. These are roughly: economic resilience and stability, financial health and budgetary outlook, monetary policy direction, governance and institutional strength, and balance of payments and international financial position.
The three agencies publish different methodologies, but there is broad alignment on indicators used and convergence on the ratings given to countries. Firstly, the quantitative indicators, weighted differently, decide a cumulative score; the higher, the better. Then, unknown qualitative measures adjust the score, determining the final rating.
There is grave potential for bias in the qualitative indicators’ lack of transparency. Moreover, the quantitative indicators give Global North countries clear advantages. For instance, as shown by Dr. Vijaya’s paper, the rating methodology prioritises the size of economic activity, meaning a larger GDP or GDP per Capita results in better ratings. Larger economies are mostly located in the Global North.
What currency a nation has highly impacts its sovereign credit rating. A country gets upgraded if it uses what is called a reserve currency—USD, Euro, Canadian Dollar—as legal tender because it is deemed less risky. Reserve currencies also give countries improved credit ratings indirectly by decreasing the proportion of foreign currency debt, as foreign currency reserves are usually held in USD or Euro. Debt issued by developing states in local currency displays greater sensitivity to shifting economic conditions. This currency hierarchy reinforces existing inequalities in the global financial system.
Repayment as the Bottom Line
There is, furthermore, no mechanism for developing countries to catch up. Neither the rating agencies, the International Monetary Fund (IMF) or the World Bank—the two main financial institutions disbursing loans and grants to the Global South—distinguish between different types of government expenditure. Spending on education or spending on weapons. For a country’s ability to access development finance, it counts the same.
This is because the international financial architecture leans towards ensuring repayment. Dr. Vijaya explains: “The metrics that are used are all about how [developing countries] can pay back and how quickly they can pay back. Fiscal discipline is okay, but you need to talk about where that [expenditure] cut should come from. If you’re not interested in that, it seems like you’re just interested in the repayment aspect. You’re not really interested in directing these funds to the right place. That is, I think, crucial.”
Similarly, there are no evaluation criteria to ensure that funds are not squandered by corruption, as seen in the case of Sri Lanka between 2019 and 2022. “Where were the global institutions when they were pushing Sri Lanka to take all these loans? Their valuations never looked at those issues whereas Sri Lankan civil society was constantly asking: ‘Where is the money?,’” Dr. Vijaya said.
China has in recent years emerged as an alternative lending source for developing countries, providing over $1.3 trillion between 2000 and 2021. China does not follow the conventional sovereign credit ratings. There is, for instance, evidence that a disproportionate share of Chinese state loans to Africa are made to governments with high credit risk levels. The long-term impact of China on traditional country ratings remains to be seen.
What Denmark can do to Help
Development in the Global South requires fair access to credit. Presently, the international financial system is trapping South countries in a Catch-22. They can either prioritise their sovereign credit rating and decrease spending on healthcare and education or try to develop such social infrastructure while paying higher borrowing costs. Advanced economies do not have to make this choice.
Denmark can use its platform at the UN and other multilateral forums to advocate for positive change. The Danish Development Cooperation Strategy focuses strongly on mobilising climate financing for the green transition. Developing countries need greater fiscal capacity to raise the money needed to combat climate change. The current short-term, austerity-based fiscal spiral advanced via sovereign credit ratings makes such expansive policy hard, if not impossible.
Dr. Vijaya thinks Denmark should:
- Support the African Union’s call for more regional credit rating agencies, breaking the dominance of the big three firms
- Offer expertise and partner with Global South actors to establish these regional credit rating agencies
- Platform and support G77 proposals for reforms of the unequal sovereign debt system
- Invite scholars from the Global South who study international financial inequalities to partner with Danish universities
- Support the UN Framework Convention on International Tax Cooperation, which centres on developing countries
Ultimately, improving sovereign credit ratings is part of a wider reform agenda to decrease global inequality. Developed states such as Denmark have a responsibility to play their part.
Adrian Ganic has a M.Sc. from THE LONDON SCHOOL OF ECONIMCS AND POLITICAL SCIENCE a is a DDRN INTERN
