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Should You Listen to Ratings Agencies on Sovereign Debt?

Last night, the credit ratings agency Moody's Investor Service downgraded its ratings on Italy, Portugal and Spain. It also lowered the ratings outlook on France, Britain and Austria to "negative" from "stable."

The question is: should you care?

Moody’s and its rival S&P rose to their preeminent role in capital markets by rating traditional corporate debt issuances and the general obligation bonds of states and cities. They have an arguably decent track record in this area of core competency—although critics argue that they frequently assign ratings that are too low to municipal bonds.

But outside their core competency, Moody’s and S&P have a much less stellar record. We all know the history of their disastrous ratings on mortgage-backed securities and complex structured credit vehicles.

As it turns out, they are not especially competent when it comes to rating sovereign debt. They have a poor record of predicting sovereign debt crises, currency crises or financial crises, according to a 2002 paper by the scholar Carmen Reinhart. That incompetence goes in both directions—they fail to accurately foresee crises about as often as they predict crises that don’t happen.

The main problem is just that sovereign debt crises are difficult to predict. The pretense to predictive expertise is just that—a pretense, an illusion.

Reinhart found that part of the problem is that ratings agencies aren’t very good at predicting the types of crises that lead to defaults—such as currency crises or financial crises. Defaults are very tightly linked to currency crises—only a minority of sovereign defaults occur outside of a currency crisis. (It doesn’t hold the other way, though. Lots of currency crises don’t result in defaults.)

“It would appear that rating agencies have tended to focus on a set of fundamentals that—when it comes to anticipating currency crises—are not the most reliable,” Reinhart writes.

According to Reinhart’s paper, the ratings agencies are probably somewhat better at predicting defaults than the crises that lead to defaults. But they often get the timing of a default wrong.

But in some ways, the accuracy of the ratings agencies may not matter. In all sorts of ways—from legally imposed capital requirements to contractual arrangement by institutional investors—the ratings of the agencies can change who can and cannot hold certain bonds. Losing a high rating can force sales. Even the fear of the loss of a rating can cause a sell-off.

But this is not always true. After the US was downgraded in the summer of 2011, its bonds rallied.

So perhaps the best thing to do when it comes to sovereign debt ratings is just to ignore them. There’s more noise than signal there.

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