A Financial Early-Warning System

NEW YORK – Recent market volatility – in emerging and developed economies alike – is showing once again how badly ratings agencies and investors can err in assessing countries’ economic and financial vulnerabilities. Ratings agencies wait too long to spot risks and downgrade countries, while investors behave like herds, often ignoring the build-up of risk for too long, before shifting gears abruptly and causing exaggerated market swings.

Given the nature of market turmoil, an early-warning system for financial tsunamis may be difficult to create; but the world needs one today more than ever. Few people foresaw the subprime crisis of 2008, the risk of default in the eurozone, or the current turbulence in financial markets worldwide. Fingers have been pointed at politicians, banks, and supranational institutions. But ratings agencies and analysts who misjudged the repayment ability of debtors – including governments – have gotten off too lightly.

In principle, credit ratings are based on statistical models of past defaults; in practice, however, with few national defaults having actually occurred, sovereign ratings are often a subjective affair. Analysts at ratings agencies follow developments in the country for which they are responsible and, when necessary, travel there to review the situation.

This process means that ratings are often backward-looking, downgrades occur too late, and countries are typically rerated based on when analysts visit, rather than when fundamentals change. Moreover, ratings agencies lack the tools to track consistently vital factors such as changes in social inclusion, the country’s ability to innovate, and private-sector balance-sheet risk.