Subnational Capital Markets in Developing Countries: From Theory to Practice

By John Petersen; Mila Freire | Go to book overview

Chapter 10
Credit Analysis and
Credit Ratings

Credit analysis is a demand-side activity. Investors and their advisers exam- ine information on issuers and their obligations and make judgments on the rewards and risks of investments. Credit risk, typically taken to mean the economic, legal, and political risk inherent in a particular obligation, ultimately boils down to default risk.1 Information used in credit analysis can be garnered from a variety of sources, such as government statistical data or the local newspapers, as well as issuers and borrowers.

Credit analysis demands resources and analytical skills that many in- vestors, especially individuals and smaller institutions, lack. Thus most in- vestors rely on the opinions of experts (box 10.1). An independent, objec- tive system of credit ratings of high quality is an essential component of the development of a vibrant capital market. It is especially important for security markets, with numerous investors that must rely on information provided by issuers and others. If the ratings are respected and used, the rating companies have the clout to demand full disclosure by issuers. To the degree that these companies are successful in obtaining data and that their ratings reflect legitimate risk indices, the entire market is aided by the categorization of debt and the monitoring of performance.

The role of credit ratings is not without controversy. For emerging mar- ket economies, with their chronic shortage of trained analytical staff, rat- ing agencies offer a pool of skilled analysts who can assess credit quality on behalf of all investors, using a standard methodology (at least standard to each agency). On the negative side this concentration of opinion, using methods that are proprietary and not fully disclosed, can lead to a danger- ous dependence on a handful of experts who can influence the market without an effective check.2

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