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Brendan Keenan: It's hard to credit, but ratings agencies aren't always right

'WHAT are these ratings agencies?" someone asked. The simple questions are the hard ones. What are they indeed, and how did they get to be so important?

The idea behind them could not be simpler. If you have money to lend, and do not quite feel up to checking out who best to lend it to, why not pay somebody else to do the donkey work?

That is what the agencies do. Down at the bottom of the pile, there are agencies rating the likes of you and me, to see if there is anything in our credit history which makes us a poor risk for a car loan. At the top of the pile, Standard & Poor's (S&P) says the government of France is not as safe as it might be.

On the face of it, the idea behind the public ratings agencies seems eminently sensible. Not every lender is a Goldman Sachs. The average small pension fund manager should not be expected to analyse the respective merits of lending to Rio Tinto Zinc or the government of Portugal. A bit of expert help is very useful.

But perhaps lenders have relied too much on such help. The rules of pension funds, or other investment bodies, often automatically prohibit lending to entities with credit ratings below a certain level. That gives the agencies a lot of power to do a lot of damage.

For instance, the reduction of France's AAA rating poses a threat to the living standards of every Irish person. It is a small threat as yet, but in theory it could mean higher borrowing costs for Ireland's bailout loans, because the French and Austrian downgrades mean the EU borrowing fund, the EFSF, also lost its AAA status.

It does not help that the reasons for downgrading a country such as France are themselves contentious and politically charged.

S&P defended the downgrades on the basis that December's EU summit did not provide a "sufficient breakthrough" in dealing with the eurozone crisis. Commissioner Olli Rehn disagreed, claiming it had produced "decisive action".

One can come to one's own conclusions, although the ECB rather helped S&P's case, by claiming the summit agreement was already being watered down.

That is part of the problem. The ratings agencies may have seemed particularly insensitive in their timing, and obscure in their analyses, but EU leaders keep doing their best to prove them right. Italy's "technocrat" prime minister, Mario Monti, as good as said this in an interview with the Financial Times.

When S&P gave its opinion that the lack of progress on the European financial crisis "may reflect structural weaknesses in the decision-making process within the eurozone and European Union", it was only repeating what many officials say in private.

One thing the agencies cannot be accused of is cowardice. Their reputations were badly damaged by the failure to spot the risk in sub-prime mortgage derivatives, and they are threatened with more regulation, even abolition, in Europe, but they continue to put the boot in.

That is admirable, but being brave is not the same as being right. The body which best recognised the dangers of those complex derivatives was the central banks' umbrella group, the Bank for International Settlements. But in a recent analysis, it seemed largely defeated by the present crisis, saying it was too unlike anything which had happened before to allow for any accurate assessment of risk.

In such circumstances, the differences between AAA and AA may be largely notional. It is already clear that Greece will not be able to repay all its debts as they fall due; it is widely believed that Ireland will not be able to; and it is greatly feared that Italy is in the same position.

Beyond that, things get very hazy, if not downright bizarre.

In a report last week, analysts at the US Citigroup bank opined that there will be only a handful of countries with top credit ratings in a few years' time. They will not include the US or Germany. The biggest economy in this elite group will be Canada.

If that is the case, it is better to think of ratings as comparisons between countries rather than absolute measures. The very best should always be an elite group. It may have been another delusion of the debt years that most of the rich world was rated AAA. As I have often tried to point out, an economy like Ireland's is always at risk.

That may be fine provided lenders -- the pension funds and so on -- take the same view and loosen their rules a bit. More likely is that they will demand higher interest rates from governments and their taxpayers than has been the case in recent decades.

And there is the possibility -- cited last Wednesday by the World Bank -- that they will bypass many debt-laden, elderly, rich economies altogether; in favour of the exciting potential of emerging nations. In which case, the agencies have not yet been hard enough.

Sunday Indo Business