This chapter provides a review of the literature which already exists in relation to the impact of Credit Ratings on Leverage, Debt Maturity and Sources of Funding on the private enterprises in the global economy, and specifically its application for funding for the Asian firms. Accordingly, this chapter will initially discuss the concept of credit ratings; it will then move on to describe and analyze the impact of CR on leverage deals and debt maturity in response to the demand for funds by the firms in the emerging economies. This chapter will also provide an analysis of the current credibility of CR and the market acceptance in providing cheap sources of funds for the Asian firms. The impact the CR does to various types of instrument will also be analyzed in the context of the current state of the world economy and future practice.
The concept of CR is closely linked to that of sovereign ratings assigned to the economies from which sources of funds were demanded by the private companies through debt market. The review will also look at the linkages that determine the relationship between the two although the study will focus on the impact of the fund requirement of private enterprise. Finally, there will be a critical analysis of the benefits and challenges of a CR system of sourcing the funds and the shortcomings of system and the implications will be presented.
1.2
The concept of credit ratings
Credit ratings are the assessment models which helps to know about the financial health of the company. They use two measures to assess the risk or the cycle of expected loss. First, they enumerate the current financial and second, the future performances are incorporated in the assessment. They also provide outlook of the economy as well as the industry and it judges the financial capacity of the issuer of the instrument. (Metz and Cantor 2006). "The importance of credit ratings to investors and other market participants had increased significantly, impacting an issuer's access to and cost of capital, the structure of financial transactions, and the ability of fiduciaries and others to make particular investments". (Kisgen* 2007). In short, the credit ratings have become a market arbiter which not only affects the process but also a borrowing trend that determine the funding behavior of the investor.
International credit rating agencies are much respected for their assessment criteria; Their assessment will include : 1. Country specific ratings ; 2. Industry Ratings and 3. Firms ratings. They use quantitative and qualitative tools to arrive at the CRs. In the qualitative measure , they use economic variables and in the quantitative , they use government policies and the other non-government factors. Both of which help them prepare risk profiles of the firms. (Cheung 2000).
There was a time when the Asian economies focused inwards had very little to worry about foreign direct investments. The globalization changed the way they approached to the international financial system. The need for capital flows led them to change their domestic laws, resulting in the domestic firms becoming active participants in the field of borrowing capital and many considering the debt option as the cheapest source of funds. Interstate movement of capital involved processes involving on one hand, an investment opportunity for the investors and on the other risk opportunity for the potential borrowers. Meantime, the opportunity also gave rise to dependency for capital and the capital provider from the West. It created an opportunity for the credit rating agencies, to provide risk models which will help to set up a financial processes which will be transparent and maintain harmony in the volatile capital markets.
In the article, Debt Specialization the author argues that credit quality is the main criteria for the investment firms in choosing the various types of debts available in the market. (Colla 2011, 13). Secondly, the capital structures of the firms which plan to seek market capital are affected by the ratings given to them by the CRA. Thirdly, the firms tend to postpone their borrowings at the time of ratings upgrade and downgrade. The major influencing factors that have to be considered in this context are follows: 1. Credit ratings and debt structure relationships within the context of the funding of private enterprises ; 2. Credit lines and debt structure relationships and the access issues in the emerging nations.
In the research to be undertaken our focus is on corporate entities hence the role of capital structure of the firms is also influenced by the country's financial system and the role of debt in the market where the monetary instruments are floated for the investors. (Jong 2007). However there are common factors which have to be analyzed before proceeding to funding aspects of the private firms.
Some of the factors are : First, the institutional environment of the firm; second, the availability of efficient banking and capital market system; third, legal environment and fourth, shareholder and creditor's rights. (Alves and Ferreira 2007). In the article on Capital Structure and law around the world, an interesting observation is made it says , the determinants of capital structure are same for both the developed and developing countries. (Alves and Ferreira 2007, 4)
Yet another issue which bothers the investors is the creditor's rights standards. The investors look forward to institutional variables as the foremost among the determinants in selecting the financial instruments and the firms where they intend to invest.
The five variables of firms that matter in funding are : 1. Market to Book; 2. Profitability ; 3. Size; 4. Tangibility and 5. EFWA. (Alves and Ferreira 2007)In choosing the firm to invest, the size of the firm is a major criteria in the institutional environment. In a study conducted across 34 countries, it is also cited as the major factor in market leverage.
1.3
Leverage deals and debt maturity
Credit ratings play positive as well as negative role on leverage deals that firm use to finance their operations. Capital structure gets deeply affected by the downgrades that happen in credit ratings. CR becomes a major tool in allowing the private firms better fundraising opportunities in the market. The leveraging of the firms is solely dependent on CR. Any downgrading of the firms leads to their being denied benefits which are part of the leveraging. Capital markets will restrict the sale of commercial paper, investor access, and interest rate swap. It will require to provide high disclosures, maintain high cash reserves and third party deals will fall through. (Kisgen* 2007). The advantages of leverage are as follows :
1. The firm which owns high level of bank debt is in a better position to leverage itself. ; 2. Banks are reluctant to finance firms which have high levels of debt.;3. Dividend payouts are not criteria to raise funds.;4. The companies with volatile earnings can leverage themselves to public debt. (Antoniou, Guney and Paudyal 2008).
Legal aspects of financial contracting have a deep impact on the way the leveraging is conducted by the private firms. The debt and equity instrument are governed by the national laws which determine the kind of response the international investor will give to the firms. There are two types of laws that govern the working of financial relationship between the borrower and lender. First, the English law ; and Second, the French law. The former is a common law observed in most of the market based economies, while the latter is seen in underdeveloped countries. The major difference between the two systems is the way they treat the minority shareholders.
The borrowing of the firms however depends on their capacity to market their needs through appropriate sources. The external financing is the main source used by the private firms for the borrowing. 1. Financing from local and foreign banks; 2. Equity finance; 3. Operations are financed and 4. Finance from development banks, money lenders, public and other sources. (Thorsten Beck October 2002).
According to World Bank Study, most of the private firms prefer bank and equity finance options to the other external sources. It also found that the countries which follow common law practices are the attractive destinations for the leveraged deals. The equity finance, the report suggests are easier to obtain than the other sources. It also points out that small and medium firms find it difficult to arrange for debt funds.
The borrowers who seek funds from the market are those who generally with 'higher financing need'. (Thorsten Beck October 2002). It is pertinent to note Myers's hypothesis here : "corporate borrowing is inversely related to the proportion of market value accounted for by real options." (Myers 1977). In this instance real option or call options are those whose value are determined by the riskier investments it might undertake in the future.
In this context , it is worthwhile to consider the optimal capital structure theory of Miller and Modigliani which emphasize that the financial decisions may not affect the value of the firm.
The theory argues that the corporate financial structure in the traditional sense can be undone by robust markets and the intelligent investors. It has to be coupled with impartial tax regime. In this scenario, surplus or the defict debt will be carried forward by the system without having any effect on the market value of the firm. The market value of the firms is the sum total of debt and equity. The theory suggests that the market value of the borrowing firm depends on income driven by assets rather than debt. It does not take cognizance of the distribution of dividends or in plain words profits generated by the firms. (M. H. Miller 1991, xiii).
There are four aspects of this theorem: 1. In a given situation, the debt-equity ratio may not affect the market value of the firm; 2. The borrowing firm may not be affected by the weighted average cost of capital.;3. Dividend policy has nothing to do with market value and 4. The financial policies do not influence the equity investors. The theory helps us to classify the firms in risk class and they also provide a method to fix arbitrage cost. (M. H. Miller 1991)
Another dimension which needs a careful scrutiny is firms' characteristics in developing financial choices and raising the liquidity from the market. 1. Debt over equity; 2. Short-term debt over equity.;3. Long-term debt over equity.;4. Short-term debt over total debt, and 5. Retained earnings over total liabilities. (Schmukler 2000). The Kaminsky and Schmukler's study have developed a 'multidimensional index' based on "account controls on interest rates, legal restrictions for firms and banks to borrow in foreign markets, level of reserve requirements, and restrictions for residents to acquire assets in foreign currency." (Kaminsky 1999).
1.4
The impact of CR on leverage deals and debt maturity
Access to international markets for the emerging economies depend on the capacity to leverage short term and long term debt. At the same time, firms also have to ensure better credit ratings upgrade and downgrades. In a way, the capital structure of a firm depends on the credit ratings. In short, there also exists benefits that a firm may get on account of credit ratings. First, most of the bond investments are solely depending on the type of investor a firm can approach in the international market. For example, the pension funds and the banks are prohibited from participating in bond buying if a certain level of ratings is not achieved. Secondly, the information released by the credit agencies also signify the quality of debt that is offered by the prospective firms. Thirdly, the ratings can also cause combining of firms into a group.
Kisgen, in his credit rating-capital structure hypothesis, argued that the firms who are under review by the credit ratings tend to not to go to the market with debt offering than those who are not to be graded.Secondly, the firms who are having distress grades but are about to get an upgrade tend to go to market for more debt. (KISGEN June, 2006). The effect on credit rating on the fundraising is all encompassing. It not only affects the firms' ability to raise money but also puts a variety of restrictions on the way it handles various other aspects of business. First, the firms may find the rating affecting the supply contracts. Second, the employees deserting the firms. Third, the customer relations management (CRM) may get negatively affected.
The Tradeoff theory illustrates the working of capital structure model. It states that the firm will fix an optimal leverage based on bankruptcy cost and the cost of debt against the factors of interest tax shields and debt advantages. The reasoning the theory gives is the company will weigh cost and benefit analysis for both the equity and debt finance and choose the right option to optimize the leverage.
1.5
The current credibility of CR and the market acceptance in providing cheap sources of funds for the Asian firms
In the last decade, the Asian economies have registered phenomenal growth in terms of production output as well as the generation of profits. The countrywide figures for the year 2000 show that for example .Indonesia, Thailand, Hong Kong added to their GDP by more than 2% during the period. In fact , the economic crisis also could not put stop the positive growth story of some of the countries in the region. However the Asian currency crisis found many of the firms in the region becoming casualty of what is termed as,'information asymmetry'. (Cheung 2000) It led to decline in credit worthiness of many of the Asian firms. The situation led to the investors began to focus on companies which possess a 'high level of credit'. The credit rating which values a company purely on the basis of credit gives an erroneous impression of strength and weakness of the economy.
In Hong Kong, HIS index shows only 32 companies with high net worth based on upgrading status , while the 700 firms are part of the larger AOI index. (Cheung 2000) Convertible bonds are most favored instrument in the scenario where the investors do not get adequate information. Post Asian Currency crisis, the Credit rating agencies came as a savior to change the lopsided situation. It rejected the concept of convertible bonds, It also provided 'risk and return profile' (Cheung 2000)of many of the Asian firms who otherwise would never have been able to raise resources in the open market. In the new situation, the institutional investor flocked to the market and began to in a way certify the usefulness of the credit rating agencies. Their inclination to subscribe to bonds issues gave the firms much needed impetus in the global financial system. Since then the nations of the region have made joint efforts to promote a long term bond market for the benefit of the local borrowing firms.
The difficulties to develop this market are as follows: first, there exist in cultural division within the Asian markets; second, the countries of the region are still not sharing the company data with each other in a direct manner as happening in the west. Third, except for Japan and China no other nation has a sizeable financial environment which will promote what is known as economies of scale in the financial market. In the critical situation such as these the role of the credit rating agencies is not just crucial but also definitive. They can provide better credibility to the firms and allow them to leverage better in the international market.
Credit ratings agencies can assist the firms in following ways : First, they can analyze and rate the firms. Second, they can provide impartial analysis of the firm. Third, the CRs can help the investors compare the different firms. Lastly, the CRs can give guidance to investors about the purchase of bonds or the extent of loans. (Cheung 2000). The situation is improving , however the skepticism about the national credit rating institutions doing a creditable job remains among the foreign investors. The internationally renowned agencies also claim that many of the firms refuse to provide quantitative and qualitative information thus hindering the expansion in the bond markets. Nevertheless, the international credit rating carries better credibility among the investors.
1.6
Types of instrument in the context of the current state of the world economy and future practice
There are three types of financial needs felt by the Asian firms. First, long term financing ; second, medium term financing and third, short term financing In the long term the firms are looking for funds over the period of 5 to 10 years and the funds are used to build the plants or expansion of existing production capacity. / . In the medium term, the finance is raised for the period of 3 to 5 years. It is done to fund the deferred expenses. In short term money is raised to finance cash, stocks and debtors. In the normal course of funding the long term funds are generated through equity and the medium and short term funds are raised through money market instruments. The types of instruments used are : 1. Long term, Medium term or Short term Bonds ; 2. Variety of equity instruments; 3. Foreign exchange; 4. Hybrid instruments; 5. Derivatives and insurance papers. At the end of last century, the market began to provide a host of facilities for the firms to raise resources based on their need and their risk profile. In the early days, the market activities were focused on New York, now with the passage of time, markets have expanded to Tokyo, Singpaore, Zurich and Hongkong. (Nils H 1989, p. 135-144).
In the leverage financing the credit rating agencies are expected to provide qualitative analysis. They cover following areas: 1. Cash flow statements have to be analyzed. It should discard any type of overhyped sales, merger and profit-loss projections. ;2. The CRs should give sufficient scope for the costs of buyouts and mergers that may occur in future. ;3. It should incorporate two or three negative downgrades. ;4. Risk rating agencies will inspect the quarterly records for variations in sales, production and profits. ; 5. The mortgage valuation will always be independent of the firms which are under review. And 6. The credit rating should always value assets and mortgage sale in a conservative manner. (OCC 1999).
1.7
Sovereign ratings and debt market linkages
In the discussion on the impact of CRs on sourcing of funds, one other area which deserves attention is the role of sovereign rating. The financial markets are always eagerly reacting to the upgrades and downgrades of a nation. The ECB working paper, Sovereign Credit Ratings and Financial Marketing Linkages point out that although the market response to downgrade cannot be quantified. It can be established that the market does react to sovereign downgrade beyond the 'rating notation'. (Afonso, Furceri and Gomes. 2011). Secondly, the report also argues that the frequent announcement of ratings causes less upheaval in the market. It compares Moody's and S&P or Flitch to show that the former which reports rating announcement on a longer range is awaited and reacted more by the markets. Thirdly, the report also suggests that downgraded sovereign rating also disturbs the rating of higher ratings of neighboring countries and in turns lessens the chances of firms gaining access for funds in the region. (Afonso, Furceri and Gomes. 2011). The report draws two major conclusions: First, the market response to sovereign rating is more due to not discounting the fundamentals and second, on the positive side, the macroeconomic and fiscal decisions announced by the governments can help the markets to forestall the effect of the market downgrade of the vale of the firms. (Afonso, Furceri and Gomes. 2011).
The deleverging of the national banks which results from sovereign downgrades can affect the local firms in more than one way. According to a survey conducted in the European Union, the corporate financing goes down significantly and the SMEs find it very difficult to raise funds. It also shows that borrowing costs going up along with loan margins demanded by the bankers and investors. In the next stage, the financial cycles of the firms collapse further aggravating the crisis. They will find it very difficult to service the debt burden in the adverse conditions. This also results in a decline in the quality of bank assets as corporate credit declines from the market. Another negative trend is the national banks may be forced to sell their assets, further leading to all round fall in asset prices in the region. This phenomena is called 'market to market losses' which further complicates the chances of fund raising for the firms. In short, the funding shortages are observed in the economy. (IMF 2012).
1.8
Focus on the local bond market to meet the fund requirement of private enterprise
There is an increasing demand for developing local bond market to meet the funding the demand of the local enterprises. It is argued that the measure will help in reducing the dependence on the international markets and also will insulate the firms from the extreme foreign exchange fluctuations. The Asian crisis in the last part of the 1990s further gained currency from the discussion on the issue as many emerging economies are in Asia and looked for cheap sources of funds. It is argued that in a large measure Asian crisis occurred due to mismanagement of investment and funds requirements. In the new scenario it is argued that the investors can buy bonds in local currency with appropriate CRs and can assist the process of growth.
The bond market is a prime mover for corporate funds in the developed countries. At present, most of Asia except for Korea, Mayalisa and Japan are using the facility for their economic growth. What is more interesting is more than 40% of US bond market investment comes from the Asian investors. Secondly, this also means the requirement of funds of firms located in Asia could easily fulfilled by the local investors who are now going out to the Western markets. Prof Akira Tsusaka blames this situation on the lack of the security framework (Tsusaka 2006).. He further points out that East Asian markets have outgrown this phase on account of banking sector restructuring which happened in 1996-2002. (Tsusaka 2006).It was caused by a negative demand situation where the investors had a liquidity while then there was no demand. The government stepped in and the local bond market became the source of funds for the government. Singapore, Hongkong, Mayalysia and Korea now boast of structured bond markets. Prof. Akira calls the situation is ripe to spread this experiment further as the global economy including the US economy in a bad shape and their interest rates are extremely low. (Tsusaka 2006).
1.9
The benefits and challenges of a CR system of sourcing the funds
The major point in studying the issue is the role of the issuer (corporate firm) in the process of credit ratings. It is also known as 'issuer pays model'. The first aspect of getting the CR is to find out cost and benefit analysis of the evaluation. It is also connected to actual rating that will come about after the detailed exercise and the knowing the complexities and costs involved in the ritual of CR. The following are some of the advantages: First, the firm can use the data to argue better debt terms from financial institutions.;Second, the funds can be sought from a variety of sources. Third, the CR helps firms in complying with domestic and international rules applicable in fund raising.; Fourth, the CRs can help the firms to assess the potential and risks in a structured manner. The disadvantages of the CRs are as follows : First, it is a lengthy process and can cost a quite a lot for a firm. Second, it calls for the firm to open its internal records for outside scrutiny. Third, the outcome may not favor the firm.; and fourth, the current rating may harm future CR. (Werth 2012).
Company
(Issuer)
requests
Rating
CRA
conduct
basic
research
Management
Meetings
between CRA
and Issuer
Lead Analyst
prepares
recommendation
Rating
Committee
Rating
decision
Publication
of Credit
Rating
Overview of the credit rating process (issuer pays model) (Langohr and Langohr 2008).
The dependence on CRs to raise funds has also created its own share of problems. First, the agencies are focusing more on business cycles. Second, they are often judged by the industry as per the agency expectations of it rather than as an independent entity. Third, the CRs do not provide plain financial information. Fourth, many have written extensively about the conflict of interest issues which affect the rating industry. However their role as service provider to resolve the asymmetry of information between the lender and borrower continues their presence in the international financial system.
The main challenge that comes in the form of the issuer who solicits the information from the rating agency. The firm is a client of the CRA hence is in a position to influence the CR. Second, the big agencies like S& P and Moody's tend to ignore the negative aspects as the activity forms more than 80% of their annual revenue. (Werth 2012).
Since , the final rating is arrived at after the due process as illustrated above , the chances of it being altered to suit the client remains very high. The agencies argue that they maintain a high level of internal discipline in their working to arrive at the CRs. Secondly, they are dismissive of the fees given to them by the client claiming that the revenue earned is a miniscule compared to total profits generated by the company.
The three agencies together namely, S& P, Moodys and Flitch generated $ 3.7 billion in revenue in 2008. This concentration of CR power will be perhaps the biggest challenge in the future. In case of big US firms , Enron and Freddie Mac , the role of the CRA has come under adverse reporting by the SEC. Lastly , disclosure practices followed by the CRA are found to be limited by the benefits it brings to them. They also use confidentiality clause to hide much that may prove useful or harmful to the client companies. (Werth 2012).
2.0
Shortcomings of system and the implications
The borrowing by the Asian firms is rising on account of monetary and fiscal policy changes in many parts of the Asia. The demand for investments in the infrastructure and the service industry is causing hoards of borrowers approaching the debt markets for cheap source of funds. The basic criteria as the discussion showed is firmly and clearly is credit ratings as that is considered as part of fiscal prudence that must be complied. There is a lot of leveraging that is happening which is purely a balance sheet driven activity. The financial crisis has brought the attention back on agencies which certify these numbers based on which most of the funding is taking in place in different parts of the world.
Some of the shortcomings of the existing system are : 1. Asian firms are finding it difficult to meet the statutory requirements of the international financial system. ;2. The western CRA may not be favoring many of the Asian firms , considering the funding market in Asia is double the size and may end harming the western financial system. ;3. Failure of Asian governments in developing viable alternatives to western style debt market. ; and 4. Also no alternative model of rating is developed by the Asian governments to meet the assessment criteria of the global economy. (Cheung 2000).
The implication of the situation is as follows: First, the Asian firms are constrained in getting themselves adequate financial resources in spite of growing demand of the industry. Second, they are dependent on outsiders to raise funds even as the Asian investors queue up the US and the Germany to invest in their bond markets. Lastly, the continued emphasis on western models causes over dependence on European funds and in turn democratization of existing economic architecture is kept in limbo further hurting the sourcing of funds. (Tsusaka 2006).
2.1
Conclusion
With the help of the review of literature following conclusions can be drawn: First, the rating agencies remain the pivot along which most of the borrowing decisions are taken by the individual enterprises. Second, the impact of the CR is excessively emphasized on as they actual borrowing may happen before and after the downgrade and upgrade. Third, there is an urgent need for the Asian countries to develop their own assessment models as well as bond markets to reach out to their own investors who invest abroad so as to meet the financing requirement of local firms.
