Thursday, July 19, 2012

Power, Soft Power & China !

What is Power? Power - "It is the ability to influence the behavior of others to get the outcomes one wants."
There are three primary ways by which one can affect the behaviour of others:

  • Usually Power is narrowly defined, just in terms of "command and force".

e.g. Suppose there are two people 'A' and 'B'.

So, the narrow definition would say, 'A' has power, if he/she can make 'B' to do something that 'B' would otherwise not do.
So, if I command my young nephew to play video games and guileless as he is [], he starts playing his favourite Max Payne 3 game on PS3, so do I have power over my nephew? Things are not this straightforward. What if my nephew loves playing PS3?
So when we measure power in terms of the changed behavior of others, we have to first know theirpreferences, else we may be thinking like a rooster, that his crowing makes the sun rise. 

Another example would be to think, the then Viceroy of India, who executed Saheed Bhagat Singhproved his power. This is wrong, as Saheed Bhagat Singh was seeking martyrdom so that he can motivate youths for national freedom.

So, power always depends on the context in which the relationship exists.

  • Power can be understood in two ways: Behavior & Resources. 

Sometimes one can affect other's behaviors without commanding it. So if someone believes that my objectives are legitimate, I may be able to persuade him without using threats or inducements. So, for instance the recent incidence of some fanatic muslim guy shooting people in France[he also seem to have planned Indian consulates as targets] in name of jihad and Osama Bin Laden, not because of payments or threat(Osama is anyway dead), but because he believed in the legitimacy of Al Qaeda's objectives.
It is in this context that soft power comes into picture. So the ability to make others to want the outcomes that you want is soft power. Here you are co-opting with people rather than coercing them.
Resources:Power is also understood as the possession of capabilities or resources that can influence outcomes.
So, a country is powerful if it has a relatively large population, territory, natural resources, economic strength, military force, and social stability. This way power becomes more measurable and predictable. We must have usually come across terms in "diplomatic" discourse or in news, that certain country is holding the "high card". It basically means being powerful from resourcing perspective.

It is in this context that hard power comes into picture. You either use force or economic power and coerce others to toe your line.
But defining power as synonymous with the possessing resources, may lead to something called "vehicle fallacy".

Vehicle Fallacy: This is the confusion of power as a 'resource' and power as a 'behavioural change item'.
Power cannot be exercised without the use of some resource (vehicle). In other words, since power does not have its own legs to go, it has to ride on some vehicle. With this in mind, let's explore the fallacy

Take culture for example, it's considered as one of the resource (vehicle) for exercising Soft Power, but culture in itself does not provide powe
r. So, Coke and Big Macs do not necessarily attract people in the Islamic world to love the US nor does the popularity of Bollywood assure that India will get the policy outcomes it wishes.
This is true for h
ard power as well. If suppose you have tanks, you may win battle in deserts, but that may not help, if the fight is taking place in swamps!!! So considering power as some "concrete" entity e.g. bombs or bullets, which if used on some country can lead to some behavioural outcomes is a fallacy. If "possessing more resource" was equivalent to "possessing power", then why did US lose in Vietnam war when US had far more resources than the tiny country? Or even take the example of 9/11.

So, you must be wondering, you have resources and still no power?? The answer lies in my next point.

  • Inorder to convert resources into power, so as to obtain desired outcomes, one needs to apply "strategies" and "skill-full leadership".

How do we do that? By finding out who is holding the high cards (see above to understand what holding high cards means), and understanding what game one is playing - i.e. which resourcesprovide the best basis for power behavior in a particular context? E.g. Oil was not an impressive power resource before the industrial age nor was uranium significant before the nuclear age.

  • One other thing about power one needs to note is that the value of its resources change over time. So, if the Talibans, Haqqani N/ws or the Saudi rich Osama Bin Laden(which were created by US), did help US to win the Cold War at some point in past, but now pose the single biggest threat to US. So, we see how value of power resources change over time and this needs to be noted.

So analysing the above four points, we have come to a conclusion about power as follows:

  • power resources cannot be judged without knowing the context
  • Before understanding who is holding the high cards → understand what game you are playing and how the value of the cards may be changing

Soft Power Vs Hard Power 
What is Soft Power ? 
I have described above, the hard power - military and economic might, often get others to change their position. But sometimes we can get the outcomes we want without tangible threats or payoffs. A country may obtain the outcomes it wants in world politics because other countries admires its values, emulates its example, aspiring to its level of prosperity and openness. It is your ability to shape others preference so that they want what you want them to do.This is what we call Soft Power

Resources that generate soft power are:

  • Culture is set of practices that create meaning for a society. It can be high culture like literature, art and education that appeals to elites and mass culture - TV, cinema, music. So when a country’s culture promotes universal values that other nations can readily identify with, it makes them naturally attractive to others.

[US has had a huge appeal for its open culture, pop music, hollywood etc. ]
So, things like tourism of that country, what is the global power of its native language, how many gold medals it won in World sporting events like Olympics etc. are few things coming under this component of soft power.

  • Political values and institutions that govern a nation strongly affect the preferences of others. So, if a govt. effectively uphold values like transparency, justice, and equality domestically, it will have more attraction for outside world.

[The recent retrospective tax has had a lot of negative press of India in the world. It had led to lot of
decrease it India's soft power. This new regulation did not showed India in good light w.r.t transparency in
its dealing etc. Our political instability (Ma Maati Manus ! heckles in every other reforms move is causing lot
of Soft Power decline for India]
Transparency of govt., its Human Dev Index, Political stability, democracy or authoritarian etc falls in this category

  • Foreign policy is about country maintaining legitimacy and moral authority in its conduct abroad. Is it seen as good force or bad to be with.

[1. How do you think other countries would rate foreign policy of North Korea vis a vis that of India?
2. Don't you think with recent democratic initiatives taken by President Thein Sein, Myanmar's soft power would have increased? Why else do you think, Ms Clinton, Mr Cameroon or our MMS visited there in succession? Ofcourse there are economic underpinnings as well, but we must credit soft power here as well.
Voice of America was a successful Public Diplomacy tool used to enhance US soft power around the world]Public Diplomacy: It is defined as actions of govt. to inform and influence foreign public. In today's world, anything that govt. or private parties does from popular culture,fashion, sports, news, Internet, that have an impact on foreign policy, national security, trade, tourism and other national interests. 

So, if govt. A tries to enrich its traditional diplomacy route, by either directly (blue lines) propagating its positive image to public in country B or indirectly (through its own society - society A, green lines), would be called public diplomacy. However, explicit influencing public can be termed as "propaganda", which may not be good for its soft power. So a balance has to be maintained.
So, position a country takes in world fora, its interference in other countries sovereignty, Foreign Aid (amount and terms and conditions), Visa regulations, Strength of its national brand etc are few things which falls in this category.

  • Education has been used effectively by countries to further their public diplomacy initiatives. The ability of a country to attract foreign students is a powerful tool of public diplomacy for countries.

[1. The Ivy League colleges of US - Harvard, Wharton, Stanford etc attract a lot of students world wide, which increases US's soft power. Almost 50% of Indian students studying in US are from Andhra Pradesh. Many students after completion of studies return to their motherland and further US's cause. 
2. Sir Ivor Jennings once remarked that "the ghosts of Sidney and Beatrice Webb stalk through the pages of the text" of the DPSP of Indian Const. As it happens, the Chief of the Drafting Committee of the Constitution, Dr. Ambedkar had once been a student of the London School of Economics, which was formed by Sidney and Beatrice Webb. It has been said that the socialist agenda of Nehru and Indira were deeply influenced by LSE graduates V.K. Krishna Menon, P.N. Haskar and B.K. Nehru.]

  • Business/Innovation is extremely important in today's globalised world. Attractiveness of a country’s economy in terms of openness, capacity for innovation and regulation, also defines its soft power.

[Did you check where does India rank in Global Transparency Int'l report or Global Competitiveness Index? Few steps Indian govt. has taken to provide investor friendly environment are - Investment Policy liberalization (FDI/FII), MCA-21, e-gov initiatives, GST Reforms, MSME Act 2006, RTI Act 2005 and the recent National Manufacturing Policy to list few]
Level of foreign investments, business competitiveness of the country, no. of international patents it has etc.

Hard Power Vs Soft Power
  • Hard and soft power are related because they are both aspects of the ability to achieve one’s purpose by affecting the behavior of others. The distinction between them is one of degree.

So we can imagine them as a range along a spectrum with "Command Power" at one extreme and Co-optive power at the other end.

Command power—the ability to change what others do using coercion or inducement.
Co-optive power—the ability to shape what others want, without using force or threat.
Soft-power resources tend to be associated with the co-optive end of the spectrum of behavior, whereas hard-power resources are usually associated with command end.

  • Hard and soft power sometimes reinforce and sometimes interfere with each other.

Let's take example of US invasion of Iraq in 2003.
Hard Power and Soft power reinforcing each other:
Hard power - some of the motives of US could be for deterrence and also a message to Syria or Iran to not harbour support to terrorists.
Soft Power - export democracy to Iraq and transform the politics of the Middle East and thus make this war self legitimizing.
Hard Power and Soft Power interferring each other:
US has the unipolar power when it comes to military strengths. So there is no balance of power at the moment. But countries like France, China and Russia, without directly countering the US’s military power, made it more costly for US to use its hard power (i.e. the military power).
Such balancing act involves the use of international institutions(like UN), economic statecraft, and diplomatic arrangements to limit the use of American power to wage preventive war.
Also, millions of people protesting against US's invasion of Iraq led to severe decline in US's soft power. Due to this several countries like Turkey declined US, to enter Iraq from North, using its territories. Turkey was vary of losing its ground in the Islamic world, thereby its soft power. So decline in US's soft power came in way of its usage of hard power.

  • Soft power may not necessarily be better than hard power.

Like any form of power, it can be wielded for good or bad purposes. Hitler, Stalin and bin Laden all possessed a great deal of soft power in the eyes of their followers, but that did not make it good. It is not necessarily better to twist minds than to twist arms.
Suppose, if I want to steal your money, I can threaten you with a gun or I can also persuade you that I am a guru to whom you should donate your investments, so that you are placed directly to heaven [lol ]. So though the means depends upon attraction or soft power, but the result remains fraud and theft.
We often judge ethics on three dimensions:

The means, dimension is particularly important.
Let's compare consequences of Gandhi ji's choice of soft power with that of Yassar Arafat's choice of gun. We are contrasting means here. 
While Gandhi ji was able to attract moderate majorities over time with a consequence that India got it's independence. On the other hand, Arafat’s strategy of hard power, particularly in th2nd Intifada, led to consequences of creation of Hamas and its perpetual fighting with Israelis. Nor could he achieve his goal of a Palestinian state.

  • Europe counts too much on soft power and the US too much on hard power

"Americans are from Mars and Europeans are from Venus"Europe has long relied on soft power through its culture, institutions, human rights and EU [Recent Financial crisis led to huge loss of soft power for Europe], and on the other hand US has often acted as though it military pre-eminence could solve all problems - Persian Gulf (1991), Bosnia (1995), Serbia (1999) and Afghanistan (2001).
But it is a mistake to count too much on hard or soft power alone. The ability to combine them effectively is “smart power”. During the Cold War, the West used hard power to deter Soviet aggression, while it used soft power to erode faith in Communism behind the iron curtain. That was smart power. To be smart today, Europe should invest more in its hard power resources, and US should pay more attention to its soft power.

  • Military Power and its role in spreading Soft Power

Though Military force is a defining resource for hard power, but the same resource can sometimes contribute to soft power. Take for example the role of Indian Army in various humanitarian measures, US forces in Haiti after the devastating Earthquake. This can add to soft power of the country in eyes of others.

  • Changing nature of power in 21st century - relative importance of soft power increasing

Power today is less tangible and less coercive than ever before. Almost 50% of world countries are democracies now and hence the way in which international politics was played in 19th or 20th century will not work anymore. Today, for example if a country has military might, smaller countries might not fight directly but may group together and use "soft power balancing" and would make usage of your hard power extremely costly. (We saw US example above).
The information revolution and globalization of the economy enhanced US power in 20th century. But with time, technology has spread to other countries and peoples, and US’s relative pre-eminence diminished. With the information revolution, virtual communities and networks are created which cut across national borders. Transnational corporations, NGOs , non state actors will play larger roles. Many of these organizations will have soft power of their own as they attract citizens into coalitions that cut across national boundaries. Politics then becomes in part a competition for attractiveness, legitimacy, and credibility. Soft power then becomes even more important.
The countries that are likely to be more attractive and gain soft power in the information age are those with multiple channels of communication that help to frame issues, whose dominant culture and ideas are closer to prevailing global norms (which now emphasize liberalism, pluralism, and autonomy) and whose credibility is enhanced by their domestic and international values and policies.
Power Distribution in World, Balance of Power & Hegemony 
In today's world, power distribution across the world can be understood in following ways:

  • First dimension is the Military Power - US is the only country in this dimension. Power here isunipolar or hegemony.
  • Second Dimension is that of Economic power - The distribution of power is multipolar. Today US alone cannot obtain the outcomes it wants on trade, antitrust, or financial regulation issues without the agreement of the European Union, Japan, China, and others.
  • Third Dimension is that of Transnational issues - Here no single country has power. So issues like terrorism, climate change, infectious diseases etc falls under this dimension. Power is widely distributed and haphazardly organised among state and non-state actors.

Lets chalk out the transition of power and evolution of power resources in last several centuries. 

In today's world, no country is better equipped with all three power - military, economic and soft power than USA. 

War has been the crucial instrument of multi-polar balance of power. Take Europe for example, there has been wars b/w great powers of Europe for 60% of time since 1500. However in today's Nuclear age, resorting to such measures can be disastrous. On the contrary, many regions of the world and periods in history has seen stability under hegemony, when one power has been pre-eminent. 

The term balance of power is basically a predictor of how countries will behave i.e. will they pursue policies that will prevent other countries from developing power, that could threaten their independence. Many have argued that growing preponderance of US will cause other smaller countries to gang up and eventually limit US's power. However there are few things that needs to be considered:

  • US enjoys a geographical benefit of being separated from Eurasia and offers a less possible threat than neighbouring countries. This explain why inspite of US being the single largest power in 1945(after WW II), Europe and Japan, allied with US, rather than Soviet Union, whom they saw immediate threat, because of its geographical proximity and revolutionary thoughts.
  • From history we see that inequality of power has led to peace and stability, because there is little point in declaring war against a dominant nation. Pax AmericanaPax Britannica and Pax Romania ensured an international system of peace and stability.

But the question that needs to be answered here is how much and what kind of inequality and for how long?

So, if US has to maintain its Superpower status, it needs to work on its soft power and soft pursing the non-provocative preventive wars, which goes against the norms of international politics for any democracy.
China's Softpower 

When we talk about power trainsition, we talk about rise of Asia. I would rather call it as "return of Asia". So if we looked into 1800s, more than 50% of world population was in Asia and they made around 50% of world products. Now fast forward it to 1900s, more than 50% of world population still lives in Asia, but they made only 1/5th of world products. What happened?? Industrial Revolution, which meant all of sudden, Europe and America become dominant powerhouse. But in 21st century, we are seeing slowly Asia is gaining the lost ground and it is poised to regain its status soon. 

This diagram from Mckinsey report of world's economic centre of gravity, says exactly that, except that it measures urbanization of world and the pace in which it is happening. 

China is one of the major reason for this rise of Asia (Japan, India being the other powers).

Since beginning of 21st Century, China's economic and military powers (the hard powers) have grown significantly. This has made its smaller neighbours (including India) concerned. It is with this thought, that they are looking for allies to balance China's increase in hard power. But if China could do something, to increase its soft power of attraction, its neighbors could feel less need to balance its power. For e.g., Canada or for that matter Mexico do not seek alliances with China to balance U.S. power the way Asian countries seek a U.S. presence to balance China.
So, realising all of these, President of PRC Hu Jintao had told the 17th Congress of the Chinese Communist Party(in 2007) that China needs to invest more in its soft power resources. 
China's most important soft power tactics have been its foreign aid, the economic networking it tries to achieve and the cultural transmission it does. So, three most important soft power resources used by China are:

  • Development Agenda - With the brilliant success in its economic development, China is now looking to invest it in achieving soft power.

Beijing Consensus forms the core of China's soft power resources.

It has been popular with many developing countries, especially in the African Continent,where the Bretton Woods advocated Washington Consensus has failed. Moreover, IMF or World Bank aid comes with huge list of Do's and Don'ts. Chinese or for that matter even Indian aid, comes with little or no pre-conditions attached. This makes aid from such countries more meaningful and lucrative.

Opening of the World Expo in Shanghai and the spectacular Beijing Olympics(2008) was similar display of China's arrival in the global arena. All of these events gave a huge boost to China's Global Soft Power reserves. 

Washington Consensus (for comparison with Beijing Consensus) - Adopted by IMF, World Bank

  • Foreign Policy - China's foreign policy combined with careful diplomatic rhetoric about the"Peaceful rise" & "peaceful development" theory is second important part of China's soft power resources. This makes China's move its focus from US to its neighbourhood.

The purpose of the peaceful rise theory is to reassure other countries that China will not constitute a risk because of its domestic economical needs and that instead of being opposed to globalization, China wants to take part in it what will create prosperity and stability throughout Asia and the world. Peaceful development, similar to the peaceful rise theory, says that peaceful development is the only way for China to create and achieve prosperity and that it is in China's interests to create and maintain a peaceful world order while at the same time solving its domestic problems and needs.

Non-interference into other's sovereign matters have been China's another major foreign policy drive. Unlike US, China respect other countries sovereignty issues as was evident from recent stance it took on Libya, Syria and other middle east countries. It's only condition has been "no Taiwan" and "no Tibet". 

  • Culture Transmission - Chinese civilization enables China to seek moral leadership in East Asia. So, the values connected to Chinese history and culture can be used in diplomacy to create common Asian values by leaning on things like Confucianism. Many Confucius Institutes have come up across the world as an initiative towards this end.

Chinese Influence on World 

BBC Survey of China's image in World.

Key observations from above chart:

  • Fairly good rating in Middle East and African Countries - No wonder Chinese unconditional developmental agenda in African countries is paying dividends. Many countries also sees China as balancing power for US.
  • Europe has average to low rating for China - Human rights issue, authoritarian views has been China's major problem. recent issue around that blind human rights activist being the recent example.

There is still long way to go for China to compete with US on Soft Power aspects. 

What steps can China take to increase its Soft power in World?
1. Increase the hard power, which is the basis of the soft power

  • Accelerate the transformation of the economic growth pattern
  • Improving the socialist market economy system
  • Making greater efforts to improve China’s capacity for independent innovation

2. Stick to the path of peaceful development and adhering to the independent foreign policy of peace
3. Develop socialist democracy, comprehensively implementing the rule of law as a fundamental principle and speeding up the building of a socialist country under the rule of law and increasing transparency. 
4. Develop education and culture to improve the educational level of the people

Thursday, July 12, 2012

Credit Rating Agencies & Sovereign Rating

Why do countries(or for that matter anyone) resort to debt?

(click on picture to expand)

As evident from picture above, for its functioning, govt., chalks out various policies, programs for which it presents the budget every year, which mentions the expenditure which it will incur. Then there are day to day admin and other expenses. To meet all these expenses, the first capital access it has is the revenue it collects from its citizens and corporates(operating within its territories). However, they are not sufficient to cover all its expenses. So to meet the shortfall it resorts to debts. 

However, debts are either not free or they are also not easily available. one has to have good creditworthiness for the debt provider to issue you debt. 

Remember the GDP formula of GDP = Govt Expenses + Investments + Consumption + (Exports - Imports)

So, govt. expenses we spoke above. Now about the investments and thereby consumption. 

Apart from investment by Indian corporates, the country also depends on investments by foreign investors(who have bigger stock of cash with them). These foreign investors can make investments into a country in two ways - FIIs or FDI. Now, unless a country is in good credit steadying in eyes of these investors, they will NOT put in their hard earned money in that country. So having good credit rating and thereby attracting foreign investors is important. 

Hence we realise the importance of credit rating for any country. The same can be applied to any company who is looking for debt to fund its growth or expansion plans. 

What is Credit Rating & Who are Credit Rating Agencies (CRAs)?

A credit rating is an opinion on the creditworthiness of a "debt instrument" or its issuer. 

It is the Credit Rating Agencies which issue this credit rating and can rate anything, but primarily they rate bonds (and other securities) and central govt. across the world. 

What are types of Credit Rating?

So as you see from above picture, credit rating can be for "debt issuer"(who issues debts) or "debts instruments itself" !! 

What is the scale on which credit rating is given?

As you see from picture above, that India is on borderline of investment grade and speculative grade(also called "junk bond" status). Hence recently S&P warned that India could be the 1st BRIC nation to lose its investment grade status. 

Credit Rating Vs Outlook: 

Many times, the CRAs rather than changing the credit rating of a "bond/debt" OR a "bond/debt issuer", they issue something called an outlook. This is NOT credit rating, but an assessment of what may happen in next 6 months - 2 yrs time.

Outlook can be Positive OR Stable OR Negative . 

So if the outlook changes from Stable --> Negative, then its a signal to watch out, because there may be an issue and you may face a "downgrade" of your credit rating.

See where different countries in the world stand on credit rating

Observe that all "peripheral nations" of European Union(i.e. in periphery of EU e.g. Portugal, Greece, Ireland etc) are in trouble and their credit rating is in speculative grade. Recently Greece received a credit rating of "CCC" from S&P.
[Note: This picture is from 2011, so rating for many EU nations were downgraded since then and hence may not reflect the current scenario. This picture is just to help you understand the overall world scenario on credit rating. Observe in EU, Germany has a very good credit rating, which is same till today. One can ask why? One main reason(among many others) for this is that Germans have a very good habit of savings. Unlike the people in US/UK(who mainly survive on credit), Germans use debit cards more often than they use credit cards. Hence they are well prepared for any unexpected credit crisis. They also believe in investment which adds fillip to the nation's growth. Savings in short run may slow down the economy, but have lasting advantages in long run. No wonder, this intrinsic "savings" mentality is guiding the "austerity" drive suggestion of Ms Angela Merkel ]

Who are major CRAs of the world ?

1. Standard & Poor's (S&P) 

2. Moody's 
(together, the above two companies occupy around ~50% of credit rating market worldwide.) 

3. Fitch - 15% market share

These three CRAs issue their own credit rating for corporates, sovereign or debt instruments.

Major Indian based credit rating agencies are:

1. CRISIL - Standard & Poor's company

2. ICRA India - Moody's company

What are revenue sources of CRAs?

As you see from picture above, the "bread and butter" for the CRAs comes from rating the corporate bonds/debt. Sovereign ratings(given to countries worldwide) do not draw any revenue and are conducted mainly for "public relations" and marketing purposes.

How are Sovereign Rating for Countries prepared?

CRAs also do credit rating of countries across world, and its called Sovereign Rating. This rating indicates the ability of a country to pay back its debt. Several factors are considered by CRAs before they decide on the rating. Though the exact variables are not known, but they key things which CRAs look are:

As we see from picture above, credit rating for any country are of two types : Foreign Currency Rating and Local Currency rating, which tells the creditworthiness of country to pay debt which is in foreign currency and local currency respectively. Since, the chances of paying local currency is always higher than foreign currency, hence the local currency rating is always >= foreign currency rating. 

[Note: Ultimately debt owned by govt. are paid back from tax payer's money. Hence political decision, stability of govt., tax reforms etc also affect the creditworthiness of the govt.]

What are the impacts of Credit Rating Downgrade?

IMPACT 1. Cost of capital for bond issuer, who wants to sell bonds and collect debt increases. So if India's credit rating is downgraded, investors who are 'risk averse' will not want to buy bonds from India. As a result, India may have to offer higher returns than it usually offers and as a result its cost of raising capital goes up. 

Bonds: I have explained above why do countries or any company go for debt. So issuing bonds is a type of debt collection mechanism, in which the debt issuer, collects money from its investors and promises to pay back after some time(maturity). Until maturity, the bond issuer pays interests(also called coupons). 

Bonds can be issued by governments (both state and centre) as well as individual companies. The aim of bonds is to collect money from market. 

Look into below picture: 

To explain further, lets assume the face value/nominal value of bond is Rs. 100. Also, suppose the above example is for a fixed rate bond. 

The above picture shows a bond, which will:

Provide to its holder a coupon of Rs. 7.49(becoz the rate is fixed) every 6 months (In India its halfyearly) till 2020, and then will provide Rs. 100 (nominal value) in the end of maturity period. 
It also says that currently the bond is trading in the market at Rs. 118.93 (which changes every min or hour) and the expected yield for the investor for this bond is 8.44%

Remember, market price of the bond is helpful in determining the yield of the bond. Investors always gets back the nominal or face value of the bond. In this case its Rs. 100 for each bond. So higher the price, lower is the yield, because the difference b/w market price and face/nominal value increases and hence yield decreases. 

So how is credit rating and bonds related? 

Good credit rating for any company or government which issues bonds, increases the demand for its bonds. This increase in demand of bonds will increase the price of bond. This ways the bond issuer can command a coupon rate for its bonds. It can offer lower coupon rate than what its currently offering, since its bonds have been rated high and are considered safe

So the bond issuer always has a motive to rate its bonds higher. Therefore, bond issuer getting its bonds rated by CRAs is actually conflict of interest !!! 

In the same respect if any govt. has got poor soverign rating, demand for its bonds decreases and to sell them(and borrow money from market), it may have to provide higher coupon rate to its investor. So its debt servicing obligation increases.So you may have read things like "increasing cost of capital", which means exactly this. The govt. with a bad rating will have to pay more to borrow and hence its cost of capital increases.

In above example, if currently suppose, govt. is paying 7.49% coupon rate for each bond, tomorrow if the credit rating of that govt. is downgraded, the investors would show less interest in buying the bond. As a result govt., inorder to raise money, will offer investors more coupon rate and try to attract them. So this way govt. is paying more due to lower rating !!! Hence good rating helps govt. who wants to raise money from market.

Credit Default Swaps (CDS):

It is cost of insuring against default by a bond issuer. So if the rating of the bond or the bond issuer is bad, its CDS will increase as low rating would mean more chances of default. 

This concept was popularized in the 2008 Credit Crisis in US when investment banks(Lehman Bros etc) clubbed different risk types of mortgage backed securities (risky, safe, medium risky) into one bunch, called then Collateralized Debt Obligation (CDO), got it rated with Credit Rating Agencies as "AAA" rated securities. Since its "AAA", the Credit Default Swaps (CDS) value will be less, so they insured these securities for less and sold it to investors. This was one of the main reasons for credit crisis, where risky mortgages(sub-prime mortgage) were clubbed along with safe mortgages (prime mortgages) and sold together. 

IMPACT 2. Investment climate in the country goes down. 

Remember the GDP = G + I + C + (X-M) formula ?? The I here is the investments. So countries needs to boost the investment momentum to fuel economic growth. 

Recently PM Manmohan Singh met with key infrastructure ministers and secretaries and Planning Commission to set targets for Infrastructure for 2012-13. He said and I quote

"The needs of the infrastructure sector are vast – estimated at over $ 1 trillion in the next five years. The government alone cannot invest such huge amounts and therefore it is important that we involve the private sector in our efforts, through Public Private Partnerships." - PIB 6th June 2012

So, there PPPs are FIIs or FDIs flowing into our country. If credit rating is downgraded, the investors will turn away from our country and govt. in itself or the indian corporates do not have that much money to invest. Hence credit rating downgrade is a matter of concern. 

IMPACT 3. Overall Impact on Economy

All the boxes, highlighted in "Pink" are affected due to low credit rating. 

1. Click on picture to expand

2. Think of reasons, why I marked certain boxes in pink and lets discuss why some are marked pink whilst others not  ]

What are the issues with Credit Rating Agencies?

Problem 1: Poor track record - failure to predict crisis in past 

(i) The CRAs continued to give an investment grade rating to Lehman Brothers’ debt until the day it filed for bankruptcy.

(ii) The CRAs are accused of ignoring the structural problems of peripheral Europe for almost a decade. As recently as December 2009, Greece—whose bonds today are considered ‘junk’—had an ‘A’ rating. (See rating scale above)

(iii) Asian Credit Crisis in 1997 - Through 1996 and the first half of 1997, not a single Asian sovereign’s credit rating was downgraded barring Moody’s downgrade of Thailand in April 1997. By September, Asia was in depth of a full-blown crisis.

(iv) In February 2001, the Turkish Lira crashed by more than 30%. CRAs predicted it late. 

It has been argued that the 'financial model' which CRAs uses to come up with credit rating is very superficial and checks only the most obvious things and not underlying currents. Take for example the Asian credit crisis of 1997. At that time CRAs included items like GDP growth, GDP per capita, external debt, default history, inflation experience and level of economic development to come up with Sovereign Credit Rating. However, crucial variables such as capital inflows, foreign exchange reserves and strength of the financial system were excluded. Hence the CRAs were not able to foresee the Asian crisis in which the reversal of short-term capital flows and a weak financial system played a critical role. In February 2001, the Turkish lira crashed by more than 30%. The triggers of the issues were in a weak banking system and over-reliance on ‘hot money’ flows. So, we can say that the roots of the crisis lay in a deteriorating financial sector, not in broader macroeconomic imbalances. 

Apart from this, as we know currency and debt crises are closely linked. Researches have shown that CRAs do not lay much emphasis on variables linked to currency. 

Much of this failure of sovereign credit ratings to predict debt crises is due to the fact that the CRAs rely entirely on ‘public information’ and therefore fail to detect the changes in the environment that often work hidden and yet play a major role in precipitating crises. 

Problem 2: Conflict of Interest - Bond issuer getting themselves or their bonds rated

As you must have seen from the holding structure of CRAs, they are not govt. companies. It has been alleged that during 2008 credit crisis, CRAs colluded with investment banks and got their securities rated "AAA" to sell them to investors. 

So this business model of bonds issuer paying has been heavily debated. It has been said that CRAs are softer on corporates primarily because they earn revenue from them, whereas CRAs have been very critical and harsh on countries as its for FREE. 

Problem 3: Problem of Identity - Power without Accountability

There are problems related to identity and legal standing of CRAs. Technically, a credit rating is simply anopinion on the creditworthiness of a debt issue or issuer. Rating agencies argue that an opinion is NOT arecommendation to buy or sell and thus does not constitute financial advice. This semantic distinction between ‘opinion’ and ‘advice’ has saved CRAs from litigation till now. It has also kept them outside the purview of regulatory oversight unlike say banks or brokerages whose research divisions provide explicit recommendations (and hence advice). In US CRAs enjoy the legal status of financial journalists, protected by the freedom of the press provided in its constitution.

Problem 4: Growing clout of Credit Rating Agencies

For long now, regulators have relied on credit ratings to set norms for for capital markets. Banking regulators set prudential norms for banks based on external ratings. Similarly other regulated financial institutions are also bound by ratings in structuring their portfolios. 
For example, Provident funds in India are not permitted to invest in securities that fall below a certain rating grade. 

So this regulatory outsourcing has de facto made the rating agencies regulatory agencies themselves whose ‘opinion’ sets regulatory benchmarks. Credit ratings have become virtually mandatory for every bond issue, be it a simple coupon bearing bond or a complex engineered synthetic instrument. Thus, in a sense, regulators have ‘outsourced’ regulation to the CRAs who have become gatekeepers of the debt capital markets. This 'king maker' position of CRAs have led them to malpractices as was seen in recent credit crisis.

So what is the way forward?

1. CRAs should improvise upon the methodology they currently employ to provide credit rating.

2. Appropriate business model for CRAs should be devised. Current business model raises a lot of question on their integrity.

3. There should be some sort of regulatory body for CRAs, who can held them responsible when CRAs fail to predict any crisis or waves a red flag when there is an obvious conflict of interest between investors and rated agencies or when ratings appear to be influenced by extraneous factors. 

4. The quality of analysts at these CRAs also have to be re-looked. Failure to predict macroeconomic issues of countries is also because of the fact that the CRAs did not have the right people who fully understands the economies.

So CRAs are far from perfect but they are here to stay !!