Year: 2011

In spite of a run of bad news, the US Assistant Secretary of State for South and Central Asia, Robert Blake, believes India is on its way to becoming the world’s largest economy by 2050. He recently observed at the Centre for Strategic and International Studies: “India is a rising giant whose influence is felt not only in the Indian Ocean, but in the Americas, in Africa, the Middle East, and in Central Asia… Its rise, fuelled by a dynamic, young, optimistic and educated population, will be one of the great stories of our time.”

A survey published by Ernst & Young at the beginning of June showed that despite regulatory obstacles, India remains one of the most favoured destinations for FDI thanks to its comparatively high economic growth. “India is undergoing a transition in terms of investor perception of its market potential, which is bolstered by economic growth projected to surpass eight percent annually,” it said.

Due to its acknowledged success as a centre for business outsourcing, India will rank fifth among the most attractive business locations for European companies within the next three years, the Ernst & Young survey showed. “Foreign investors are not deterred by current regulatory issues to invest in India, and its perceived specialisation as a low cost business process outsourcing hub continues to appeal to investors across the globe,” the report said. The survey, to which around 800 executives from top level international companies contributed, also stated that Mumbai and New Delhi are among the cities most likely to create the next Microsoft or Google.

Contrary to the support issued by Blake and the survey, data published at the end of May showed India’s economy grew at its weakest pace in five quarters, as it slowed to 7.8 percent in the three months to the end of March. Analysts have attributed the slowdown intense inflation, a gradual increase in borrowing costs and lacklustre investment sentiment.

And yet, the government saw it coming. The country’s economy grew last year by a comfortable 8.5 percent, just 0.1 percent central bankers’ predictions. Representing a steady climb of a half percentage point from the year previous. Fuelled by export demands across technology and material markets, the country is enjoying the rush for commodities to support the ever-growing call for specialists identified by the Ernst & Young report.

India has always been marred by reports of corruption at government levels – a contamination that the state has been striving to cleanse. Now, with traditionally Western automotive and telecommunication groups moving into the country, it seems Blake might be on to something in the long-term at least. Here, we profile some of the regions appealing most to investors.

Mumbai
Known as the financial and commercial capital of India, Mumbai is the home to numerous key financial institutions, including the National Stock Exchange, the Reserve Bank of India, the Bombay Stock Exchange and the India Government Mint. Although Mumbai’s affluence originally began thanks to its textile mills and seaport, it has developed into a hub for IT, engineering, diamond polishing and healthcare industries, among others. As an increasing number of companies employ more skilled labour, more and more industries have emerged as significant economic contributors in and around the city. Among the most prevalent are the Bollywood film industry, clothing, pharmaceuticals, utensils and food industries.

Thanks to the success of some of these industries, some of the nations’ highest earning companies are headquartered in Mumbai. One of the biggest players, with revenues of $62.5bn at the last count, is the Tata Group. The company which acquired Jaguar Land Rover three years ago for $2.3bn from Detroit carmaker Ford, sold more than 28,000 units last year. This year, Jaguar Land Rover set up its first assembly plant in India to assemble the Freelander 2 Sport model, which will use parts from Tata’s Land Rover facilities in the UK.

Mumbai-based Reliance Industries announced it is to acquire Bharti Enterprises’ majority stake in Bharti AXA Life Insurance, the latter’s general and life insurance ventures with Europe’s biggest insurer. Reliance Industries will hold 57 percent in the companies, while its associate Reliance Industrial Infrastructure will hold 17 percent. AXA will retain its 26 percent interest in the companies, the maximum stake allowed to a foreign company in an Indian insurance joint venture. Reliance’s billionaire owner Mukesh Ambani is hoping to expand in the financial services arena as demand increases, and is aiming to diversify the business as earnings grow from its core oil and gas business. Commentators anticipate Ambani is keen to keep any extra funds generated from the recent deal in his birth city.

New Delhi
The capital serves as the heart of India’s government, and is located within the wider city of Delhi. The city’s service sector is constantly expanding as an increasing number of multinational companies open businesses. In addition to banking, media and tourism, IT and telecoms have flourished as key industries within the capital. Major IT companies have emerged over the last few years, taking advantage of the skilled labour,  and bolstering the city’s reputation as a hub for cutting-edge technology.

New Delhi-based IT product design and manufacturing company MSI India serves as the benchmark for the industry, with global customers recognising its award-winning production of notebooks, motherboards, networking and server products. The company recently announced its intentions to launch its own range of portable tablet computers in the domestic market soon. It also announced it is to spend around $1m on marketing and advertising this year, with aims to double head count and expecting revenues of around $60m for this financial year. That’s a $15m increase on last year.

Another New Delhi-founded e-commerce company, BenefitsPLUS Media, continues its acquisition spree as it aims to gain a market share of between 10 and 15 percent of the domestic market. In June, the company came closer to its target when it announced that parent company DigiVive Services had acquired one of India’s leading group buying websites, Koovs.com for $2m.

In a bid to further expand different industries in New Delhi, a governmental team will shortly review four sick public sector companies to fast track their disinvestment process, according to an official within the Ministry of Heavy Industries and Public Enterprises, . The companies, which are just four of 27 sick under the administrative control of the ministry, have been listed as Richardson & Cruddas, Hindustan Cable, Hindustan Machine Tools and Tungabhadra Steel. The team will consider a range of options, one senior official said. “In some cases it can be an outright sale, while the option of revival through a joint venture will also be explored.”

The government originally considered disinvestments only through public offers. The ministry has been postponing the sale of shares in some profitable companies because of stock market unpredictability but aims to raise around INR 400bn ($8.87bn) through divestment in public-sector companies to improve the fiscal deficit.

Bangalore
Bangalore is another city which has developed into a centre for heavy industries, Indian telephone industries, BPO and IT. The city’s IT industry is divided into three main groups: the International Tech Park, the Software Technology Parks of India, and Electronics City.

Bangalore has rightfully earned its nickname as the Silicon Valley of India, which first emerged after the establishment of the country’s biggest electronic industrial park, Electronics City. The park currently houses several global companies including Siemens Information Systems, 3M India, HP, General Electric, Bharat Heavy Electricals, CGI and Yokogawa. Infosys technologies and Wipro, the country’s second and third largest IT services companies respectively, are also based at there.

Great news for Bangalore came in mid-June, when Infosys Technologies clinched an INR 1bn ($22.2m) deal with India Post as the countrywide organisation embarks on a huge modernisation programme. Infosys beat its largest domestic rival, Tata Consultancy Services, to clinch the contract, with the widest postal network in the world. The company operates approximately 155,670 post offices, of which nearly 90 percent are located in rural areas. According to company, only 12,604 of its post offices have so far been computerised.

Although IT is a key facet in Bangalore, a recent survey published by Monster Employment Index showed a slow demand in the IT and ITES area has lowered in recent months, as different industries grow more attracted to the city. Aircraft manufacturer Airbus SAS, which has an engineering centre in Bangalore, announced in mid-June that it had signed a strategic agreement with CADES Digitech and QuEST Global. The two Bangalore-based companies, which are already suppliers to Airbus SAS, are to establish centres which will solely focus on the design of aircraft components while providing engineering services. Each company will concentrate on a different aspect of the initiative, with QuEST focusing on wing and pylon engineering, while CADES will deliver aircraft main body fuselages across various aircraft programmes. According to an Airbus statement, each company will have offices in Europe and dedicated centres in India. The new agreement with the two companies will attempt to consolidate engineering services already acquired from a variety of different suppliers, and will “focus on the development with the two tier-one suppliers.”

SunTechnics Energy Systems, one of Bangalore’s largest companies dedicated to solar energy, said in June that it would change its focus, name, and branding. It will now take on its parent company name Conergy to become Conergy Energy Systems, and shall focus mainly on solar photovoltaic projects.

Conergy’s clients in India outside of Bangalore include key telecom, oil, and gas companies, as well as government agencies, state and national government units, and manufacturing sector customers.

Kolkata
Home to India’s largest bourse, the Calcutta Stock Exchange, Kolkata is the key business, commercial and financial centre of East India and the north-eastern states of the country.

Much like the other key Indian business cities, IT has become a chief pull for investment in Kolkata. In addition, Kolkata has always been an important centre for banking and finance, for which it is respected on the global stage. At the minute, a variety of large international banks like Bank of America, Standard Chartered Bank and HSBC Bank boast offices and branches in Kolkata. This is in addition to the country’s three large nationalised banks, Allahabad Bank, UCO Bank and United Bank of India, who have their headquarters in Kolkata.

State-owned Allahabad Bank, which is planning to open more overseas branches in Singapore, Hong Kong and Schenzen in China, announced that it is aiming to achieve business growth of 24 percent during the financial year 2011-12. The bank’s shareholders additionally approved a dividend of INR 6 per equity share of face value INR 10 for fiscal year 2010-11. At the bank’s annual meeting its managing director JP Dua said: “Targeting a 24 percent growth for this fiscal year will take the business level to INR 2.8trn [$62bn].”

In and around the city sit several industrial units managed and operated by various large domestic companies. Some notable organisations headquartered in Kolkata include ITC, Birla, Haldia Petrochemicals, Exide Industries, Britannia Industries, Bata India, CESC, RPG Group, Texmaco, Bengal Ambuja, Philips India, Coal India and Damodar Valley.

Silk Air, a regional wing of Singapore Airlines, commenced lower budget flights to Kolkata’s Netaji Subhash Chandra Bose Airport from the beginning of July, a move that has brought a great deal of attention from those considering investing in the city. The thrice-weekly service between Singapore adds to the flights already operated by its parent company, and will cost 15-20 percent less. The additional traffic in and out of the city provides a platform for more skilled workers bringing more money to the city.

Ever since the financial crisis eased its grip, the construction industry has been plagued with a seemingly incurable post-recession hangover. Staggering in its severity, the sharp decline in construction between 2007 and 2009 resulted in steep losses amounting to over $650bn a year according to Global Construction 2020, a significant report published jointly by Oxford Economics and UK-based consultancy Global Construction Perspectives. To put the dramatic figure in perspective, it exceeds the combined annual construction production of Germany and the UK.

The UK’s construction nosedive
Although the recession left no country unaffected by its forceful and menacing advance, some nations took more of a beating than others. Suffering a great while longer after the rest of the world had been freed from the shackles of recession, the UK seemed incapable of kicking the downward spiral for many years – and is still struggling.

So severe was the decline and its aftermath that business plummeted for the 22nd month running in December 2009, only to recover a fraction at the beginning of 2010 – and then stay more or less even until now, with subtle fluctuations.

In June 2011, the Chartered Institute of Purchasing and Supply revealed that the UK construction industry had slowed down: during that month the construction purchasing managers’ index, which gauges future construction demand, dipped from 53.6 compared to 54 in May. Not causing too much of a stir, the figure roughly matched expectations, and crucially the index remains above the 50 mark, which separates growth from contraction.

In terms of sector specifics, many commercial construction projects ground to a halt around 2007-9, and the residential arena suffered as badly as its commercial counterpart. The UK hasn’t struggled solely in terms of construction though – most industries have been adversely affected, with the retail sector particularly badly tarnished. However the recession seems to be persistently plaguing the construction sector, and the local industry has experienced a dual aspect decline as client numbers have dramatically tumbled along with a sharp fall in new business.

Diamonds in the rough
Something that has to be taken into account when scrutinising the decline of the market, and particularly so the domestic property market, is that the UK is quite unique in that it enjoyed a significant spurt in activity in the years leading up to the recession. During those rosy days, house prices famously rocketed by about 20 percent a year in London, making it impossible for first time buyers to get on to the golden property ladder. Although it was anticipated that property prices couldn’t climb any higher, the boom to bust drama that occurred in 2007 still left the nation in shock and a vast number of properties were repossessed.

Fast forward to the present day, the only major construction project worth mentioning is the major regeneration drive to revive and upgrade the east London suburb Stratford in preparation for next year’s Olympic Games.

Aside from the creation of the Olympic Park itself, the area has been revamped to become a sustainable hub of shopping and business, including the second London retail venture from the Westfield Group. Another London project that hasn’t escaped anyone’s gaze is The Shard – a towering piece of commercial real estate conceived by highly prolific architect Sir Norman Foster.

Aside from these eye-opening projects, however, the future of the UK construction realm looks somewhat bleak, as the government’s stifled budget will no doubt affect the sector adversely for an extended period.

Japan’s stifling bureaucracy
Despite being the fortress of fancy, high tech architecture and interior solutions, Japan’s construction industry suffered a massive blow in 2005, long before the global crisis hit. Serving as the catalyst for the dramatic decline in the market was a new set of building regulations, implemented after the discovery that earthquake safety data for dozens of hotels and apartment blocks had been falsified.

 The scandal created a media frenzy and Hidetsugu Aneha, the architect accused of forging the vital safety documents, was jailed for five years. But no amount of investigation or censure – seven other people were arrested for suspected violations of the Architect Act – could prevent the ensuing property crisis.

New regulations meant that properties had to be carefully checked even after gaining approval from ministry-licensed auditors. But while architects accepted the need to reassure prospective buyers that their new homes could withstand the impact of natural disasters such as powerful earthquakes, the lengthy delays in issuing new permits made a big dent in the regional property market. So extreme was the slump that the government was forced to step in and offer emergency aid. As part of the scheme, the economy ministry granted loan guarantees to about 150,000 companies, including surveyors and architects.

The global recession naturally worsened the state of Japanese construction, and the tsunami and earthquake disaster that struck in March 2011 has further accelerated the downward spiral. Another contributing factor is the country’s declining population and restrictions on infrastructure expenditure stemming from government debt. Not surprisingly, recovery won’t happen anytime soon – experts claim that it will pick itself up so sluggishly that by 2020, the country’s construction activity will still be lower than it was in 2003.

US suffering set to ease
One of the first countries to be struck down by the devastating recession was the US, and the crash has continued to have a serious effect on the construction market. Although there have been momentary peaks in spending, the pot hasn’t been properly replenished since before the credit crunch surfaced. Fighting over the small budget available, the competition between American construction companies is decidedly tough.

Indicating the prolonged severity of the slump, 2010 represented the lowest point for the regional sector, and it’s been forecast that the recovery won’t progress until 2013 at the very earliest.

Residential construction suffered the most out of the different segments, and in 2009 housing starts reached their lowest point since records began in 1959. When the industry was in splendid shape, residential construction accounted for 53 percent of total construction. The figure dropped to just 31 percent in 2010, with equally dramatic losses in both single-family and multi-family properties.

Doomed as the US construction market may seem, the country is still considered one of the largest procurers of construction services in the world, and the government remains a strong contender in the line-up for the most promising candidates of new projects, be they building or civil undertakings. The housing sector, meanwhile, is predicted to advance with gusto in the next few years to compensate for the dramatic losses since 2007.

Change is in the air
On the whole, the global construction sector has been making a decidedly sluggish recovery in the wake of the financial crisis. However the sector picked up marginally last year, mostly owing to the rise and urbanisation of developing countries, but also thanks to the new industry of green technologies.

If a new crisis can be kept at bay, the future looks bright. Construction funds have started to flood in and are set to increase. According to the Global Construction 2020 report, growth in global construction will outpace world GDP over the next 10 years, growing from $7.2trn to $12trn – a compound annual growth rate of 5.2 percent.

This powerful growth is likely to be fuelled by the growth of the Asian powerhouses, as well as the cyclical rebound in the US. Collectively, it’s estimated that these countries will generate over half of the $4.8trn growth. Thanks to these markets, construction has never seen such rapid growth above GDP. The report claims that a total of $97.7trn will be spent on construction globally over the next 10 years.

China and India’s rising population, rapid urbanisation and strong economic growth are key drivers for construction. Significantly, China overtook the US in 2010 to become the world’s largest construction market, boosted by stimulus spending. The size of the country’s construction market will more than double over the decade, reaching $2.5trn by 2020, an amount that equates to as much as 21 percent of world construction. India, meanwhile, is predicted to overtake Japan to become the world’s third largest construction market by 2018. Boosting the positive outlook further, the US will register a sharp cyclical rebound in construction with short term double digit growth in both residential and non residential building sectors.

It’s plain to see that construction will become one of the most important global growth industries of the next decade, and as well as these three key nations, other countries set to flex their construction muscles include Indonesia, Brazil, Canada, Australia and Russia.

The rise of the Aerotropolis
Town planning is undergoing a renaissance. In the new era of city construction, airports are set to form an integral part of urban life – if not serving as its very heart. The movement in the making is so major that a new term has been coined for hubs with airports at their centre: enter the Aerotropolis.

China is at the forefront of this new trend in urban development. About 100 new airports are set to spring up in the country by 2020, and each one will be in close proximity to cities, making life more practical for its residents. It’s estimated that 1.5 billion Chinese people will live within a mere 90 minutes of an airport. A new book Aerotropolis – The Way We’ll Live Next, charts China’s new airport-centric approach, with the premise that the cities of tomorrow will be built around airports; as opposed to the other way around.

So why focus so intently on the airport and its convenient, centrally located position? In today’s marketplace, where air travel is becoming ever more crucial, the importance of accessibility and speed can’t be underestimated. It’s not only travel-happy businessmen and holiday makers that have been accounted for; trade is also an important factor, as the value of air cargo is dramatically increasing.

Existing Aerotropolises upon which town planners can model new variants include Dubai, Abu Dhabi and Doha, and South Korea’s manmade island New Songdo City.

As a result of globalisation, the construction sector is becoming ever more international. Leading architects, designers and talents in the field of new technology now operate globally, with offices in many different parts of the world. China is a definite draw for many players within the creative industries, as it allows much room for innovation; and as such the country is set to become something of a hotbed for new architectural ideas and experiments.

Pulitzer award winner Thomas Friedman famously said in 1996: “There are two superpowers in the world today in my opinion. There is the US and there is Moody’s bond rating service. And believe me, sometimes it is not clear who is more powerful.” These words still ring true, as the oligopoly of the three US-rooted credit rating agencies (CRAs) – Standard & Poor’s, Moody’s, and Fitch Ratings – all possess the power to destroy a country, simply by downgrading its government bonds.

The role and influence of CRAs has long been debated in North America, but criticism has been more frequent from European quarters of late, after CRAs were accused of heavily affecting the European markets. CRAs are frequently proclaimed to be financial market gatekeepers, due to their role in ranking the probability of a company, nation or financial product repaying the debt it has acquired. As the European economic downward slope began to take its toll, CRAs were among the first market partakers to be held responsible by critics, policymakers and government officials.

Honest origins
CRAs were originally fairly trivial players in the markets and enjoyed a reputation for earnestness and frankness. Information about financial products and their issuers was simply published by CRAs and helped add transparency, while investors could choose to use the data to make judgement calls about valuable investments.

The difference at that time was that there was no legal obligation behind the information, as it was strictly edifying. In that environment and framework, CRAs merely supplied financial markets with what is perceived as their most valuable asset: data. That is, until regulations came in, distorting the rules of the game; and CRAs started getting their income from investors who subscribed to their advice and ratings.

It was not until the US government decided in 1975 that an official stamp is necessary that things started to change for the worse. This change is now considered one of the key factors why CRAs have an immense influence on the European markets and beyond. The SEC, because of its need to manage the potential threats investors and banks took, decided it was required to ascertain an official classification of what risk entailed.

The simplest way to go about this was to name the three chief CRAs, Moody’s, S&P and Fitch, as the official ones, and give them the power through the benefit of being a new legal force. From the time of the law passing, additional agencies became part of the same club, but the original three CRAs preserve their dominating status as the most influential financial market CRAs.

The cost of this lawmaking shift can be felt today as European economic markets face the abundant consequences following the establishment of this oligopoly, which guaranteed the CRAs a solid flow of income. Worse still, it shaped the effective compulsion for the issuers of financial products to use those products ratings, seeing as capital requirements and the arrangement of investors’ portfolios relied on these ratings of CRAs. This was because the lower the bank’s portfolio risk of assets, the less capital it had to carry and the more funds it could invest. In addition, top rated assets permitted banks to free up capital, meaning they vigorously sought out such assets.

The omnipotent agencies ensured that ultimately a product’s significance was now particularly contingent on their ratings as issuers were required to submit their products to them. Rather than receiving the money from investors as before, they were now remunerated unswervingly by the issuers of financial products. It is no surprise then that the end result was a radical transformation in the CRAs business formation. Today the three key CRAs dominate 95 percent of the market, which is undoubtedly a sign that there is not enough competition in this area.

Yet many ask nowadays how it is possible for US investors and then Europeans, all the way across the Atlantic Ocean, to blindly trust the ranking and verdict of durability and solidity of assets just because the CRAs judged them that way. The answer is simple: CRAs, in spite of their alleged defective processes and questionable reliability and impartiality, could only have the benefit of such magnitude because of bureaucracy and regulations.

The ratings industry today
Downgrades by the three big CRAs have emerged more and more as Europe faces unparalleled political disorder and social clashes over cutbacks in public spending and mounting taxes for the public. Sadly this scene is set against the ubiquitous backdrop of overwhelmingly elevated unemployment. The European crisis continues to infect nations such as Ireland, Greece, Portugal, Spain and more recently Italy as a result of downgrades, and the affected economies have been rocked by a recurring chorus of assertions by the CRAs.

The agencies appear to be in an antagonism with one another that manifests as a habitual lowering of ratings and continued pressure on states due to the expectation of downgrades.

Regardless of the debate that envelops CRAs, it has to be appreciated that they have a significant purpose, as they supply financial markets with data by issuing ratings of both financial products and issuers of financial products. In addition the ratings determine investor portfolio arrangements and influence the price of financial products. CRAs moreover sway investors’ reliance in financial products issuers and so the cost of borrowing of governments and businesses equally. A recent downgrade of ratings in both Greece and Spain that caused a sharp climb in both the interest rate of their treasury bonds and CDS confirms this. The quantity of capital that banks are obliged to hold consequently depends on the letter gripping the assets they own, which makes CRAs especially controlling and prominent.

Previous CRA downfalls
In the US, CRAs continue to be under close scrutiny for having given investment grade ratings to mortgage-backed securities based on high risk subprime mortgage loans. US regulators are now reported to be considering civil fraud charges against CRAs as part of a wider investigation into the sale of mortgage debt which led to the financial crisis. The CRAs, which through their inaccurate ratings falsely predicted market conditions, are now blamed for their partial contribution to the financial crisis.

A recent report issued by a senate subcommittee revealed a list of features responsible for the inaccurate credit ratings linked to collateralised debt obligations and mortgage-backed securities. The report’s findings and recommendation to the SEC are predicted to also heavily impact on the methods used by CRAs overall, including when rating European government bonds and instruments. Some of the more apparent downfalls of CRAs listed in the report were found to be pressure put on the CRAs by investment banks to drive up ratings; CRAs’ drive for market share while competing against the other two big agencies; imprecise rating models; and inadequate rating and surveillance resources. The subcommittee also found that federal regulations that restricted certain financial institutions in the purchase of investment grade financial instruments encouraged investment banks and investors to pursue high ratings, leading to credit rating agencies providing those top ratings.

The report urged the SEC to make use of its regulatory authority to rate CRAs in terms of their performance if the CRAs show signs of knowingly or recklessly failing to conduct a sensible and rational investigation of the rated security. It was moreover pointed out that the SEC needs to examine and inspect CRAs to preserve an environment that does not promote conflicts of interest among employees and puts at risk the accuracy of the agency ratings.

The Dodd-Frank impact
While policymakers in Brussels and politicians internationally have been endlessly deliberating various channels to make rating agencies more accountable and rating procedures more transparent, Europe continues to struggle with CRA downgrades or their threats of looming downgrades. Suggestions to revamp CRA regulations range from increased disclosure requirements to eradicating references to credit ratings in rules and regulations. However, the one thing they all seem to have in common is the attempt to strip CRAs of their intemperate power.

The US has already incorporated changes in the newly implemented Dodd-Frank Act, which brought in a chain of reforms in the credit rating agency system. These comprised the establishment of the newly operational SEC Office of Credit Ratings, responsible for supervising the credit rating industry (among others) by conducting statutorily-required annual examinations, whose reports must be made public. The act also authorises the SEC to discipline, impose fines, and remove CRAs and connected employees from the register for infringing the law, and gives them the power to deregister a CRA for issuing poor ratings.

In addition – and perhaps more importantly – the Dodd-Frank Act permits investors to file private cases of action against CRAs if they intentionally or recklessly fall short of conducting a realistic, reasonable investigation of a rated product. Furthermore, CRAs are now obliged to establish in-house controls to guarantee high quality ratings, and divulge data relating to every issued rating, their rating technique, and the methods used.

The domino effect
The globe’s financial markets are so interlinked that bad news for Europe often translates to a domino effect all the way across to the US. At the end of June McGraw-Hill, the parent company of S&P, announced that due to Europe’s debt crisis investors in the US government bond market could be hit by severe losses. Should S&P or any of the other chief CRAs downgrade the US, it is highly likely that treasuries would plummet in worth by up to $100bn.

This would come much closer to reality if the US, the world’s largest economy, loses its AAA rating. If this happens the US could experience higher bond yields and lower prices, which again would signify the US treasury shelling out $2.3bn to $3.75bn more yearly in interest on financing a revised $1trn annual budget deficit. Although the risk of a downgrade for the US is remote, it seems investors are anxious about a more fragile economic environment and financial contamination stemming from the Euro debt predicament.

It remains to be seen what the other CRAs have planned after S&P followed through on its threat to downgrade the US rating to AA+ with a negative outlook, after the resolution to lift the treasury debt ceiling failed to meet its requirements. Moody’s and Fitch both said they had no immediate plans to follow suit, but the former had previously observed a reassessment may be warranted.

Violent overthrow
While the CRA commotion in both the sovereign and corporate debt space from Athens to DC injured risk appetite numerous times over the past few months and simultaneously infuriated policy makers, investors and the general public with the effects of downgrades (or threats of them), the business model of CRAs once more became the primary focus in Brussels in June. A top German economist even went as far in calling for a ‘violent overthrow’ of US CRAs, because they significantly shape the future of the nations they rate without consequence to them.

Thomas Straubhaar, director of the Hamburg Institute of International Economics, told the press after S&P dropped Greece’s rating to CCC junk bond status that he felt CRAs were anachronisms from the 1990s, which US regulators had ‘imposed’ on Europeans and other nations. The CCC rating, which is only four steps away from default, did not phase the CRA as it commented afterwards that the downgrade was due to complex political and economic conditions, which meant efforts by the EU and the IMF to save Greece were looking increasingly unstable.

It was especially the ill-timed drop in the rating system that infuriated Straubhaar and other critics, as the drop makes it even harder for Greece to restructure its debt and take steps in the right direction to fight its burgeoning economic crisis. The general consensus is that an untimely downgrade – as experienced by Greece in June and Portugal just before that – also threatens to overwhelm other EU nations. Straubhaar appealed to the German government intently to assist in the creation of a revamped system to cease the influence emerging from US companies as he said that US input was unsuitable for Europe and caused problems in the long run.

Frankfurt – a new CRA home?
It is CRAs’ critics such as Straubhaar, and other sceptical voices emerging from various European quarters, who are looking at whether Frankfurt, Germany’s financial hub, could be the centre for hosting a European credit rating agency to challenge the US CRAs. An initiative was launched by the German stock exchange Deutsche Börse, the consultancy Roland Berger, and the government of Hessen (the federal state that includes Frankfurt), to try to determine if Frankfurt could present an alternative to the big three.

Emerging discussion, which highlighted the importance of a complete and truly independent agency, came just a few weeks after the European parliament asked for additional action to be taken to either fix existing CRAs or look at the prospect of establishing a new, independent “European rating foundation.” Other options that were considered in an attempt to increase competition in the sector included the idea of a network of smaller European credit rating agencies. Yet, as anticipated, the notion of a part publicly funded European rating agency is generally perceived as challenging, and European officials have acknowledged that the idea requires “some further analysis.”

ESMA’s role and beyond
At long last, after numerous attempts to draft a directive to control what is often perceived as irresponsible action taken by CRAs, the final draft of the CRA II Regulation was passed in May. Approving the law meant that from the beginning of July, the European Securities and Markets Authority (ESMA) will be the sole controller of CRAs in Europe.

ESMA’s role– technically speaking – is the regular inspection of the registered CRAs. Obligatory registration for CRAs and succumbing to assessments with ESMA is now the order of the day, in addition to the agencies having to display sufficient internal measures to attend to conflicts of interest and assure for the exposé of such divergence in an appropriate and timely manner. ESMA will be given the authority to request information, to launch investigations and to carry out on-site inspections.

One continually deliberated area of the new regulation is the registration of non-European CRAs, which momentarily is governed by a legal code declaring that ratings issued in a non-EU country can be used only if the regulatory regime in that country has been judged to be comparable to the one in the EU. Presently the US is generally seen as comparable, while Japan has been proclaimed fully equivalent. ESMA is now closely observing how the newly passed Dodd-Frank Act will change US legislation with time. Despite there being provisional requirements, ESMA will ensure that the work of both European and non-European CRAs will not be concerned by the new licensing needs.

Critics are weary of CRAs as economic market gatekeepers, and their often superfluous decisions are exactly the market malfunction that the new EU regulation looks to cure. Although CRAs are often given the stamp of sketchy performers due to their alleged unreliable ratings, it would not be realistic for investors and governments to plainly cease using CRA ratings. The continuous emphasis on revolutionising the business model applied by CRAs, while simultaneously lessening the dependence on ratings, seems on the whole to be what CRA critics hope to set right.

Brussels will need to make certain there are additional actors in the market, to depart from the destructive supremacy of the big three CRAs. This will also ensure greater competition in the rating agency market. The principal test for Brussels will be to find a means to overcome the prevailing payment and allocation system. The model with the issuer paying is a deeply flawed structure that will unavoidably lead to conflict of interest, with the entities being rated literally paying the CRAs for the ratings they obtain.

There are several proposals of alternatives the European Commission could consider to modify a newly created CRA. Varying the current structure through an ‘investor pays’ system, the creation of a ‘postponed payment’ system, a ‘pay upon result’ type structure or even by stripping CRAs of their legal status and going back to basics where investors can chose to ignore the CRA published data are all viable options that could be considered by Brussels.