The experience of many countries shows that developing a credit rating industry is an effective means of improving and facilitating information transparency and capital market development. This paper argues that credit rating activities should be promoted in Vietnam. It opens with a description of the need for credit rating in Vietnam: to enhance information transparency, help attract international capital, and promote integration of its capital market into the regional capital market. Arguments are then put forward as to why Vietnam should develop domestic credit rating agencies (CRAs). To do so, however, it must bear in mind certain principles and conditions, such as guaranteeing independence and information confidentiality of the rating activities, reflected in various aspects such as the legal framework, ownership and management. The role of foreign assistance in establishing local CRAs in Vietnam is therefore emphasized.
.VEMR Economic Research PROMOTING CREDIT RATING IN VIETNAM ECONOMIC RESEARCH Promoting Credit Rating in Vietnam for Capital Market Development Vo Tri Thanh and Nguyen Anh Duong * ABSTRACT The experience of many countries shows that developing a credit rating industry is an effective means of improving and facilitating information transparency and capital market development This paper argues that credit rating activities should be promoted in Vietnam It opens with a description of the need for credit rating in Vietnam: to enhance information transparency, help attract international capital, and promote integration of its capital market into the regional capital market Arguments are then put forward as to why Vietnam should develop domestic credit rating agencies (CRAs) To so, however, it must bear in mind certain principles and conditions, such as guaranteeing independence and information confidentiality of the rating activities, reflected in various aspects such as the legal framework, ownership and management The role of foreign assistance in establishing local CRAs in Vietnam is therefore emphasized Introduction Credit rating is the determination of “credit risk” inherent in a specific security (Berblinger 1996) Such risks include, but are not limited to, country risk, sector risk and enterprise risk Specifically, the credit risk is determined, and made comparable, by assigning “marks” on a scale which usually ranges from AAA (virtually zero credit risk) to D (default) As a source of information about credit situation of issuers, credit rating seeks to provide users with the (estimated) likelihood of whether their investment will not yield the promised return Different credit rating agencies (CRAs) usually have different sets of criteria and procedures, though their ratings are somewhat comparable (see Appendix) * Dr Vo Tri Thanh is director of Department for International Integration Studies, Nguyen Anh Duong is a researcher at Department for International Integration Studies, Central Institute for Economic Management This paper was presented at the International Conference “Promoting the Development of Credit Rating Industry in the Asia Pacific Region”, in Hanoi on 12 June 2006 The views expressed in this paper are solely of the authors and not necessarily reflect those of CIEM Number Winter 2006 Vietnam economic management review 41 .VEMR Economic Research PROMOTING CREDIT RATING IN VIETNAM Unlike other systems of deterministic rankings, the relative attractiveness of security as inferred by the credit ratings seems more ambiguous In fact, higher rated securities may not turn out to be better ones to invest in Even ignoring the quality of ratings, other risks with influence on return of the security, such as exchange rate risk, interest rate risk, etc., possibly affect the investment outcomes Moreover, as argued by Kerwer (1999), the securities with lower ratings often compensate investors with higher profits In that sense, credit ratings are just a source of information; they provide no deterministic answer as to which securities to buy and sell Again, as a source of information, credit rating services by professional agencies are important for a couple of reasons Firstly, since such rating implies the inherent credit risks of security issuers, information asymmetry between issuers and investors can be reduced In order to have a security rated, potential issuers often have to supply information about their financial situation, such as leverage, sales, etc Such information is, in aggregate, processed more efficiently and accurately by CRAs, which are usually large enough to achieve economies of scale This provision is also less risky and costly than providing all the similar information directly to all potential investors Secondly, in doing so, CRAs contribute significantly to the enhancement of transparency and efficiency in the capital market More information internal to the issuers is combined in credit rating process; so the requirement of credit ratings in issuing securities generally promotes transparency in the market Meanwhile, as credit ratings reduce information asymmetry between issuers and investors, it facilitates a more efficient channel of funds at the aggregate level Vietnam’s capital market is still in the early stage of development The stock market has only been operating since 2000, with two trading floors in Ho Chi Minh City and Hanoi As at 10 January 2007, the former had 108 listed companies and investment funds, while the 87 listed companies in the latter are all of a smaller scale The market is still small, with total capitalization equivalent to 17.7% of GDP (of 2006) Government bonds have been the key instrument in the market, while corporate bonds are almost non-existent However, nearly all Government bonds are on primary issues, and secondary trading has been quite rare The future development of Vietnam’s capital market still requires numerous policy measures, including the enhancement of information transparency In such context, promoting information disclosure via credit rating proves itself to be a crucial measure Nevertheless, requirements on credit ratings may constrain credit provision – an obstacle to market development in the early stages Moreover, CRAs may need a minimal degree of capital market development in order to be commercially sustainable (World Bank and IMF, 2004) To shed light on the issue, this paper attempts to address whether there has been a sufficient need for a credit rating industry in Vietnam and, if this is the case, whether the country should establish local CRAs The paper is structured as follows In Section it presents an argument as to why credit rating should be promoted in Vietnam In addition, given the necessity of credit rating, the paper supports the view that local CRAs need to be developed In Section 2, using the experience of other developing countries, particularly India, the paper then describes the objectives of credit 42 Vietnam economic management review Number Winter 2006 .VEMR Economic Research PROMOTING CREDIT RATING IN VIETNAM ratings, the requirements for organization and operations of CRAs, as well as the required conditions for viable development of CRAs Some areas in credit rating development on which Vietnam should focus are also suggested The Conclusion section, Section 3, summarizes the importance of credit rating for capital market development in Vietnam, and the role of Government and foreign assistance in such process The need for credit rating in Vietnam There are several grounds for supporting the promotion of credit rating in Vietnam Firstly, as mentioned above, Vietnam is only in the early stage of capital market development In addition to establishing and strengthening other market fundamentals, there appears to be an increasing need to build up institutions to enhance the transparency of the market For sustainable and healthy development in the financial market, information asymmetry between security issuers and investors must be minimized Despite being in its early stage of development, Vietnam’s capital market has grown rapidly over the past years Investor accounts at the Vietnam Stock Exchange have gone up dramatically in number, from a few thousand in the early days to around 30,000 in 2005 and over 60,000 as at April 2006 With enormous unexploited growth potential, Vietnam’s market has appealed to both domestic and foreign investors In particular, the equitization of state-owned enterprises, including some State-owned commercial banks, has significantly increased opportunities for investors Barriers to foreign investment continue to be relaxed, which leads to increasing foreign investor interest in Vietnam’s capital market Yet the scale of Vietnam’s capital market is often regarded as too limited relative to the economy’s size Besides, available financial instruments are also limited in variety, which restricts the choices for investors In fact, numerous policy measures have been undertaken to increase the variety of financial instruments For example, on 19 May 2006 the Government promulgated Decree No 52/2006/ND-CP to make way for corporate bond issuance The Decree implies the necessity of credit rating, but no policy measures or regulations have been implemented to set out a clear configuration of credit rating services in Vietnam Market regulations, particularly those relating to information disclosure, are either unavailable or poorly enforced This results in severe information asymmetry between issuers and investors and, subsequently, a lack of investor confidence that, without timely solutions, will hinder the longterm development of the country’s capital market Secondly, as Vietnam is striving for comprehensive industrialization and modernization, demand for resources is predicted to go up and remain so for a long period Meanwhile, the economy remains of small size, which fails to meet such a permanent increase in resource demand The excess demand for resources must then be financed by international capital Vietnam has recently been successful in raising $750 million from issuing bonds in the international market, and local corporations have been subsequently encouraged to make similar attempts To maintain credibility, however, information provision is critical for foreign investors to properly assess the risk of such investments This highlights the role of credit rating, which Number Winter 2006 Vietnam economic management review 43 .VEMR Economic Research PROMOTING CREDIT RATING IN VIETNAM adds to the information available to investors and allows them to choose a proper investment portfolio Acknowledging the importance of credit rating, in April 2006 the Bank for Investment and Development of Vietnam (BIDV) became the first bank in Vietnam to receive a rating assignment from an international CRA - Moody’s1 Thirdly, Vietnam also aims at integrating its financial markets with those in the region One of the necessary conditions is for the country to standardize regulations for the financial market in accordance with international and/or regional norms For example, following the Chiang Mai Initiative (CMI), the key principal areas of cooperation among ASEAN+3 will be monitoring capital flows, regional surveillance, swap networks, developing regional bond market, monetary and exchange rate coordination, and training personnel Therefore, information measures are required for the purpose of identifying inherent risks, at both the country and industry level This gives rise to the demand for a comparable measure of risks across the regional economies For these reasons, credit rating is emerging as a sound measure to support development and integration of Vietnam’s financial markets Bearing in mind that view, the question remains as to whether we should establish our own CRAs or whether we should employ the services of international CRAs instead Despite the quality of services provided by international CRAs, developing local CRAs has its own benefits Local CRAs may have better knowledge about local conditions, local “norms” of business practices, and other local institutions Therefore, they may have more appropriate measures of credit risk than international CRAs Also, if established, local CRAs will have the ability to provide small rating services, which appear to be more common given the high proportion of small- and mediumsized enterprises (SMEs) in Vietnam Meanwhile, such services may appear unattractive to large international CRAs, unless they target SMEs as a strategy for market penetration A more economic explanation of the preference for local CRAs over international counterparts lies in the first mover advantage In the market for credit rating services, it seems to be very difficult for a second firm to enter the market due to a lack of credibility and market acceptance This problem is exacerbated in developing markets, perhaps because investors may prefer rating services by an already established firm The success of Credit Rating Information Services of India Ltd (CRISIL) in India presents a good example of what can be done to establish Vietnam’s own CRAs It is worth noting that the CRISIL attained profitability in its first months of operations in 1987, even though at this time secondary markets of debt were in an embryonic stage and the market size would not support a rating agency Moreover, it has remained profitable ever since (Ravimohan, 2003) In the case of Thailand, the first CRA, the Thai Rating and Information Service Co Ltd (TRIS), was established as the pace of development in bond markets accelerated after the enactment of the Securities and Exchange Act in 1993 (Jantaraprapavech, 2001) Given its rather fast growing economy and the high expectations for capital market development in Vietnam, commercial sustainability seems not so much of a concern for local CRAs, if established 44 Vietnam economic management review Number Winter 2006 .VEMR Economic Research PROMOTING CREDIT RATING IN VIETNAM For all of the reasons mentioned above, in the authors’ belief Vietnam would seem to better benefit from establishing its own CRAs However, this paper by no means argues that developing CRAs is the only ingredient to capital market development Sound development of the capital market also requires establishment and/or improvement of other aspects, such as financial institutions (bank and non-bank), government bond market (providing a benchmark yield curve), financial regulations, judicial systems, accounting and disclosure standards, and clearing and settlement arrangements, etc Put another way, the development of credit rating industry is only a necessary condition, rather than a sufficient one, to capital market development Yet it may be critical to identify the objectives of establishing local CRAs in the first place, and then review the major requirements and principles of CRAs’ organization and operations Setting up and promoting local CRAs Objectives of establishing local CRAs First of all, local CRAs should be developed to contribute positively and significantly to efficient resource mobilization from investors to issuers As a source of information about credit risk, it deepens investors’ knowledge about the securities that they decide to invest in With such information, individuals may also be more confident in investing in financial instruments instead of other non-productive assets As a benchmarking certification of a credit situation, credit rating then enables issuers to seek finance from wider groups of investors This also proves be quite crucial in the context of Vietnam beginning to seek external finance for accelerating its development In another instance, local CRAs may provide a marketing tool for entities that place debts with clients, similar to the experience of the CRISIL in India Yet the role of international CRAs, even in the initial stage, needs to be appropriately considered, since their services enable Vietnam’s large and eligible corporations to attract international capital The presence of international CRAs also increases the variety and quality of services supplied to issuers and investors Competitive pressure from international CRAs will also force local counterparts to improve the quality and competitiveness of their service Nevertheless, with a view to develop local CRAs, in the initial stages the entry of international CRAs should only be permitted to support international capital attraction Such entry to other market segments should only allowed after some stages, provided that the roadmap is transparent and credible At the macro level, establishing local CRAs may help provide a market-driven system to Vietnam’s regulators so as to promote capital market development Intentionally assigning misleading marks to the credit situation of certain industries may prove to be too costly, particularly over the long term, as it becomes harder to rebuild credibility among users Allowing for market-driven credit rating may provide a good surveillance instrument to regulators because a downgrade in credit ratings may require special attention and measures to resolve underlying problems Similar to the case of CRISIL in India, local CRAs may help to “institutionalize a viable and market-driven system of credit rating in India” (Ravimohan 2003) Number Winter 2006 Vietnam economic management review 45 .VEMR Economic Research PROMOTING CREDIT RATING IN VIETNAM Principles for the organization and operation of local CRAs To begin with, if established in Vietnam, local CRAs must be able to maintain the independence of rating process This is a crucial condition, if not prerequisite, to the efficient contribution of credit rating to capital market development There is often intentional influence brought to bear by issuers and interest groups on a rating outcome For example, an issuer may be willing to bribe the CRA so as to receive a rating which appeals to investors, and a country may be tempted to lobby the CRA in order to hide its problems from creditors While this may have benefits for certain firms or industries, such benefits result from violating the code of conduct and may only last in the short term In such cases, a misleading credit rating is dangerous as it deepens information asymmetry between issuers and investors Once the ratings are found to be false, the credit rating industry may even collapse since it would be difficult to restore credibility Hence, the independence of rating process must be maintained as a necessary condition for the sustainable development of credit rating industry in Vietnam The ownership and management structure of local CRAs must support that independent operation The CRAs may be either state-owned, in the form of not-for-profit or profit-making organization, or private firms In India, the CRISIL was promoted by the major Indian financial institutions, with the ownership account being comprehensively and clearly known and updated in the public domain Management of the CRISIL was also independent of ownership; financial professionals with expertise in their own fields were allowed to undertake the task independently, and no shareholders were involved in the process However, in the case of Vietnam, several reasons may be presented against the involvement of private credit rating firms Firstly, those private firms may have too limited scale relative to the requirements of capital market development As a result, they may fail to reach economies of scale Secondly, there is a risk that some issuers may simply establish their own rating firms (eg indirectly via a relative) to have misleading marks assigned to their credit situation This could pose massive challenges to ensuring rating quality, since effective monitoring and surveillance may be too costly These issues may be less likely in the case of state-owned CRAs - the ground for the authors’ view that state ownership is preferable Yet state-owned CRAs have their own weaknesses, the most severe of which is the possible intervention of Government in rating outcomes To maintain rating quality, the enforcement of effective monitoring, surveillance and accountability mechanisms must be emphasized The ownership choice of local CRAs, in addition, requires careful consideration of necessary scale, professionalism, etc Another possible approach is to set up state-owned CRAs in the initial stages and then allow them to transfer to private ownership later Apart from ownership and management aspects, the rating process must also maintain rigor and integrity That is, to minimize the risk of making an error or oversight, rating procedures must be comprehensive and try to cover as many aspects as possible The entire process and evaluation criteria must also be publicly available to maintain consistency and make the rating procedures transparent Moreover, the person responsible for security rating must not be allowed 46 Vietnam economic management review Number Winter 2006 .VEMR Economic Research PROMOTING CREDIT RATING IN VIETNAM to buy or sell securities This was a beautiful experience from the CRISIL in India, where such measure was undertaken to prevent potential conflict of interest (Ravimohan, 2003) Finally, the rating process and outcomes should be reviewed for consistency The method and criteria of ratings should also be renovated, so as to fit in with new conditions Another core principle of CRAs’ operations is guaranteeing information confidentiality To provide an accurate rating of credit risk, CRAs often require detailed information, particularly about the issuers’ performance and financial position Quite often, the required inputs for credit rating are internal, at a more detailed and comprehensive level than those reported to the public If such inputs become publicly available, issuers may be severely threatened To protect issuers’ interests, certain regulations must be imposed on CRAs to ensure they keep that internal information confidential Otherwise issuers may be reluctant to use credit rating services, or may be inclined to supply untrue information if credit rating becomes mandatory in the issuance of new securities Conditions for viable development of CRAs Prerequisites for the development of CRAs in Vietnam must be the recognition of and demand for credit rating as one of the most comprehensive indicators of inherent credit risk Without a correct perception of the role of CRAs, the market may turn to other available means of credit risk assessment However, in an underdeveloped financial market, such means may also be unavailable In such circumstances the development of the capital market may be hindered, since investors may opt to invest in assets other than financial instruments This problem is critical in Vietnam; with the capital market only in the initial stage of development and there being limited awareness of credit rating, the country should have effective measures to increase the public perception of such service Specifically, the public, including issuers, investors and regulators, must understand the advantages and limitations of CRAs, so as to avoid skepticism and/or make incorrect decisions due to misinterpreting rating outcomes Vietnam must introduce certain regulations to ensure independent operation of rating agencies right from the very beginning The existence of such agencies without independence may raise concerns about possible influence by certain interest groups on the rating outcome, which in turn undermines public confidence Supplementary measures, such as monitoring and accountability, are also required to prevent possible collusion between issuers and CRAs, which can be equivalently devastating In addition, information transparency must be promoted to create a favorable environment for viable CRAs The legal system must be modified to allow for improvements in disclosure, accounting and auditing standards Without such conditions, rating outcomes may be misleading since certain information is excluded from issuers’ reports to CRAs Transparency also guarantees the variety of information sources - substitutes - to investors To exist and make profits, CRAs must improve the quality of their services so as to compete with those substitutes The answer to whether credit rating should be mandatory in security issuance, however, is less clear and more controversial Although in most developing countries with CRAs, mandatory ratings by accredited CRAs have been introduced, and often, a system is set up to license Number Winter 2006 Vietnam economic management review 47 .VEMR Economic Research PROMOTING CREDIT RATING IN VIETNAM approved CRAs, rating regulations vary across countries2 In fact, it may be argued that mandatory credit rating is important to developing a credit rating industry, particularly in the initial stages, since it effectively creates a demand for such services As information sources to investors appear to be small in variety (only periodic financial reports), mandating the use of credit rating may also help to increase the information available to investors The risk remains, nevertheless, that such requirements on security issuance may in effect enable the local CRA to operate as a monopoly That is, the lack of information is effectively replaced by a marketdistorting requirement on using credit rating, without evidence as to which one is worse The risk and distortion may even be exacerbated since the issuers are in a weak position and might have to pay bribes in order to obtain a rating mark in time Considering such issues, the suggestion is that in the early stages of application, credit rating can be mandatory for issues by major stateowned corporations and commercial banks, and afterward need only be on a voluntary basis (i.e issuers must recognize the overwhelming benefits of credit rating to themselves) Capital markets, particularly debt markets, should be liberalized On the one hand, this helps to broaden the investor base, as with permitted entries of foreign investors there would be large capital inflows Liberalization would also make those markets more vibrant, with increasing market activities and liquidity Moreover, the abolition of certain market distortions may cause investors to be exposed to default risk To ensure safe investment, they would require as much detailed knowledge of the issuers’ credit risk as possible In such cases, demand for reliable credit ratings would increase - a favorable condition for the development of CRAs The issue of the optimal number of local CRAs is also worth considering Too much competition in an underdeveloped market may cause an inflation of ratings with low quality Too little competition, on the other hand, raises concerns about the slackening of standards and performance (World Bank and IMF 2004) Lastly, the role of foreign assistance in establishing local CRAs in Vietnam should be emphasized Credit rating is a new concept that requires training by foreign experts to gradually become part of the public perception Establishing local CRAs, albeit at the right time, is fundamentally a learning-by-doing process Hence, without such training, there will be a lack of qualified personnel with adequate knowledge/expertise in the area Foreign expertise is also highly valuable in helping the designation of CRAs to meet local conditions Obviously, CRA models in other countries may not necessarily be applied directly without adjustment to Vietnam’s circumstances Sharing knowledge and best practice is another benefit of foreign assistance, since it enables the country to avoid the mistakes made in other economies Promoting and utilizing foreign assistance is, therefore, critical to fostering the effective development of a credit rating industry in Vietnam Conclusion As Vietnam strives to accelerate its growth process, developing the capital market becomes an urgent requirement One of the necessary conditions is therefore to improve information transparency in the market The experience of many countries, including developing economies, 48 Vietnam economic management review Number Winter 2006 .VEMR Economic Research PROMOTING CREDIT RATING IN VIETNAM has demonstrated the success and crucial role of credit rating in that improvement Apart from helping to raise development finance, credit rating services provide Vietnam’s regulators with a market-driven system to promote the development of the capital market Using a set of evidencebased reasoning, this paper contends that the time has come for Vietnam to set up its own CRAs In fact, Vietnam now considers the establishment of CRAs an important measure to accelerate capital market development (Le Thi Bang Tam 2006) The Government plays a pivotal role in establishing local CRAs Firstly, it should broaden public awareness of the significance of CRAs The public must also understand clearly the limitations of CRAs, and that building up local CRAs is insufficient for reducing information asymmetry and promoting capital market development Secondly, the Government should set up a proper regulatory framework Certain regulations are required with respect to the organization and operations of CRAs, with the emphasis on consolidating the independence of the rating process This paper notes the role of capital market liberalization, particularly in creating demand for credit rating and putting pressure on local CRAs to develop Finally, there should not be too much expectation of credit rating development in Vietnam, since such a service is relatively new to the country In other words, developing a credit rating industry in Vietnam is no more than a gradual process; after learning best practice, Vietnam may re-design it to match the country’s circumstances Foreign assistance is also valuable, particularly in designing and training, so that Vietnam can avoid the mistakes seen in other countries/economies Notes 1.For BIDV, financial strength was rated E, with a positive outlook, reflecting the bank’s significant asset quality problems and below-average liquidity; ratings for long-term local and foreign currency deposits were Ba1 and B1, respectively, whereas short-term deposits and debt ratings were at Not Prime (Vietnam Business Forum, 2006) 2.For example, in Colombia, ratings from nationally-recognized CRAs are required for regulatory purposes, while in Argentina ratings are voluntary and are used as a disclosure gesture In Hungary, ratings from local CRAs are required for public issues but not for private placements on the domestic markets (World Bank and IMF, 2004) Today, 95% of privatelyplaced debt issues – where ratings are not mandatory – have been rated by the CRISIL’s Rating group (Ravimohan, 2003) References Berblinger, J (1996) “Marktakzeptanz des Rating durch Qualitat”, in Buschgen, H.E., and Everling, O (ed.) Hanbuch Rating, Wiesbaden: Gabler, 21-110 [In German] Jantaraprapavech, S (2001), “The Bond Market in Thailand”, Paper presented at the Asian Policy Forum, ADBI, Tokyo, 26 January Number Winter 2006 Vietnam economic management review 49 .VEMR Economic Research PROMOTING CREDIT RATING IN VIETNAM Kerwer, D (1999) “Credit Rating Agencies and the Governance of Financial Markets”, Paper prepared for the 11th Annual Meeting of the “Society for the Advancement of SocioEconomics”: Globalisation and the good society, Wisconsin, July 8-11 Le Thi Bang Tam (2006), “The Role of Financial Market in the Process of Industrialization and Modernization in Vietnam”, Economic Bulletin, Central Economic Commission of CPV, No 112, April (in Vietnamese) Ravimohan (2003) “Setting up and Running a Ratings Agency in India: The CRISIL Experience” Mimeo Takkar, N (2005) “The Role of Credit Rating Agencies in Asia’s Emerging Bond Markets”, Paper presented at the 38th Annual Meeting of Board of Governors, Asian Development Bank Istanbul, May Vietnam Business Forum (2006) Available at: http://vibforum.vcci.com.vn/news_detail.asp?news_id=6543 [May 30, 2006] World Bank and IMF (2004), Developing Government Bond Markets – A Handbook, Washington D.C Appendix: Rating Scales 50 Moody’s Standard & Poor’s Aaa AAA Aa1 AA+ Aa2 AA Aa3 AA- A1 A+ A2 A A3 A- Baa1 BBB+ Baa2 BBB Baa3 BBB- Ba1 BB+ Ba2 BB Ba3 BB- B1 B+ B2 B B3 B- Caa CCC+ Ca CC Vietnam economic management review Quality Investment grade Speculative grade (close to) Default Number Winter 2006 .VEMR Economic Research C PROMOTING CREDIT RATING IN VIETNAM C D Source: Cantor and Packer, 1994:3, cited in Kerwer, 1999:3 Number Winter 2006 Vietnam economic management review 51 ... and foreign assistance in such process The need for credit rating in Vietnam There are several grounds for supporting the promotion of credit rating in Vietnam Firstly, as mentioned above, Vietnam. .. market More information internal to the issuers is combined in credit rating process; so the requirement of credit ratings in issuing securities generally promotes transparency in the market Meanwhile,... Research PROMOTING CREDIT RATING IN VIETNAM Kerwer, D (1999) ? ?Credit Rating Agencies and the Governance of Financial Markets”, Paper prepared for the 11th Annual Meeting of the “Society for the