The Politics of Ratings, and the Politics of Avoiding Ratings

A while back I wrote a post about the muddling of finance and politics. The Eurozone crisis had seen France stripped of its AAA rating, and the move hadn't been taken well in France or the rest of the Eurozone. In particular, there was a significant, and very public, "answer back" from the French government and central bank, claiming that the UK should be downgraded first. 

These downgrades, along with those of Italy and Greece, had been notable for the significant political rhetoric behind the ratings. As was plainly cited at the time, the lack of political leadership and consensus was one of the main factors behind the downgrades, making the CRAs political commentators as well as risk assessors. This has never been denied by the CRAs. In their sovereign rating methodologies, each of the Big Three provide for political risk factors to be included in the assessment, along with "other factors" that the analyst might deem relevant. (Standard & Poor's sovereign rating methodology can be found here, and Moody's methodology is here. Interestingly, Moody's is currently seeking feedback to proposed "refinements" of its sovereign rating methodology. More on this in a later post).

The problem now, though, is that the US is facing the same. The fiscal cliff negotiations that played out in the final minutes of 2012 displayed to the world how divided the US legislature really is when it comes to solving the fiscal problems facing the US. Maybe "problems" is an understatement? 

In August 2011, Standard & Poor's downgraded the US one notch from AAA to AA+. This was the first downgrade in US history and stunned Washington. S&P cited - unsurprisingly - the large debt burden, but also the political stalemate that made tough decisions to tackle the deficit nigh on impossible. It seems that Moody's and Fitch, however, are looking very closely at their top ratings in the US. Fitch, speaking during the negotiations, reminded us that failure to raise the debt ceiling would exacerbate uncertainty over US fiscal policy and send the US into an unnecessary recession. It stated that this could erode medium-term growth potential and financial stability, leading to an increased likelihood that the US would lose its AAA status. Moody's, taking a similar line, has also expressed concern about the lack of political consensus to come up with a credible long term debt reduction plan. It stated that the current AAA rating will only be confirmed if current negotiations lead to a long term strategy that reduces debt to GDP ratio. 

The political aspect of downgrades of Berlusconi's Italy centred on the lack of credibility of the leader. But in the US, the political agenda is not the issue, so much as the lack of ability to reach a suitable agreement. Politics may not be the issue, but it got in the way of finding a solution to the real, underlying problem. The fiscal cliff may have been avoided, but the issues surrounding debt levels remain. It is estimated that without action, the US debt will reach $25 trillion by 2022. Moody's statement that only a reduction in the deficit will lower the likelihood of a downgrade seems rather trite considering the figures. For now, the country remains on "negative outlook".

... and the downgrades continue

And so the banking crises and the sovereign debt crises rumble on, with endless meetings in Brussels that have so far achieved stupendously little given the time already devoted. We are being reassured that progress is taking place, so perhaps just a little longer...

In the meantime several more European downgrades have been occupying the rating agencies. On the 18th October Moody's cut Spain's sovereign credit rating, making it the last of the big three rating agencies to take such action, lowering the rating from Aa2 to A1. A couple of weeks before, Fitch had cut Spain's sovereign rating to A minus from double A, followed closely by a similar move by Standard and Poor's. Considering Spain's sovereign rating was triple A status until September last year, recent downgrades mark the latest turn in a significant drop. Moody's cited reasons of political uncertainty (further elections could see the conservative People's Party make huge gains in elections on November 20th), unrealistic deficit reduction plans (from 9.2 per cent of GDP last year to 4.4 per cent in 2012) with equally unrealistic growth figures (forecasts of 1.8 per cent growth have been estimated by Moody's to be closer to 1 per cent). Further reasons cited include the government debts of Spain's 17 autonomous regions, and the willingness of these to curb their spending.

Moody's have also downgraded both Belgium and Italy, the latter following a similar move by Standard and Poor's last month. Standard and Poor's have also downgraded three large Italian banks although it confirmed the ratings of 18 large banks - including the largest by assets. 21 regional banks were also downgraded. However concerns have been raised by the head of Italy's banking association and chairman of Monte dei Paschi, Giuseppe Mussari, that EU bank recapitalisation plans being discussed in Brussels could do more harm than good in Italy by forcing banks to hold 'unnecessary' amounts of capital and exacerbating the sovereign debt crisis. Italy's 10-year bond yield rose 7 basis points to 5.867 per cent on Tuesday, the highest close since before the European Central Bank began buying Italian bonds on August 8 to try keep down borrowing costs.

As negotiations to bail out Greece and the Euro with it continue in Brussels, Moody's has announced that it may change the outlook on France's triple A rating from stable to negative in the next three months. As is customary in such situations, a downgrade is neither forthcoming or imminent, but the mere prospect of such sends shivers through the markets and French banks' shares fell following the announcement. Moody's praised France's 'very high economic strength', its 'ample capacity to absorb shocks' and its 'favourable public debt maturity', along with political efforts aimed at fiscal consolidation. However, the global financial and economic crisis had, according to the rating agency, led to a deterioration in French 'government debt metrics'.

The agency stated that France's finances were now among the weakest of those countries which still had a triple A rating. France's public finances are not only looking vulnerable but French banks are heavily indebted to Greece. Standard and Poor's last week downgraded BNP Paribas by one notch from double A to double A minus citing exposure to Greek debt. What's more, major consequences could follow for France if Greece defaults on its liabilities and markets react poorly, or if there are any further defaults. Add in the fact that France has been gradually becoming less competitive for businesses over the past years - in contrast to neighbouring Germany - and it becomes easy to understand why Sarkozy might be worried. Moody's isn't alone, however, as Standard and Poor's included France in the role call of countries likely to see further downgrades in the case of a double dip recession - alongside Spain, Italy, Ireland and Portugal. France's public debt is approaching 90 per cent of GDP and so a downgrade could prove extremely painful, even though this figure is set to fall as France's budgetary deficit is brought down from 5.7% currently to 3% in 2013. These figures are - as most Eurozone projections - based on optimistic growth forecasts. France anticipates 1.75% over the next year. Most commentators doubt this will materialize, either making deficit reduction a longer-term goal, or necessitating further austerity measures in the run up to the election next year.

France is already committed to €158.5bn ($217bn) in guarantees for the new eurozone rescue fund, the European financial stability facility, which is equivalent to 8.5 per cent of GDP. It has also just agreed to guarantees for the failing Franco-Belgian bank Dexia. Now these don't matter much unless and until one of these fails, at which point the government is bound to step in. But it does mean that France has much less room for manoeuvre on its balance sheets than it did three years ago, leaving it vulnerable to further financial shocks. It is also limited in the resources it can supply to the European Financial Stability Fund (EFSF), and Germany's peas for a greater Greek write-off followed by French re-leveraging of banks is, as a consequence, increasingly difficult. Politically, at least, Sarkozy has hailed the AAA rating as 'untouchable', and while rating agencies take political direction into account, it will no doubt take more than a statement of intent to preserve France's rating.

S&P Downgrade Italian debt

Standard and Poor's yesterday downgraded Italian sovereign debt to A with a negative outlook. This means that further downgrades are still possible. This means that Italy's Standard and Poor's rating is now 3 notches below that assigned by Moody's, which announced last week its intention to review the Italian measures brought in to deal with the debt problems.

As is usual with these things, the base rate of borrowing rose, leaving yields on 10 year Italian bonds at 5.80% this morning, the highest since the European Central Bank started buying Italian and Spanish bonds in August, according to the FT. By contrast, 10 year German Bund yields this morning were at a low of 1.75%.

Standard and Poor's cited Italy’s “weakening economic growth prospects” and the difficulty of the “fragile governing coalition” being able to “respond decisively” to the crisis, however Berlusconi responded by calling the downgrade political. The Italian government passed an an austerity package just six days ago, however Standard and Poor's has clearly not been much reassured. It would appear that concerns surrounding Italy's ability to deal with the debt crisis are as much about political capability than fiscal stringency.

The Eurozone may be preoccupied with an imminent Greek default, and while this would be tricky and painful, Greece's economy could - just about - be propped up by the rest of the Eurozone, should it choose to do so. However the larger Italian economy is not in this position, and as such any prospect of Italian default should signal something akin to a "save yourselves" policy turnaround. And then there's Spain...

The European institutions have, predictably, reacted angrily to the news, and have threatened a third round of regulation of CRAs, setting up a wholly independent European rating agency. Commentators have largely been skeptical about this threat, but more here if and when the plan is taken forward.