Ratings Matter for the Euro Area
As you all have heard, Friday was (again) S&P’s day in the limelight. The rating agency downgraded over half of the 16 Euro area countries put on credit watch negative in December 2011. A quick look at my feed shows several takes on S&P’s action: the Economist’s Free Exchange comments on the now soft-core country, France; Michael Schuman hammers out the implications of the EA policy makers’ ‘misguided’ approach; Bruce Crumley (h/t Schuman) sees problems for Sarkozy; and as always, one of my favorite authors, Edward Hugh, eloquently characterizes the downgrades in the context of the real economy.
However, there’s one curt take on the downgrade that I disagree with. Barkley Rosser at EconoSpeak (h/t Angry Bear) compares the downgrade of France and Austria from AAA to AA+ as the same as a downgrade to the US or Japan. Furthermore, his title implies that these downgrades are irrelevant. I wholly disagree. There is one simple reason for this: France and Austria are subject to high rollover risk, while the US and Japan are not. Why? Because France and Austria do not have monetary autonomy over the currency in which their debt is issued (euros, to which the ECB holds the right to supply), so all debt issued can be treated as foreign-currency debt. Debt issued by the US and Japan is primarily local-currency debt.
A bit of background on ratings. When S&P, for example, changes its rating for a country, the rating that market participants (and the press) usually discuss is the foreign-currency rating. There’s another rating, the local-currency rating, that is used to quantify the risk associated with bonds denominated in the currency issued by the monetary authority. Now, for countries like the US and Japan, where the lion’s share of its debt issuance is denominated in its local currency, foreign-currency ratings are largely meaningless. The central banks in the US and Japan can always monetize debt issuance when needed. However, for any country in the Euro area (even Germany), debt is issued in a currency over which it has no effective control. Therefore, the foreign-currency rating is the one that matters.
For foreign-currency ratings, external indebtedness and leverage trajectories are key metrics. The next couple of quarters are likely to show either an improvement or deterioration in these metrics. If the real economy has not stabilized – the ECB desperately hopes it has – and turns downward in coming months and quarters, creditors in euros will favor the markets with the higher credit metrics, Germany, Netherlands, and Finland relative to those with lower metrics, France and Austria. Better put: if the growth trajectory is worse than expected – the 63 respondents to the ECB’s Q4 Survey of Professional Forecasters expect +0.8% GDP growth in 2012 – spreads to German bunds (the only remaining AAA with a stable outlook, as rated by S&P) will rise.
Ratings do matter for the EA countries. S&P’s action is a harbinger of bad economic and political things to come, not lower rates.
5 Responses to “Ratings Matter for the Euro Area”
bleichroeder • January 16th, 2012 at 6:19 pm
While this is true on a large scale, individual governments can always monetize with the cooperation of domestic banks via TARGET. While this has mostly been discussed in the problematic context of the southern periphery, which can't be cut off from ECB credit without being kicked out of the euro, the French banks have already been doing this on a larger scale by punting unlisted new issues straight to the ECB. In that it allows the status quo to persist indefinitely while obscuring/delaying resolution of the real core problems I don't think this is positive in the least.
rwilder3 • January 17th, 2012 at 12:28 am
@bleichroeder,
Think of the Fed plus US Treasury as one balance sheet. The Fed targets some interest rate in the banking system, while the Treasury spends/saves. Any spending/saving the Treasury does results in lower or higher interest rates via reserves in the banking system. If through the Treasury's spending/saving rates fall/rise beyond that targeted by the Fed, then the Fed will lower rates through reserve creation.
The ECB plus the French Finance Ministry do not act in a similar manner. The ECB monitors the EA banking system as a whole. For now, it has chosen to avoid catastrophe with its 3-yr LTRO and easing of collateral standards. But that's it. The ECB does not target any French rate, only the average rate. Thus, the ECB is not ever going to monetize French debt. Sure, it's doing some back-door monetizing; but the French government is still subject to high rollover risk since it does not control the ECB.
In its credit review of the EA sovereigns, even S&P explicitly states that if the ECB did not respond appropriately if future pressure arises, a lower monetary score could lower the rating for several countries. Link here.
The French sovereign has no power to create money beyond those limits set by the ECB. If French rates started rising quickly due to lack of liquidity – they will – then there's nothing that the central bank can do except hope that the ECB is planning to respond in kind.
Rebecca
rosserjb • January 18th, 2012 at 7:15 am
Barkley Rosser here. I beg to disagree with Rebecca Wilder, who has disagreed strongly with me. In principle, I would expect her to be right about the importance of bond ratings downgrades, and I also agree that France and Austria face greater "rollover risks" than did or do the US or Japan. However, it is precisely that even in the face of these facts bond yields in France and Austria followed what happened in the US and Japan that one must downgrade the importance of bond downgrades, at least for these generally highly rated countries. In what way will these downgrades make the rollover risk higher for France or Austria? The markets do not seem to think so, even if the markets are imperfect, which they are. But they are not completely stupid.
rosserjb • January 18th, 2012 at 7:17 am
I confess not to having a good explanation of this admittedly odd phenomenon. Perhaps it is a counterpart to the old line that markets "buy on the rumor (of good news) and sell on the (good) news." In this case, it would be "sell on the rumor (of bad news) and buy on the ( bad) news," although I do not find this entirely satisfactory.
Rebecca Wilder • January 18th, 2012 at 7:01 pm
Hi Barkley,
Thank you for stopping by!
You are confusing the market reaction to the announcement to what had already been priced in. French 5-yr CDS is 205 bps, implying a 16.6% probability of default over the next 5 years (In june, it was more like 80 bps). Compare that to Germany (100 bps) and the US (47 bps), and you get the sense that the markets are seeing what S&P is seeing. Markets had already priced in the downgrade of France. The rate on a French 10-yr bond is like 1.3% over that in Germany! Given that the liquidity in France and Germany are similar, I'd say that the risk premium is primarily default (and possibly exchange rate) risk.
I'd argue that the initial drop in rates (just 5 bps) was more a factor of the market being relieved that it was just one notch downgrade than an indication that France's rating is irrelevant.
Thanks, Rebecca
