Europe's 'downgrade diary' flags up new market pressures
LONDON, Aug 5 (Reuters) - New European rules requiring credit agencies to announce their rating decisions to a pre-set timetable are likely expose the region's shaky sovereign borrowers to more bursts of market pressure. But they may also have an impact further afield. Under the CRA3 rules taking effect at the start of next year, credit rating firms will have to make the dates of their sovereign reviews - when downgrades, upgrades or outlook changes usually happen - public in advance. Ratings are a key part of the financial system because investors use them to judge how likely they are to get their money back, but the financial crisis has led to unease that the market is relying on them too much. Europe's changes aim to make the secretive ratings process more transparent, reduce the clout of big firms like Standard & Poor's, Moody's and Fitch, and stem the constant downgrade rumours that unsettle investors. But behind the scenes some policymakers are warning that the plans could end up creating what one called a "downgrade diary" that speculative traders could use to target vulnerable states. Regulators and rating agencies are worried too, concerned that having specific dates for moves risks producing "cliff effects" whereby markets gyrate in anticipation of possible rating changes and then correct on the news. "It will be similar to the way you get stock market volatility ahead of Fed, ECB and Bank of England meetings as the market tries to second-guess what they will do," said Alan Reid, managing director of DBRS, the largest rating firm outside the big three. "In between the (rating) decisions there will be less volatility, but overall there could be more because right around those dates you would concentrate it."
MARKET IMPACT Analysts are not exactly sure how big the pre-rating decision price swings will be under the new rules. Mario Draghi's "whatever it takes" promise last year on behalf of the euro has reduced market sensitivity to ratings, but traditionally it has been high, especially if a move or outlook change takes rating in or out of investment grade territory, or makes such a move likely. The ECB's two-tiered lending system, where banks are allowed to borrow 5 percent more if the bond they put up as collateral is rated in the AAA to A- band, also plays a big role. When Moody's downgraded Portugal by four notches in July 2011 following Greece's debt restructuring, Portuguese and Irish bond yields leapt almost 250 basis points and European shares lost 3.5 percent in the space of two days. And an International Monetary Fund study last year showed that a top agency putting a country's rating on "downgrade-watch" on average leads to a 100 basis point widening in Credit Default Swap Spreads (CDS) in advanced economies and one of 160 bps in emerging borrowers. "We would have to adjust what we do and start thinking about who is vulnerable as those dates approach," said Deutsche Bank senior euro zone economist Mark Wall. "If you have deteriorating fundamentals, if there has been disappointing progress on structural reforms, then there is the risk of a downgrade and the market is going to be looking at that."
INTO AFRICA Agencies will be able to change their ratings outside the pre-set timetable but only in extreme cases, for example if a government falls or makes a sudden huge change to its finances.
Rating watchers wonder whether some countries will try to "game" the new system by leaving bad news until just after reviews, but for traders the limited room for manoeuvre means they can position fairly confidently for key rating dates. There are likely to be plenty. Even if just the big three agencies - S&P, Moody's and Fitch - are included, 28 European Union sovereigns being rated twice a year still adds up to 168 potential bouts of market stress. And it doesn't stop there either. One of the quirks of the new rules means that if a country in another part of the world is rated by an analyst based in Europe, it too will be subject to the new requirements. For S&P that is roughly half of the 127 countries it rates and includes most of Africa and the Middle East, and for Moody's and Fitch it is a similar story. African and Middle Eastern markets are for the most part more thinly traded than those in Europe meaning, the price moves could be larger, though the limited liquidity could at the same time reduce the appetite for major short selling. "The Nigerians thought we are mad when we told them about these new rules," said one top rating agency sovereign analyst who requested anonymity.