Why Sovereign Debt Ratings May Not Matter That Much
Standard & Poor’s decision late Monday to threaten 15 euro zone nations with ratings downgrades will put even more pressure on European Union leaders when they begin holding talks on the debt crisis on Wednesday.
Part of S&P’s message seems to be that there is no “free lunch” for Europe: if Germany and France cut a deal to share the debt burden of nations like Italy and Spain, their own credit ratings may suffer.
S&P added to the threat on Tuesday by warning it may downgrade the EU bailout fund—known as the European Financial Stability Facility —as well.
Markets pulled back on Tuesday in reaction to both warnings. The question is: Should investors really be worried? History suggests no.
As longtime market strategist Barry Ritholtz points out, S&P downgraded the credit rating of the United States on Aug. 5. This was followed by a sustained rally in Treasurys. Stocks have had a volatile ride since then but the major US indexes are all up by over 5 percent, mostly because the quiet riot rally in equities that began in early October.
In short, the downgrade of the US seems to neither have predicted nor caused a crisis in debt or equities.
Historically, ratings downgrades have failed to predict downside moves. Downgrades of sovereign debt, in particular, tend to follow crises rather than predict them.
“It seems the markets force them to act, that traders are issuing the call long before the analysts at Moody’s or S&P actually downgrade a corporate or sovereign ratings,” Ritholtz writes.
When economist and financial crisis historian Carmen Reinhart looked at this problem in 2002, she found that a huge part of the problem was that the ratings agencies tend to focus on a set of “fundamentals” that do not reliably predict defaults or financial distress. Things are good predictors—liquidity, currency overvaluation, asset price behavior—get the short shrift.
In particular, when downgrading the US, S&P cited “the difficulty in framing a consensus on fiscal policy” as a primary cause of the downgrade.
But there is little evidence that the absence of political consensus on taxes and spending makes default more likely. In fact, the most troubled nations in Europe were characterized by strong political consensus. The defaults or near defaults by Russia and Mexico in the 1990s came under situations where the governments were strongly unified.
One possible reason why the track record for sovereign ratings is so bad is that there is no market for them. The ratings agencies are not compensated for rating sovereign debt. This means that there is no direct market check on the accuracy of their ratings. The agencies lack access to information about the market view of their accuracy that would come if there was a price for these ratings.
Note that this is not the same complaint that is often heard about the compensation model of ratings agencies with corporate credit. The conventional wisdom holds that the ratings agencies are corrupted by the fact that they are paid by bond issuers, which incentivizes them to overrate debt. (Click here to read why "issuer pays" was not the problem.)
That said, a downgrade of France or Germany will probably wouldn't have the same effect that the downgrade of the US had. The US still controls its own currency and issues debt in that currency. The US government can always fund its spending, regardless of access to external debt markets or tax revenues, so long as it keeps inflation under control and doesn’t push aggregate spending beyond the economy’s capacity.
The euro zone isn’t like that. The governments of France, Italy, Spain, and Germany issue debt in the euro, a currency they do not control.
These same governments spend euros when they appropriate money for projects. This means that they are required to raise euros from external markets—either by borrowing them or collecting them as taxes.
They can experience budgetary shortfalls that disrupt their ability to spend or service debt.
What’s more, the individual nations of Europe are not as wealthy as is sometimes thought. Germany has a per capital income that is more than 20% below US levels, below the level of Alabama and Arkansas, as economist Scott Sumner has pointed out. The population is already heavily taxed, leaving little room for higher taxes to raise revenue.
This is far short of the level of wealth needed to even agree to something like funding a “first loss” facility for periphery debt.
The outcome of Europe’s crisis is hard to predict precisely because there's been nothing like it before. It's a test of an entirely new economic model—a currency union of semi-sovereign nations—along lines that the architects of that model never anticipated.
In other words, no one really knows—including the ratings agencies.
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