FYI | Sep 12 2011
– What exactly is a credit rating?
– How do relative sovereign ratings stack up?
– Should the UK not be the next downgrade contender?
By Greg Peel
It is interesting to note the new state government of NSW has now budgeted for a fiscal deficit, part of which will be funded by the issue of infrastructure bonds – the proceeds from which will be used to update the state's sadly lacking infrastructure and create employment in the process. NSW, and particularly Sydney, had experienced a decade of infrastructure neglect based to a great extent on the previous government shying away from the expense of it all. The previous government was determined to maintain the state's AAA rating at all cost. Interviews went something like this:
“What is the benefit of an AAA rating?”
“It means we can borrow money cheaply”.
“So why don't we borrow some money then?”
“Oh we couldn't possibly do that – we'd lose our AAA rating”.
Joseph Heller would be so proud.
It is possible that NSW may lose its AAA rating as a result of the new policy, although Standard & Poor's (as one agency) has not indicated it to be an automatic assumption at this stage. Either way, if you asked the people of NSW if they would rather have efficient transport, health and education systems or an AAA rating, it's not hard to guess what the choice may be. There is actually nothing at all wrong with debt. Economies cannot grow without it, and listed companies that hoard cash are de-rated in value by the stock market for not maximising earnings growth capability. One doesn't simply borrow money to spend today, one also borrows money to invest for tomorrow.
Which is unfortunately not what the US has done much of lately. President Obama's new fiscal policy announcements made last week highlighted the crumbling infrastructure supporting the largest economy on the planet, which would tend to suggest America's extensive debt has been accumulated by spending for today, on everything from houses to wars, rather than investing for tomorrow. Throw in political bickering, and S&P decided last month the world's largest economy no longer deserved its AAA rating. This implies the state of NSW is now a safer bet for lenders.
America's extensive debt is one issue, but clearly the greater focus over the last two years has been on accumulated debt in Europe. From Greece, to Ireland and Portugal, and on to Spain and Italy, unserviceable and growing budget deficits have thrown global financial markets into turmoil. The issue lies not only with the public sector but also in the private sector, in which substantial sums of eurozone sovereign debt are held by banks from France to Germany and beyond. That is why the world went in to panic mode briefly in August when a news report erroneously suggested France's sovereign debt was about to be downgraded post the US downgrade. How could France maintain its AAA rating, it was implied, if the US was no longer AAA?
Which is an argument one could take to the nth degree. How could any country maintain a AAA rating if the rating of by far the largest economy in the world, holder of the global reserve currency, is not AAA? Perhaps it would be best – and cause the least turmoil – if S&P just downgraded every sovereign AAA to AA+ in one fell swoop. Everyone else could ratchet down as well, we could then call AA+ the new AAA, and start again as if nothing had ever happened. It would sure avoid a lot of heartache among the “real” people of the world – the small investors.
It's not going to happen of course. Instead, we may yet see France downgraded and perhaps Germany as well if the eurozone cannot get its act together definitively, once and for all. How does that leave the likes of the Scandinavian countries, Singapore, Canada and Australia all on AAA ratings at present? In the case of so-called “commodity countries”, there is seen to be a safety net in the form of China. China is America's biggest creditor, followed by Japan, yet S&P rates both as AA-.
Go figure.
It's not just about the money, however. To arrive at a credit rating an agency will consider institutional effectiveness and political risk, economic structure and growth prospects, external liquidity and international investment, fiscal performance and flexibility, and finally monetary flexibility. Perhaps within those criteria we can see why America can be AA+ and China AA- despite the former owing unrepayable amounts to the latter.
On the flipside of that argument, the question might be asked as to why Japan's rating has not also come into question of late given Japan has a greater debt to GDP ratio than that of America. The answer must lie in the fact Japan, as an export economy with the US and Europe major customers, maintains not only a trade balance surplus but also a current account surplus, balancing against its substantial fiscal deficit.
Which is not the case in the UK. With all the talk of the possibility of QE3 being implemented in the US post the expiry of QE2, it is easy to forget that the UK is still implementing its own QE2 with no end in sight at this point. The focus has been on the Fed's “exceptionally low rates for an extended period” at a time the Bank of England has maintained its 0.5% cash rate ever since the GFC with, again, no change in sight. Indeed, aside from recent anger vented by Britain's disenfranchised youth, and That Wedding, Britain has remained largely off the global attention radar. Clearly the UK will be currently thanking its lucky stars that nationalism and lack of political resolve has kept the UK in the European Union but out of the eurozone. The British pound remains an independent currency.
The pound has not, however, offered the world an independent safe haven of late, as has been the case with the totally unaligned Swiss franc. Indeed where goeth the euro, goeth the pound in most instances. The world may be unable to turn its attention away from the eurozone and the possibilities of the next significant euro-rating downgrade, but economists at Danske Bank believe the next major economic force to feel the cold steel of rating agency swords will be the UK.
The economists have applied S&P's own rating criteria to come up with their own credit assessment of the UK, and the result is disbelief that the UK could continue to not only be rated AAA but to also officially have a “stable” outlook. Indeed, Danske believes the correct relative rating for the UK should be A+. That's four notches below AAA and would put the UK on par with the likes of Italy and Slovakia.
The Danske economists disagree with internal UK projections of the country's debt burden. They suggest real GDP growth ahead could be substantially lower than forecast and that the budget deficit may be a lot harder to reduce than expected. They do not agree with the suggestion the UK's debt burden will peak in 2013-14 and then begin to reduce towards a targeted 69% by 2015-16, rather suggesting the ratio will continue to grow towards 84% of GDP in five year's time.
On that basis, Danske is expecting the UK could well lose its AAA rating in 2012. The economists acknowledge, however, their own credit rating calculation does include a rather large weighting towards political considerations. Let us not forget the UK is currently administered by a minority government.
For those despairing at the supposedly never ending European debt saga, the good news is that Danske does not expect a devastating response to a UK downgrade, even if it were by as much as four notches. The economists do not see a huge pound sell-off occurring nor a disappearance of demand for UK bonds. There would not be a crisis of confidence.
Which begs the question, why not? The British Empire may now the be thing of history books but the UK economy was still the world's sixth largest, just behind Germany and France, in 2010. Perhaps the answer may be apparent in the response to the US rating downgrade in August. The response was swift and brutal, but within a couple of weeks markets had recovered all their lost ground.
What purpose do sovereign credit ratings serve other, it would seem post GFC, than to cause dangerous market volatility?
