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One has to be struck by the recent slew of rating agency credit upgrades for European sovereign bonds. Since the start of the year, undaunted by the marked deterioration in European political and economic fundamentals, the rating agencies have sheepishly followed the market’s more favorable attitude towards Europe by providing the European countries with improved bond ratings. This has to raise question anew as to whether the rating agencies serve any useful purpose. Similarly it has to raise questions as to whether the rating agencies continue to amplify market movements in a pro-cyclical manner.
Since the start of the year, the rating agencies have been falling over themselves to reverse their earlier wave of severe credit rating downgrades in the midst of the Euro-zone crisis. From Slovenia to Spain and from Greece to Portugal, one rating upgrade has followed another in quick succession. This would all be well and good if those upgrades reflected improvements in those countries’ underlying debt fundamentals. After all, it is the primary responsibility of the rating agencies to provide an objective assessment to market participants of the rated country’s probability of defaulting on its debt.
“It would seem strange for rating agency upgrades to be occurring at a time that the political center across most of Europe seems to be crumbling.” – Desmond Lachman
The trouble with this most recent round of European sovereign rating upgrades is that it seems to be simply following the market’s liquidity-driven improved assessment of Europe rather than to be making an objective assessment of the country’s economic and political fundamentals. At the political level, it would seem strange for rating agency upgrades to be occurring at a time that the political center across most of Europe seems to be crumbling.
This political crumbling is underscored by the fact that in last month’s European parliamentary elections 30 percent of the electorate voted for parties openly hostile to the European Union. It is also underscored by the fact that the marked success of the National Front in France has rendered President Hollande a virtual lame duck; the Portuguese termination of its IMF-EU financial support program is a sure sign of austerity and economic reform fatigue; and the series of Greek court rulings against past public spending cuts pose yet a further challenge to Greece’s very shaky coalition government.
At the economic level, the rating agencies upgrades would seem to be even more incongruous. Since they are occurring at the very time that European public debt to GDP ratios keep increasing to new record highs. Italy’s public debt to GDP ratio is now expected to exceed 135 percent by year-end, while those of Ireland and Portugal are around 125 percent. Equally troubling is the fact that these disturbingly high ratios show no sign of stabilizing anytime soon especially within the context of Europe’s very feeble economic recovery.
“Sadly, the rating agencies’ actions are not without consequence.” – Desmond Lachman
The rating agency upgrades are also occurring at the very time that the highly indebted countries of the European periphery are now either experiencing outright deflation or else are on the cusp of deflation. One would have thought that it would not have escaped the rating agencies’ notice that with lower inflation more budget effort is required to stabilize the debt. As an illustration, if deflation is now expected to be around 2 percentage points lower than earlier anticipated, an additional budget effort of between 2 ½ to 3 percentage points of GDP will be required by Europe’s highly indebted countries to restore public debt sustainability. And this increased budget effort would be required at the very time that austerity fatigue has set in.
Sadly, the rating agencies’ actions are not without consequence. By upgrading a country’s rating, the rating agencies allow the purchase of a country’s bonds by financial institutions that might have been precluded from so doing by their internal rules. And by expanding the number of potential buyers, the rating agencies amplify market movements that might be being fueled more by ample global liquidity than by any improvement in that country’s fundamentals.
Perhaps the most distressing aspect of the rating agencies’ current seeming disregard for the political and economic fundamentals is how soon it follows earlier rating agency debacles. Indeed, it is not too long ago that the rating agencies totally failed to anticipate the US sub-prime mortgage crisis and more recently grossly over-reacted to the onset of the European sovereign debt crisis. This has to raise the basic question as to whether the rating agencies are capable of learning from their past mistakes and as to whether they serve any useful purpose.
Desmond Lachman is a resident fellow at the American Enterprise Institute.
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