Like naughty schoolchildren put on report, 15 of the 17 eurozone countries responded with tears and tantrums to Standard & Poor’s decision to place them on a negative “creditwatch” earlier this month. Threatened with the downgrade of their sovereign debt, some politicians resorted to denial – “a wild exaggeration and also unfair” inveighed Jean-Claude Junker, prime minister of Luxembourg. Others muttered accusations of Anglo-Saxon bias – “American rating agencies and fund managers are working against the eurozone” claimed Rainer Bruderle of Germany’s FDP. Christian Noyer, head of the Bank of France, argued last weekend that on the basis of economic fundamentals, “They should begin by downgrading the United Kingdom which has bigger deficits, more debt, higher inflation, less growth than us and where credit is shrinking”. If I go down, I’m taking you with me. And the furore looks set to continue, since Fitch announced last Friday that it too would be putting six European countries on the naughty step of negative watch.
However, the hullabaloo in Europe’s political playground has not been reflected in financial markets. In the wake of S&P’s news, eurozone government bond yields (the interest paid to creditors) hardly increased at all and actually fell in Italy and Spain. Commentators largely rushed to defend credit rating agencies from the protestations of European officials. S&P et al. didn’t reveal anything that investors didn’t already know, hence the markets’ limited reaction. Indeed, the sharp fall in value of many European bonds, such as those of Italy and France, is just one indication that the EU’s structural weaknesses have been evident for months. The role of credit rating agencies is merely to improve the flow of information about the creditworthiness of governments. What’s more, they’re actually good at this. Yes, their performance on US mortgages was spectacularly poor. But they have consistently downgraded sovereign debt a year before each government default since 1975. ‘Why shoot the messenger?’ therefore seems a legitimate retort to huffy politicians calling for the credit rating industry to be regulated and even silenced.
The trouble is, the ratings put forward by agencies do much more than merely state an opinion. If S&P followed through with its threat of downgrading eurozone debt, it would have a real impact on the region’s economy. First, it could spell doom for Europe’s €440bn bailout fund, the European Financial Stability Facility (EFSF). If any of the six triple A- rated eurozone countries that guarantee the rescue fund are downgraded, the EFSF will also lose its top credit rating, greatly reducing its ability to assist indebted countries. A French downgrade, for example, would drain the pot of €158bn of French guarantees. Taking into account the ongoing commitments to Greece, Ireland and Portugal, this would leave around €150bn, nowhere near enough cash to deal with the increasing strains on Italy and Spain.
Then there are the banks. Sovereign downgrades usually result in a subsequent downgrade of the banking system. This is because they compound economic strains, increase the cost of bank debts and, most importantly, reduce the value of sovereign bonds, which typically comprise 10% of a bank’s balance sheet. These additional problems are the last thing European banks need at a time when they are desperately trying to strengthen their capital bases and restore confidence among shareholders. The risk of default from the two largest eurozone banks is already the highest it has been since the 2008 financial crisis. A downgrade may tip the banking system over the edge.
But its not just Europe’s economy that is vulnerable to credit rating agencies’ decisions. Controversially, agencies seem to have power over politics as well. Despite the claim by S&P’s director of European ratings that the agency is “not in the business of policy making, that’s the business of elected officials”, S&P seems both conscious of its political influence and determined to maximize it. It can be no coincidence that its announcement that 15 eurozone countries could stand to lose their ratings came mere days before a European Union summit that intended to construct a solution to the eurozone crisis. This tactic was also seen in the summer when S&P threatened to downgrade US bonds in the middle of Congress’s negotiations over the debt ceiling. Moreover, the report that accompanied the agency’s warning was full of policy recommendations, including “a greater pooling of fiscal resources and obligations” and “mutual budgetary oversight”. The fact that the agency tied its ratings decision to the outcome of the summit lends credence to the view that it was trying to force politicians’ hands.
Yet, the answer is not to jump to over-regulation of agencies. The European Commission thankfully shelved its idea to ban changes to sovereign credit ratings of countries facing “exceptional circumstances”. Not only would this do little to reassure markets if a country were entering a crisis, it would impinge on agencies’ freedom of speech. Instead, credit ratings should be taken out of regulations, such as central bank collateral requirements and rules that limit which securities certain investors are allowed to hold. This would prevent the repercussions of a rating change being so widespread throughout the financial system. Steps have been taken in this direction. The Dodd-Frank reforms in the US require that regulators replace all references to credit ratings with “other standards of creditworthiness”. Yet much more needs to be done, particularly by policy-makers in Europe, if reliance on ratings is to be reduced.
Finally, the credit rating agencies also need to exercise the influence they yield more responsibly. Announcing the potential of a downgrade to what were previously considered some of the safest assets around was one thing. Doing so at a time when investors were already nervously awaiting the outcome of the most important European summit this year was unnecessarily inflammatory. It is true that in the event the markets stayed calm. But S&P’s actions could well have sparked a panic. If this had led, for example, to the collapse of a European bank, politicians’ accusations that agencies were deliberately destabilizing the currency union would have rung true. The eurozone is in enough of a mess as it is, without S&P making it worse. Europe should treat the credit rating agencies with respect and vice versa.