Ratings Agencies Have Learned Little From Their Errors
One has to be struck at the markedly changed mood at the sovereign debt rating agencies towards the European periphery in recent months. After several years of steep rating downgrades and handwringing about the poor sovereign debt dynamics of countries in the European economic periphery, since the start of this year Moody's, Standard and Poor's, and the Fitch rating agencies have all begun the clearest of upgrading cycles with respect to those countries. From Cyprus to Slovenia and from Portugal to Spain, Ireland, and Italy, one rating upgrade has followed the other in quick succession for peripheral Europe. And this has occurred despite any clear indication that those countries' prospects for repaying their sovereign debt has materially improved.
If the rating agencies are to play a useful role in rating the sovereign debt of the European periphery, they must provide an objective assessment of the probability that those countries might default on those debts. They should be providing such an assessment rather than simply following the market as they have done in the past during the downgrading cycle or as they now seem to be doing again in the upgrading cycle. Otherwise, rather than providing a useful role to the markets as an objective assessor of default risk, all that the rating agencies do is act in a pro-cyclical manner that contributes to markets overshooting in both directions in their pricing of sovereign risk.
To be sure, the rating agencies can point to some recent progress in the European periphery's economic performance that might have improved its sovereign debt prospects. After the longest European economic recession in the post-war period, there are now clear signs of an economic recovery, albeit weak, across the European periphery. In addition, over the past three years, a substantial budget effort has been made in the European periphery that has significantly reduced its budget deficit.
While the resumption of economic growth and reduced budget deficits are clear positives in restoring sovereign debt sustainability, they would seem to be being more than offset by a number of negative developments. Amongst the more important of those negatives is the fact that no fewer than eight of the Eurozone countries have now succumbed to outright price deflation. At the same time, the expected maintenance of very high unemployment levels in Europe will only exacerbate the deflationary trends already so clearly in evidence across the Eurozone.
The importance of deflation in undermining public debt sustainability cannot be overemphasized. At current levels of public debt in the European periphery of anywhere between 100 percent and 140 percent of GDP, if one has deflation of 1 percent rather than inflation of 2 percent as the IMF debt sustainability exercises for the European periphery presumes, the primary budget surplus of countries in the European periphery would need to be between 3 and 4 percentage points higher than the IMF has been assuming to put the public debt on a sustainable path. It would seem to be far from clear that many of those countries in the European periphery will be able to muster such an increased budget effort after so many years of painful belt tightening.
Yet another important negative for restoring sovereign debt sustainability in the European periphery is the clear loss of political willingness to persevere with budget austerity and structural economic reform that might hold out the prospect of more rapid economic growth. This loss of political willingness will be on clear display in the May 25 European parliamentary elections where polls indicate that anti-European parties might garner as much as one third of the vote. Particularly troubling are the polls for Italy which suggest that parties questioning the benefits of continued Euro membership might receive a plurality of the votes.
A factor making the timing of the current European rating upgrade cycle all the more curious is that it is occurring at the very time that unfolding events in Ukraine are posing the highest degree of geopolitical risk for Europe in recent years. In particular, there would seem to be the distinct risk that a further disintegration of Ukraine could lead to energy supply disruptions to Europe from Russia as well as to the intensification of economic sanctions on Russia that could negatively impact European growth prospects.
In sum, it would seem that the rating agencies have learnt little from their past experience. Rather than provide markets with an objective assessment of risk, they once again seem to be blindly following market sentiment and to be acting in a pro-cyclical manner. If that is indeed what the rating agencies are doing, one has to question their usefulness in providing a much needed public good.
