9July 2012, hours before a summit of eurozone finance ministers: comes the terrible headline: Spanish borrowing costs rise ahead of euro summit
Great. Should we worry or what? In June, Moody’s had cut Spain’s credit ratings to Baa3, just one notch above junk.
Why is it important for a country to protect its credit ratings?
In theory, credit ratings should be directly linked to interest rates on public debt. The better the rating, the lower the interest rate on money borrowed by the state to finance its debt. It is therefore in the country’s interest to maintain a positive credit rating in order to obtain good interest rates when it borrows money.
The credit rating is a signal that rating agencies send to banks lending out the money.
So far, so good.
There are three credit rating agencies in the world. They issue ratings which are more or less subjective, since each agency has its own analysts. These agencies play the stock market. As soon as they sanction a state by lowering its credit rating, investors will position themselves on the market according to the rating.
In reality, not all investors follow the signal given by credit ratings. Until very recently the downgrading of a credit note did not systematically lead to an increase in interest rates. When the USA was downgraded, interest rates on its public debt still kept decreasing.
The same goes for Italy. In August 2011, it sold bonds at 6.1% interest. Soon after, its credit rating was downgraded, but the interest rate today actually decreased to 5.8%. This morning it stood at 6.113%.
This should not makes sense if interest rates were only dependent on credit ratings. In reality, they are determined by multiple factors.
The explanation for the value of the interest rate, therefore, does not lie solely with credit ratings. In Italy, austerity plans helped to keep interest rates on a steady downward path, even though these plans seemed to be insufficient to maintain Italy’s credit rating.
In the end, players on the market could decide to quietly ignore credit ratings, or even follow the opposite strategy to that indicated by the ratings.
When operators dispose of capital, they choose to place their money on loans which they deem to be less risky. In a scenario of uncertainty, there occurs what is termed a “rush towards quality”, where operators prefer to hold on to stocks which offer a lower return but which offer no risk, or are less risky.
And some operators may develop a risk analysis which differs from that of credit rating agencies, where they reasonably think that the messages sent out by credit rating agencies do not reflect economic reality. To give an example, it is certainly more risky to invest in the US today than two years ago, but some operators still prefer to invest in the US rather than, say , Germany. Massive investment in US or Italian stocks then leads to a lowering of interest rates.
Fine. What use is it, then, to guard one’s credit rating?
An AAA rating is the top grade for good governance. Credit rating agencies examine everything: both the government’s policies and those of opposition parties, which is a government in waiting. When it sees none, or when it sees empty promises, with no accompanying figures, it lowers its rating.
An AAA rating is just a message sent by a credit rating agency. Market traders are free to follow or ignore this message.
Additionally, some operators no longer have faith in credit rating agencies, since they failed to predict the financial crisis and even assigned a top rating to Lehman Brothers just before its collapse. Banks and investment agencies also have their own economists, who carry out their calculations independently of credit rating agencies.
The real importance of credit rating agencies lies in the area of European regulations, which oblige banks to set aside part of their capital under a AAA rating. In downgrading the rating of a state, agencies also sanction banks holding its funds. As a result, it becomes even more difficult for the state to satisfy European Union criteria.
The whole discussion on the future of the global economy is precisely this: How to break this vicious cycle.
No European country has ever achieved a budget surplus in the post-War period. The problem is therefore not the rating agencies but our social system. Whether you call it austerity or some sweeter-sounding word, matters not. The functioning of the state should be cheaper. The result should not.
Since the war, all eureopean countries have borrowed heavily to finance deficit spending, knowing that economic growth would cover that debt. When economic growth ground to a halt, it all fell apart.
Fiscal consolidation is just a short term goal in many European countries. The European Central Bank president Jean-Claude Trichet has warned that “monetary policy responsibility cannot,” in the long term, “substitute for government irresponsibility.” Countries have to slash spending, fast.
Just how serious is the crisis?
Much has been made of Europe’s woes, and the political class is not without blame. Politicians will always say that this is the gravest hour because if things go badly, they will have predicted it, and if things go well, they will have the merit of having solved the problem.
If we would just draw back and take stock, we would realise that Europe has all it needs to pull through. We have a common currency which is rising in value. The EU’s GDP is three times that of China. Yet we act as if Europe were insignificant, lacking direction, incapable of creating and producing wealth. Perhaps it really is leaderless.
European states need to decide whether they intend to create an economic and monetary powerhouse by 2030-40, comparable to the US or China.
The real challenge is for European politicians to rediscover the vision of Europe’s founding fathers, that is to say a strategic vision for the long term. Will this crisis endow the Euro with the economic arsenal it needs? If the answer is yes, the outcome will be a European success, not a tragedy.
Someone should play Tiësto and Maxi Jazz’s Dance4life at the European summit. Loud. Over the intercom. With the lyrics flashing across all screens:
We protect the children of this new dawn
We’re properly skilled and we fear no storm
And what we’re building will persevere long
After the wicked then disappear.