Credit-rating agencies have long had a reputation for locking the barn door after the horse is gone. Certainly, they were consistently late in identifying imminent defaults and bankruptcies a few years ago, during the banking and mortgage-lending crisis. Yet European countries – especially France – are obsessing about possible downgrades for their credit ratings. Is this simply an issue of national pride, or do downgrades really matter?
Friday’s news was awful for European countries that worry about such things. Sources reported that Standard & Poor’s was likely to downgrade France by Christmas. Moody’s reduced Belgium’s credit rating by two levels. And Fitch put Belgium, Spain, Slovenia, Italy, Ireland, and Cyprus on its negative watch list, a sign that the agency thought a downgrade might soon be necessary. By way of explanation, Fitch said that a solution to the Eurozone crisis was “technically and politically beyond reach.”
Rating agencies are by nature cautious and slow to move when credit quality is deteriorating. That’s especially true when there is a political component to the ratings decision, as there is today with Eurozone risks. So in a sense, the agencies end up simply publicizing things that sophisticated investors have already known for a while.
Nonetheless, there are plenty of reasons that governments react negatively to a credit-rating downgrade. For example, French President Nicolas Sarkozy is about to begin a difficult re-election campaign and he doesn’t need any more bad publicity. But it’s not just a question of appearances and things that everyone already knows. Downgrades have a real practical impact – and it isn’t good.
No matter how widely recognized a country’s problems are, bad financial news is cumulative. Perceptions about creditworthiness vary incrementally across a broad spectrum and each time a credit rating is reduced or an economic outlook is questioned, the needle moves a little bit further toward the danger zone. That makes bond buyers demand slightly higher interest rates to compensate for a slightly greater chance of losing their money.
In addition, potential bond buyers sometimes have to worry about legal requirements or customers’ reactions. If an international bond fund needs to keep the average risk of its portfolio at a certain level, the fund will reduce its holdings of bonds that are downgraded. Indeed, in some cases institutional investors may be required by their own internal rules to hold only bonds that have certain minimum credit ratings.
Corporate bond downgrades tend to affect only the company whose rating is reduced. But in the Eurozone, financial relationships are so convoluted and complex that the potential damage of downgrades is multiplied enormously. Indeed, there are three important ways in which bad ratings can make the euro crisis much worse:
Higher borrowing costs. For any borrower – corporation or country – the worse the credit rating, the higher the interest on a loan is likely to be. But for the most indebted countries in the Eurozone, this has become a vicious circle. If a country’s debt is more than 100% of one year’s GDP, even a small increase in interest rates means billions of dollars in additional interest costs as old bonds mature and new ones have to be sold. This has been a threat for Italy recently, which could probably continue to carry its debt if the interest rate had remained low. Unfortunately, though, Italy has to refinance more than $100 billion of debt in the next three months and the interest rate has become quite expensive – sometimes more than 7%. In short, deteriorating credit leads to higher interest rates and additional costs, which over time further damage the country’s credit rating.
Frozen bank lending. The uncertainty caused by shaky credit ratings creates another type of financing problem. Banks constantly have to borrow money from each other for a day or two because the balance between loans and money on hand is constantly shifting. But when banks begin to worry about possible losses on Eurozone bonds at other institutions, they may refuse to lend money overnight. This leads to a so-called money-market freeze. In an emergency, banks can borrow euros from the European Central Bank if no one else will give them overnight money. But obtaining short-term dollars can be more difficult. Indeed, the Federal Reserve has already had to provide emergency short-term dollar loans to the Eurozone.
Risk-shifting to taxpayers. An invisible form of financial deterioration is also occurring because private-sector investors are steadily sloughing off potentially risky Eurozone bonds, and government institutions are having to soak up the surplus. Whether it’s individual investors looking for safer places to keep their money or banks trying to meet more rigorous risk limits, potential buyers of Eurozone country bonds are less and less willing. And so to prevent interest rates from soaring, the European Central Bank has repeatedly had to enter the market and buy bonds. In addition, a recent Businessweek story concludes that the ECB may owe the German Bundesbank more than half a trillion dollars because of accumulated short-term loans that were made to finance trade in Europe. One way or another, taxpayers in Europe or the U.S. are likely to end up holding the bag.
What all this means is that deteriorating credit ratings are not simply recording things that have happened after the fact. They are actually part of a self-reinforcing matrix that is making the Eurozone crisis worse. That’s the reason it will eventually go out of control if European governments don’t get out in front of problems fairly quickly. As some commentators have said, the Eurozone summits aren’t really kicking the can down the road, they’re kicking a snowball down the hill. It will just get bigger and bigger until it finally causes an avalanche.