International Financial Management the Sovereign

International Financial Management

The sovereign debt crisis in the Eurozone -- focused on Greece, Spain, Portugal and Ireland but threatening to spread to other countries as well -- has been caused be a number of different factors. Of the nations involved, Greece has long been in an unstable financial position, while countries like Ireland and Spain has strong financial positions prior to the bursting of the housing bubble and the global financial crisis. Aside from Greece, therefore, the financial crisis precipitated much of the crisis. Observers from outside of Europe have noted that the Euro currency itself is a major contributor to the crisis. Where devaluation is not an option, recovery is inherently slower and more painful, which in turn has an impact on the ability of countries to deal with their debt burdens, relative to similarly-stricken countries like Iceland that can devalue (Krugman, 2011).

Some blame has also been laid at the feet of international credit rating agencies. These agencies -- Moody's, Fitch, S&P to name a few -- are viewed by some as contributing to the crisis. This paper will analyze the Eurozone debt crisis largely with respect to the role that credit rating agencies have played, if any. The nature of the agencies and their role in sovereign debt markets will be considered. Based on this analysis, an investment strategy will be provided for the sovereign bonds market.

Credit Rating Agencies

The major international credit rating agencies are independent companies that evaluate credit instruments and based on those evaluations assigned a credit rating to a debt instrument. While each agency utilizes proprietary methodologies, they typically reflect the usual criteria of solvency and liquidity. Pure default risk is the baseline for assessment -- typically considered as German bonds within the Eurozone -- so the spread ascribed to the bonds of other nations reflects the default risk relative to that of Germany; in addition liquidity risk is a factor. De Grauwe and Moesen (2009) note that there is a perception in the investment community that the sovereign debt of many Eurozone nations has seen reduced liquidity in recent years, with the exception of the German debt market. Decreased liquidity equates to increased risk in any investment market and the smaller the market the greater the liquidity risk in general; Ireland, Greece and Portugal are all among the smallest sovereign debt markets in the Eurozone.

The ratings agencies were tangentially related to the sovereign debt crisis in their AAA ratings of mortgage-backed securities, which helped fuel the real estate boom that contributed to the crises globally, and especially in countries like Portugal and Spain that became dependent on new construction for their economies (Voigt, 2010). The more important aspect of the agencies' role in the Eurozone crisis has been their treatment of sovereign debt of nations within the zone and the market response to this treatment. An example of an action by a ratings agency was the recent downgrade of Greek debt by Moody's, which based its decision on endemic tax evasion, austerity plans that will cripple the economic recovery and the possibility of a forced debt restructuring by the EU in 2013. The first two factors largely affect the revenue side of Greece's budget and the latter represents a specific risk to holders of Greek sovereign debt. The market's reaction to the downgrade was to lower the price and increase the yield on Greek bonds (BBC, 2011). The rating given by a rating agency is intended to reflect the risk associated with the debt, so a rating downgrade implies that the debt is riskier than previously thought.

Critics point out two key things about the ratings agencies and their impact on sovereign debt markets. The first is that the agencies typically lag market knowledge. This fits with the rational investor theory, which holds that the market already prices in all known information. The second is that too many players in the market overreact to moves by the ratings agencies (Voigt, 2010). This is reasonable, given that the market should already have the knowledge that is built into the ratings agency's assessment of the debt. This implies that market reaction to moves by ratings agencies is somewhat irrational. Indeed, what has been seen during the Eurozone sovereign debt crisis is that an agency downgrade on one nation's debt sets off a chain reaction that lowers the price of debt on other nations in the Eurozone as well -- this reaction is irrational and purely speculative (Arezki, Amadou & Candelon, 2010). German debt is considered the safe haven in the Eurozone, so speculation tends to affect the cost of the debt of all other European nations vs. The cost of German debt; for example France saw its cost of debt increase as the result of a rate cut on Greece in 2010 (the Telegraph, 2010).

Causes of the Sovereign Debt Crisis

It is important when analyzing the Eurozone sovereign debt crisis to consider the individual nations separately. Greece is the nation with the most significant sovereign debt problem, having been downgraded to junk status and having the most significant long-run structural problems. Featherstone (2011) outlines the myriad problems that contributed to the Greek crisis: low competitiveness, trade and investment imbalances and fiscal mismanagement. The structure of the Greek economy, the inability of its government to collects its revenues and debt-to-GDP ratio of 144% - fifth highest in the world -- all contribute to the depth of the Greek crisis (CIA World Factbook, 2011). The intensity of these problems -- all deeply structural in nature - combined with the inability to spur economic growth through currency devaluation make the Greek crisis the deepest and the most intractable of all the sovereign debt issues in the Eurozone.

The other nations faced different problems. Spain and Ireland did not have debt crises prior to the economic downturn. Spain's troubles were related to a massive real estate bubble that burst, causing massive employment and therefore a sharp downturn in government revenues. In Ireland, the government bailed out its irresponsible banking sector to the detriment of essentially everything else in the economy, not only devastating the country's balance sheet but also its prospects for economic recovery. Investors saw similarities in the struggles of these nations and Greece. The prevailing view is not that these countries are in the same situation as Greece, but that if Greece could fall, other countries within the Eurozone could as well, and these peripheral countries were in the most precarious positions.

Arezki, Amadou & Candelon (2010) highlight the impact that ratings agencies play in the crisis. The markets, acting more or less irrationally, tend to sell off most Eurozone sovereign debt in response to moves by the ratings agencies. They identified that'd&P outlook revisions tend to spill across other countries, while Moody's and Fitch downgrades are more likely to spill across other countries. These effects are likely related to the market's understanding of the methodology of each agency. The complexity of the transmission of these agency moves throughout Eurozone sovereign debt markets is not fully understood by markets, regulators or scholars, but the impact is clear in that problems in one nation tend to have a spillover effect on the debt of other nations within the Eurozone.

In part, this is related to the common currency. Maurer (2010) argues that the crisis is the result of self-reinforcing debt-spirals, caused by different inflation rates throughout the Eurozone. That the problem in Greece spread to Spain, Portugal and Ireland is less a result of the long-run budget situations in those countries than is attributable to faulty design by the EMU. Maurer argues that the EMU needs to have instruments within its structure to deal with business cycle shocks in its member nations -- something that would effectively replace currency devaluation as a means of evening out the differences in inflation rates across the Eurozone. That there are no such mechanisms available has resulted in the crisis becoming a Eurozone crisis, putting the common currency at risk based on what essentially was a sovereign debt crisis in Greece (De Grauwe, 2010).

What is evident about the crisis is that the most significant elements of the crisis are structural, or related to the business cycle downturn. The ratings agencies are a contributor in that they reflect negatively on the debt of specific countries. However, some of the blame ascribed to the ratings agencies would be better ascribed to the market players who react to ratings agency moves irrationally. While it is the responsibility of the ratings agencies to be accurate with their information and objective in their assessments, they cannot be held responsible for markets that react to a change in the status of one sovereign entity's debt rating by selling off the debt of a dozen other nations on pure speculation.

The Current Situation

The Eurozone sovereign debt crisis remains unresolved. Moody's has cut the debt rating for Greece again this month (BBC, 2011), setting off another round of speculative selling in debt markets. The current status of Europe's peripheral sovereign debt, compared with benchmark Germany, is presented in Table a below:

Moody's Rating

10-Year Bond Yield

Germany

Aaa

3.257%

Greece

12.514%

Ireland

Baa1

9.384%

Spain

5.119%

Portugal

A3

7.497%

The structural issues that underlie the crisis remain unresolved. The austerity measures that have been implemented have failed miserably to restore business confidence -- they are crippling any economic recovery and have not given investors any reason to be confident about resolving the long-run debt problems faced by any of the peripheral Eurozone nations. The specter of increased Eurozone interest rates to meet the needs of Germany will only hurt the recovery of the peripheral economies further. As a result, a resolution of the sovereign debt crisis in the Eurozone does not appear to be on the horizon. Economists have made a number of proposals for the resolution of the crisis, none of which appear to have any political traction: a single Eurobond (De Grauwe & Moesen, 2009); addressing the divergence between Euro-level monetary policy and sovereign-level fiscal policy (De Grauwe, 2010), tighter controls from the European central bank (Maurer, 2010); and better understanding the linkages between rating agency pronouncements and market responses (Arezki, Amadou & Candelon, 2010). The implication of the wide variety of equally untenable solutions is that this crisis will continue to manifest over the near-term and there is significant risk that long-term solutions will not be forthcoming either.

Investment Advice

The Eurozone crisis has been characterized by lower prices and higher yields on the sovereign debt of most peripheral Eurozone nations. CDS spreads over German debt have increased, and German debt is seen as a safe haven within the Eurozone. Yet the long-run structural issues that have resulted in this crisis remain unresolved and are likely to remain so for the foreseeable future. The maintenance of the status quo will have a few different effects that should be taken into consideration. The first is that in the current situation is essentially a death-spiral for peripheral nations in that higher cost of debt makes it more difficult for these nations to resolve their debt crises. Unless the crises are resolved by Germany and the European Central Bank, the situation will only get worse. The second consideration is that the ratings agencies are likely to continue to downgrade and revise their positions on Eurozone sovereign debt. These moves lag the market, which is viewed as having perfect information, but there is an irrational reaction to rating agency moves as well. This reaction is the primary cause for the spread of difficulty from one nation to the next within the zone. Speculation and irrational behavior do provide for investment opportunity, but only if it is believed that the markets will return at some point to the rational point of equilibrium.