Credit rating agencies and the Eurozone sovereign debt crisis

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).

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.

It is recommended therefore that the Eurozone sovereign debt market be avoided for the time being. There is essentially no reason to have confidence that the long-run issues leading to the crisis will be resolved, and even the tangential contributors like the ratings agencies have not had their negative contributions curtailed. The nature of the Eurozone means that these issues are going to be contained within the zone, so non-Euro debt in the region can be evaluated independently. Indeed, nations outside of the Eurozone have significantly more flexibility in dealing with budget problems that nations within the Eurozone. Sovereign debt from outside of the Eurozone should be evaluated on a case-by-case basis. Even German debt, which is viewed as safe haven within the Eurozone, is not recommended at this time. Germany will ultimately suffer as the result of this crisis. Either German taxpayers will need to bail out the peripheral nations in order to maintain the stability of the common currency or Germany will need to face higher inflation in order to equalize inflation rates between it and the other Euro states. In either case, no nation within the Eurozone can expect to escape the impact of the debt crisis, as the markets conflate the crisis of one country with issues of all other countries within the zone, in large part because of the interdependency created by common monetary policy. Thus, it is recommended that all sovereign debt from the Eurozone be avoided until the structural issues that underlie the crisis have been addressed.

Works Cited:

Arezki, R.; Amadou, N. & Candelon, B. (2010). Bad news spreads. Finance & Development. Retrieved March 22, 2011 from http://www.perjacobsson.org/external/pubs/ft/fandd/2010/12/pdf/arezki.pdf

BBC. (2011). Greece debt rating cut further by Moody's. British Broadcasting Corporation. Retrieved March 22, 2011 from http://www.bbc.co.uk/news/business-12664681

CIA World Factbook. (2011). Greece: Economy. Central Intelligence Agency. Retrieved March 22, 2011 from https://www.cia.gov/library/publications/the-world-factbook/geos/gr.html

De Grauwe, P. (2010). The Greek crisis and the future of the Eurozone. U. Leuven. Retrieved March 22, 2011 from http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDG-papers/Discussion_papers/EuroIntelligence-March-2010.pdf

De Grauwe, P. & Moesen, W. (2009). Gains for all: A proposal for a common euro bond. University of Leuven. Retrieved March 22, 2011 from http://www.econ.kuleuven.be/ew/academic/intecon/degrauwe/pdg-papers/work_in_progress_presentations/proposal%20eurobond%20issue.pdf