The Squeeze has Begun
As my readers might have noticed, the talk of the day in the financial and economic press as well as the econsphere is still very much tied to the ongoing turmoil in financial markets. It should also be clear then that there are many entry points regarding a conceptualization of what the commotion is all about and what it means? I will neatly avoid the completeness of this question today but rather turn to one of the topics I have been particularly interested in, namely to the role and subsequent reaction of the rating agencies in this debacle with particular focus on what it will mean for sovereign debt ratings. As Edward notes this morning on Bonobo Land the first shot has already been fired across the bow as a function of Fitch' announcement that an upgrade of Japan' s investment grade debt is pretty much out of the question given the large public debt position and the lingering inability of the government to mitigate the position. Clearly this last bit seems to be complete word salad since what can the Japanese policy makers actually do at this point in time with growth stalling other than to hope that external demand somehow keeps up the pace. I mean, do we really think it would be wise to push through that consumption tax at this point? However, the rating agencies who of course are taking heat for other reasons will most likely give very little leash at this point which may put ageing economies such as most notably Italy and Japan in a very tight spot. In this light we could also point towards the obvious yet subtle fact that Japan's 'extraordinary' debt has not suddenly materialized out of the blue but has been there for some time. On top of that we would be wise to remember that S&P actually upgraded Japan as recent as in April from AA- to AA but that I guess was another time entirely. It is in this very light that we need to see Fitch' recent announcement on Japan and why it comes at this particular point in time.
Fitch Ratings ruled out an upgrade to Japan's investment-grade credit ratings because of concern about the nation's ``extraordinarily high'' debt burden.
Japan needs to make difficult decisions about its budget, said James McCormack, head of Asia sovereign ratings for Fitch, following the resignation of Prime Minister Shinzo Abe.
``The government has to raise taxes and cut spending, and it is difficult for a weak government to do either,'' McCormack said, speaking by phone from Beijing. ``The timing of Abe's resignation is odd, although the actual resignation is not.''
Japan's yen-denominated notes carry Fitch's fourth-highest ranking of AA- and the foreign-currency debt is one level higher at AA. The nation has the most public debt in the world, estimated by the Ministry of Finance to reach the equivalent of $6.8 trillion by March 2008.
Of course, it does not stop here since the rating agencies are also looking at other countries, and particular towards those in Eastern Europe where there seems to be plenty of opportunity for them to reinvigorate their reputation as responsible and sound credit appraisers whatever these two adjectives really mean in this context. As such and as a follow up to my most recent piece on Lithuania we learned yesterday that the external deficit widened in July from 259 million euros from 201.6 million euros in June. Clearly from the point of view of Lithuania's continuous sizzling growth rate which indeed seems unsustainable such news is not exactly what we would like to see. On the other hand however, we are after all only talking about a monthly figure. Yet this was apparently enough for S&P to nudge down the general outlook on Lithuania to negative, as reported by Bloomberg;
Standard & Poor's Ratings Service lowered Lithuania's rating outlook to negative, citing the threat of an economic destabilization due to a wide current-account deficit and accelerating inflation. The current account measures the difference between money flowing into a country from trade and investment and services, and money flowing out.
And please do note that this is a part of a much larger picture surrounding the Baltic economies and Eastern Europe since also Moody's is coming in on the heels of S&P with a downward adjustment of the general outlook in the Baltic economies.
Moody's Investors Service lowered its outlook for Latvia and Estonia to stable from positive, as fast inflation and widening current-account deficits erode the prospects for ratings upgrade.
The outlook change affects Estonia's and Latvia's Aa1 foreign currency country ceiling for long-term bonds, Moody's said in a press release today. The company rates Estonia's local and foreign currency bonds at A1, and Latvia's at A2.
The change was prompted by rising economic imbalances and accelerating consumer-price growth, which forced the two countries to delay euro adoption indefinitely. Standard & Poor's and Fitch cut Latvia's credit rating to BBB+ this year and lowered Estonia's outlook to negative because of the risk of a ``hard landing.''
As I hinted above we need to ask ourselves why all this is coming at this specific point in time and what it will mean? Essentially, the stars now seem to be aligning in such a way that at least a respectable chunk of that ever illusive 'credit crunch' will take place on the level of sovereign debt as a derivative of the perceived need for the rating agencies to tighten up what was previously considered overtly lax credit valuations; of course this was mainly in structured finance but this seems of little importance at this point. Let me also take the time to point out the rather clear rational justification for the rating agencies moves on Japan, Eastern Europe and perhaps also Italy at some point. Essentially, from a strict economic point of view it is not at all unjustified. However, there is also the question of timing and general institutional mark-up of the whole role of the rating agencies. Turning first to the latter I am primarily talking about Japan and Italy here (of course other ageing economies too) and the general idea of credit ratings. I mean and as I have argued before, at some point it will cease to make sense to rate Japanese and Italian sovereign debt using the same standards as e.g. USA, Brazil, and India since this could mean at some point that you would have to push them into some kind of state of technical default. However, we also crucially need to think about timing here and what clearly seems to be a somewhat pro-cyclical behaviour of the rating agencies (See e.g. a recent paper by Carsten Valgreen from Danske Bank which has also been treated here at Alpha.Sources). This seems even more evident at this point in time since the rating agencies themselves have been on the forefront of the turmoil in financial markets. So, at the end of the day it is perhaps as the Economist's ever eloquent financial columnist Buttonwood so neatly put it a while back:
But the agencies tend to lean with the wind, rather than against it. They upgrade debt when the economy is booming and downgrade it when recession strikes.
This small piece then comes with a subtle warning. Whatever the perceived need, be it endogenous or exogenous, for the rating agencies to tighten credit standards at this particular point in time my suggestion is that they don't lean too far with the wind since they might end up pushing somebody off a cliff in the process.