Credit Downgrades in the E.U.: Blaming the Messenger?

On January 13, 2012, “S&P stripped France and Austria of their prized triple-A credit ratings and reduced the ratings of seven other [states in the euro-zone], including Italy, Spain and Portugal. Germany, Finland, the Netherlands and Luxembourg were spared, along with Belgium, Estonia and Ireland,” according to the Wall Street Journal. Italy was downgraded from single-A to triple-B-plus. "We think there are elements missing in their analysis … when it comes to the growth strategy … there is no space for maneuver for fiscal impetus but we believe that a growth strategy will have to rely mainly on structural reforms," Olivier Bailly, an E.U. Government spokesman, told reporters. The Journal also reports, “Bailly also called the timing of the S&P decisions ‘very odd’ citing fiscal policies adopted to weather the crisis in the downgraded countries as well as the two successful debt auctions in Spain and Italy last week. ‘We think that there is a strange timing in this announcement considering the signals from the markets,’ Mr. Bailly said.” The “very odd” and “strange timing” reference a tacit political motive behind S&P, which the European officials point out is an American company.

The Finance Minister from the state of Germany, Wolfgang Schäuble, “sharpened his tone” toward credit-rating firms in the wake of Standard & Poor's sweeping euro-zone downgrade, questioning its rationale and impartiality and predicting a fresh political offensive to reduce their clout. The Wall Street Journal continues, “Schäuble suggested the downgrade was motivated by political and business interests, accusing the agencies of competing for attention. S&P expressed reservations about the predictability and effectiveness of European political efforts to contain the region's chronic debt crisis.” In short, he claimed that the American rating agency wasn’t giving Europe enough credit. "We know that there is uncertainty about the euro zone," he said. "I don't think that S&P really has understood what we have already accomplished in Europe."

Similarly, the incoming President of the European Parliament—an office roughly equivalent to the Speaker of the House in the American Congress—railed against the credit agency in his opening speech. Even though this strategy earned him some easy political capital in Europe, it could ultimately undercut his credibility. Moreover, political biases may have been a part of the European reaction rather than S&P’s credit downgrade of some E.U. states (as well as lowering the rating of the E.U.’s bailout facility a notch to AA).

On January 16^th, the Wall Street Journal reported that French leaders “assailed the S&P” for focusing on France and letting the U.K., which retained a top rating even though its deficit was one of the highest in Europe at the time, off the hook. Questioned about that, Moritz Kraemer, an S&P managing director in Europe, “cited as factors in the U.K.'s favor its independent central bank and the government's ambitious deficit reduction plan.” Rather than S&P having been motivated by politics, the assailing could be a case of European sibling rivalry, or jealousy, obscuring the Europeans’ own perception of S&P’s downgrades. Indeed, the “facts on the ground” in Europe were not so bright that S&P could realistically be accused of being out of touch or politically motivated.

For example, on the same day as the Journal’s article, the New York Times reported that reforms were “flagging” in Greece amid unproductive negotiations between Greece and its creditors. Indeed, talks had broken off two days before S&P’s action. The E.U. and Greece were pushing for private bond-holders to take a 50% loss in exchanging their bonds and agree to a lower interest rate (3-4%). Greece had the option of forcing the terms by subjecting the existing bonds to collective bargaining, while bond-holders, including hedge funds, could sue Greece based on sanctity of contract, and, if unsuccessful, even take the case to the European Court of Human Rights—property rights being considered a human right in the Europe. However, were such a right to apply to the speculators who bought Greek bonds at 40% of their value, the application of right could be questioned by a court. Moreover, if such bondholders were exploiting Greece’s financial bind for a quick profit, it stands to reason that the European people and their representatives would have little sympathy for the rights of Greek bond-holders. Do the property rights of private parties dwarf measures by a government to forestall default on semi-sovereign debt (Greece being semi-sovereign as an E.U. state)?  Were the bondholders unaware of Greece’s fiscal condition when they purchased the bonds? It seems to me that the public good as represented by the government (both of the E.U. and Greece) trumps private financial interests when the currency, financial system, and economy hang in the balance.

After collapsing, the talks did resume in hopes of avoiding “the sort of uncontrolled default that many experts fear could threaten the global financial system.” The negotiators were not out of the woods by any means, for the talks soon stalled again. According to the New York Times, if Athens cannot “secure concessions from the bondholders or the bailout money it needs,” (E.U. leaders were saying the next payment of 30 billion euros was contingent on an agreement), “Greece could default by March 20, when 14.5 billion euros in debt comes due and must be repaid.” With this as a rather pressing risk, plus the projection that even if the private bondholders were to agree to Greece’s terms, the state’s debt as a percent of its GDP would still stand at 120% rather than 140% in 2020, S&P may actually have been overly optimistic on its downgrades in Europe. The uncertainty alone could be expected to destabilize the state as well as the entire E.U. financially.

A week or so after one senior executive of Goldman Sachs in London dismissed the prospect of Greece dropping the euro, Ken Rogoff of Harvard and the IMF said it would be “unwise and preposterous” to think that “no one would drop out of the euro, or that the euro’s troubles are over.” The New York Times adds that with “Greece on the brink of a default, a number of business leaders, economists and policy makers predicted that a breakup of the euro zone was still in the cards, beginning with the exit of Greece and possibly moving toward other weak [states] like Portugal.” George Soros “even said that Greece might well be pushed out of the euro zone [in 2012].” The diametrical opposition of the two views expressed in the New York Times on January 26^th must have been worrying to investors well beyond those who held Greek bonds. Back on January 17, 2012, the paper had reported that the “specter of a disorderly default, rather than the voluntary losses [that were] being negotiated [at the time], unnerved stock markets around the world [the previous fall] and could prompt renewed selling [during the negotiations].” The chance that Greece could actually default and set in motion a chain reaction would surely have magnified the impact of the divergence of opinion on the matter. How could S&P be expected to ignore the risk in all this?

Claiming instead that business leaders were not recognizing the progress in Europe (particularly in Ireland and Spain, according to Angela Merkel of the state of Germany), European officials in general sought to reduce the market’s reliance on decisions made by rating firms altogether. "We want to 'downgrade' the reliance of EU financial institutions on credit agencies," Bailly said, adding that "the general aim here is to not depend on credit-ratings agencies' analysis and if we had that, we would have had a different reaction [to the downgrades] from financial institutions on Friday [January 13^th]." The problem is, the reaction could have been worse. Creating a non-profit European rating agency would not alter this, unless such an organization, unlike S&P, were subject to political pressures. The officials’ protests notwithstanding, perhaps such a rating agency is precisely what the European “leaders” wanted.

Even in speculating on Van Rompuy’s stated objective that the E.U.’s enforcement mechanism on state deficit and debt limits would be approved in a few months and operational in six, one could easily waiver in having faith in the venture, even from Van Rompuy’s description of the strengthening of enforcement as a “fiscal compact.” He might as well have admitted that it had the force of a straw man in the midst of a Kansas storm. Schäuble didn’t exactly encourage confidence by saying that the E.U. was not even political. Private capital tends to run for the hills in the face of such denial. Therefore, the salience of the rating agencies was not Europe’s problem at the time. Rather than trying to discredit the messenger of credit, E.U. and state officials would have been wiser in concentrating on the threats to “ever closer union”—namely, themselves.

Sources:

Christopher Emsden, Matina Stevis, and Bernd Radowitz, “E.U. Leaders Focus on ‘Progress’,” The Wall Street Journal, January 16, 2012. http://online.wsj.com/article/SB10001424052970204468004577164420401608382.html

Rachel Donadio and Niki Kitsantonis, “As Reforms Flag in Greece, Europe Aims to Limit Damage,” The New York Times, January 16, 2012. http://www.nytimes.com/2012/01/16/world/europe/europe-now-doubts-that-greece-can-embrace-reform.html

Nelson Schwartz, “Euro Woes Could Revive Bout of Market Volatility,” The New York Times, January 17, 2012. http://www.nytimes.com/2012/01/17/business/global/euro-woes-could-revive-bout-of-market-volatility.html

Landon Thomas, “Hedge Funds May Sue Greece If It Tries to Force Loss,” The New York Times, January 19, 2012. http://www.nytimes.com/2012/01/19/business/global/hedge-funds-may-sue-greece-if-it-tries-to-force-loss.html

Jack Ewing and Liz Alderman, “German Chancellor, Citing Europe’s Progress, Asks for Patience,” The New York Times, January 26, 2012. http://www.nytimes.com/2012/01/26/business/global/merkel-pleads-for-patience-to-let-europe-solve-its-problems.html