EKIP– Expert Club for Economics and Politics A Different Opinion
The rising wave of credit rating revisions of a number of European countries and financial institutions has sparked heated debates about the objectivity and reliability of credit ratings as a tool for guiding investment policy and determining solvency. Somewhat paradoxically, credit rating agencies are currently being criticized for doing what they were criticized for not doing in the years before the crisis.
Faced with the threat of losing one of their three A's, the leaders of the leading European economies got together, rolled up their sleeves, and got down to doing what they do best: pointless regulations. Ideas emerged for "temporary bans" on assessing the credit ratings of troubled countries, the creation of an "independent" European credit rating agency, imposing additional requirements for transparency and consistency of assessments in order to avoid sudden rating cuts, and what not. Things got to the point where the countries with the highest ratings started attacking each other in a dispute over which of them should be the first victim in 2012.
The main dilemma facing Europe is how to break the link between the agencies’ non-binding opinions and their influence on the market. A downgrade of a country’s credit rating makes it more difficult/expensive to borrow money, which in turn worsens its fiscal position. Ratings are also important because they often determine whether an investor (such as a large pension fund) can buy or even own a given bond. Thus, a downgrade of the issuing country’s credit rating can trigger a sell-off that further raises the country’s debt interest rates during subsequent auctions.
If there is one thing that bureaucracy can be relied on to do, it is to change the rules of the game the moment they stop being told to. As the crisis has grown, the aforementioned credit rating requirements for purchasing or owning a financial instrument have gone from being a guarantor of stability to an obstacle to the “proper functioning of the markets” (a phrase often used recently). For example, when Greece, despite all its problems, enjoyed an “A” rating, just 5 notches below the highest possible, everyone was happy until early 2009. Three years later, the agencies’ reasons for downgrading European countries remain the same – high levels of public debt, unsustainable deficits, an undercapitalized banking sector, a lack of real reforms and exposure to the debt of other countries of the same rating. But governments’ view of the agencies’ work is now different.
All this does not mean that credit rating agencies do not have enormous influence and at the same time can be held liable for errors in preparing a given forecast or assessment. Credit rating assessments have the status of an “opinion”, for which liability cannot be sought in most cases. The obvious conflict of interest that arises when an institution evaluates the one who pays it cannot be ignored either, but at the same time is not particularly relevant in the case of European countries whose ratings are being reduced.
However, Europe’s attempts to address such a problem in the proposed ways are doomed to failure. A ban on publishing credit ratings cannot stop agencies from publishing “unofficial ones” and is not able to restore investor confidence in a given country. The independence of a possible pan-European rating agency, on the other hand, will be seriously questioned. Such an institution would need years to prove the impartiality of its analyses and forecasts, a time that Europe does not have. There is also controversy over the extent to which a credit rating downgrade can be seen as a cause or a consequence of a country’s rising debt interest rates. For example, due to instability in Europe, US 10-year bond yields fell to record lows, despite the country’s credit rating downgrade earlier in the year.
Europe's attempts to prevent further credit rating downgrades without addressing the causes of the downgrades will not do any good, even in the short term. Investor confidence in a country depends as much on its credit rating as its credit rating depends on it. And unlike credit rating agencies, confidence cannot be regulated.
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*The article was written for the weekly newsletter of the Institute for Market Economics. The original publication can be found here.
I am at least a supporter of the idea of a European credit rating agency. First, it will be able to give intra-Union assessments of a given country's fiscal policy and second, these assessments could potentially be used as pressure on given governments. Perhaps, in the longer term, these ratings could eventually be linked to Eurobonds and the ECB's participation as a buyer of government securities with fresh (printed) money. For example, if Italy and Spain fall into the category of slightly endangered countries (such as with a BBB rating), they could count on a moderate amount of monetary support from the ECB. But Greece, for example, would have to rely only on aid from the ESM for its survival. Also, the highest rated countries could be given the opportunity to issue joint bonds with Germany, the so-called Eurobonds. Many ideas can be given, but in general I think that reducing government securities spreads will be key in the coming years.
Reducing spreads is actually the main goal of all the financial mechanisms that have emerged in the last year. If the EU does move towards Eurobonds, which in my personal opinion is the intended direction, the creation of a mechanism for providing intra-EU assessments of fiscal policy is inevitable, but I do not think it would be within the prerogatives of a possible "rating agency".
This will inevitably lead to strong pressure on it and ultimately to its politicization, which actually contradicts the idea of an independent and balanced assessment. Over the past year, we have seen a similar confluence of circumstances with the role and functions of the ECB.
Otherwise, I assume that such an agency will be created sooner or later. The question is, really, whether it will deal with internal assessments (and therefore not be a classic rating agency) or whether it will function as a counterweight to the American CRAs, which could lead to other kinds of problems.