Tag Archives: S&P

S&P’s FAQs On EA Rating Actions

S&P released another document yesterday in connection with the rating action of Eurozone governments yesterday which you can get via it’s Tweet:

On the political agreements, the release says:

We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU’s core and the so-called “periphery”. As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.

Two points.

First – yes, fiscal profligacy is not the only source of the crisis. It is typical to give the example of Spain and Ireland – and done by S&P itself – to justify this:

This to us is supported by the examples of Spain and Ireland, which ran an average fiscal deficit of 0.4% of GDP and a surplus of 1.6% of GDP, respectively, during the period 1999-2007 (versus a deficit of 2.3% of GDP in the case of Germany), while reducing significantly their public debt ratio during that period.

There is a risk in making such an argument and even progressives sometimes do so. The error is assuming that the public sector deficit is a proxy for the fiscal stance of the government! Macroeconomists using stock flow coherent macro modeling have shown that the budget balance is just an endogenous outcome and the more appropriate proxy for the fiscal stance is G/θ, where G is the government expenditure and θ is the average tax rate.

To me it seems both Spain and Ireland governments (and local governments) were actually lavish in their spending. The private sector was even more lavish in its expenditure and rising incomes led to higher tax revenues which improved the government’s budget balance before the crisis. The whole process was allowed to continue by market forces, domestic and foreign lenders who (not surprisingly) underpriced risk. Needless to say the lack of a central government overseeing demand management and the ignorance of Keynesian principles contributed to the haphazardness.

Second, most commentators – including the S&P – pay too much attention to price competitiveness. So typically one sees a graph of unit labour costs of individual nations in almost all analysis. One even does not need to take innovations in the export sector to explain the crisis.

The EA17 nations had different levels of non-price competitiveness to begin with and faster growth of income/expenditure in the “periphery” as a result of the boom as compared to slower growth in the “core” nations led to exploding current account deficits. Here’s the data from the IMF’s latest World Economic Outlook published in September 2011 on the current account balances:

With different non-price competitiveness (or income elasticity of imports) (to begin with at the formation of the monetary union rather than innovations during the last ten years) combined with fast rising income/expenditure in the periphery, this led to a dramatic increase in net indebtedness of the periphery as a straightforward consequence. To emphasize the point, even if non-price competitiveness was similar between the core and the periphery, this would have resulted in rising net indebtedness.

It is surprising how international finance contributes to unsustainable processes from continuing as if they can continue forever!


Paul Krugman has a new post on his NY Times Blog on the same comment from S&P from its FAQs but with a different viewpoint.

S&P Takes Rating Actions On Euro Area Governments

On 5 December 2011, S&P put ratings of EA17 governments on rating watch negative. See my post S&P And EA17 National Governments for link to the S&P report. Today it concluded its review and downgraded several governments.


According to the report, which can be obtained from S&P’s Tweet:

We have lowered the long-term ratings on Cyprus, Italy, Portugal, and Spain by two notches; lowered the long-term ratings on Austria, France, Malta, Slovakia, and Slovenia, by one notch; and affirmed the long-term ratings on Belgium, Estonia, Finland, Germany, Ireland, Luxembourg, and the Netherlands. All ratings have been removed from CreditWatch, where they were placed with negative implications on Dec. 5, 2011 (except for Cyprus, which was first placed on CreditWatch on Aug. 12, 2011).

The outlooks on the long-term ratings on Austria, Belgium, Cyprus, Estonia, Finland, France, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain are negative, indicating that we believe that there is at least a one-in-three chance that the rating will be lowered in 2012 or 2013. The outlook horizon for issuers with investment-grade ratings is up to two years, and for issuers with speculative-grade ratings up to one year. The outlooks on the long-term ratings on Germany and Slovakia are stable.

We assigned recovery ratings of `4′ to both Cyprus and Portugal, in accordance with our practice to assign recovery ratings to issuers rated in the speculative-grade category, indicating an expected recovery of 30%-50% should a default occur in the future.

S&P also cites that “an open and prolonged dispute among European policymakers over the proper approach to address challenges” as one of the reasons to take the rating actions.

How can the Euro Area solve its problems?

One of my favourite papers is A Simple Model Of Three Economies With Two Currencies (link) written by Wynne Godley and Marc Lavoie. The paper was written about 7-8 years back and was published in 2006 in the Cambridge Journal of Economics.

The paper’s abstract:

This paper presents a Keynesian model which describes three countries trading merchandise and financial assets with one another. It is initially assumed that all three countries have independent fiscal policies but that two of the countries share a currency, hence the model can be used to make a preliminary analysis of the conduct of economic policy in ‘the eurozone’ vis-a`-vis the rest of the world—‘the USA’. The main conclusion will be that, if all three countries do indeed operate independent fiscal policies, the system will work under a floating currency regime, but only so long as the European central bank is prepared to modify the structure of its assets by accumulating an ever rising proportion of bills issued by any ‘weak’ euro country.

G&L make an interesting remark about a possible ECB behaviour:

… If the ECB is forbidden from accommodating market-driven changes in the composition of its assets, or if the ECB rules that it will not accumulate additional stocks of securities issued by governments that have excessively large debts according to rating agencies, then fiscal policy in the ‘weak’ countries must be endogenous for stability to prevail, for otherwise it would seem that the only alternative is to let interest rates on euro bills to diverge from country to country in an unsustainable way.

Now this would seem to be a rather dismal state of affairs, from a progressive standpoint. However, it should be noted that balanced fiscal and external positions for all could as well be reached if the euro country benefiting from a (quasi) twin surplus as a result of the negative external shock on the other euro country decided to increase its government expenditures, in an effort to get rid of its budget surplus …

i.e., Euro Area nations with a weak external sector will have to deflate fiscal policy to attempt to keep the external deficit, net indebtedness to the rest of the world and interest rate in check, if surplus nations in the Euro Area do not wish to engage in fiscal expansion. Else, as G&L conclude:

Alternatively, the present structure of the European Union would need to be modified, giving far more spending and taxing power to the European Union Parliament, transforming it into a bona fide federal government that would be able to engage into substantial equalisation payments which would automatically transfer fiscal resources from the more successful to the less successful members of the euro zone. In this manner, the eurozone would be provided with a mechanism that would reduce the present bias towards downward fiscal adjustments of the deficit countries.

In my opinion, this is the only way the Euro Area can come out of the mess because it is the only way the net indebtedness of an EA nation (or a group of nations) can be prevented from exploding relative to its domestic output .

For an earlier take on the Maastricht Treaty by Wynne Godley see the article Maastricht And All That published in the London Review of Books in 1992.

S&P Again

Yesterday S&P put 15 of the EA17 governments on CreditWatch negative (comments and links here). It later came out with Credit FAQ: Factors Behind Our Placement Of Eurozone Governments On CreditWatch which gives the rationale for the action. According to the S&P

For countries in net external liability positions, including the eurozone’s peripheral economies, we see growing risks to the funding of their external requirements. In our view, financial institutions located in countries in net external asset positions (such as Germany) also face pressure where the quality of those assets is deteriorating.

So it seems to understand that the problem of the Euro Area is severe internal imbalances leading to high net external debt.

S&P also wrote an article titled Why Trade Imbalances For Creditors As Well As Debtors In The Eurozone Are Weighing On Growth, a few days back. Available through S&P’s Twitter update

A wisecrack:

More fundamentally, large imbalances between the 17 member economies remain; after many years of high current account deficits in net debtor eurozone countries, these economies have built up substantial levels of net external debt. Such high levels of external leverage will weigh on economic growth prospects–in both net debtor and net creditor eurozone countries–over the next several years. How imbalances between them are unwound, and under what conditions, could determine the success or failure of policymakers in addressing the European debt crisis.


More on net indebtedness. Australia’s ABS released its Balance of Payments and International Investment Position, September 2011. It has this chart on Australia’s Net International Investment Position (with sign reversed in their convention):

So around 60% of GDP. Highly indebted nation!

Australia’s debt is both in domestic and foreign currencies and banks have hedged most of the foreign currency exposure hedged using foreign exchange derivatives. Australia’s government has almost zero liabilities in foreign currency.

Some people claim that as long as the debt to foreigners is in domestic currency, it doesn’t matter for some kind of “intuitive” reasons. My view is that while it is true that it is advantageous to incur liabilities to foreigners in domestic currency, my reasons are entirely different. A liability in domestic currency prevents revaluation losses if the exchange rate depreciates. A net indebtedness to foreigners is still a burden.  A point rarely understood.

S&P And EA17 National Governments

First, there was a leak from FT S&P ratings warning to top euro nations and then it really happened:

Pdf uploaded by S&P here

Does it matter? Yes and No. Will have to wait for the markets to open tomorrow, although SPX and EURUSD moved a bit after FT put out the news.

The Euro Area monetary union has designed itself to be dependent on rating agencies. For example, the “Eurosystem Credit Assessment Framework” outlines what kind of collateral are acceptable for borrowing (by banks) from their home National Central Bank. So eligibility and “haircuts” depend on ratings. If a national government’s rating gets downgraded, most private sector securities issued by the nation can be impacted. It is true that for a while, some issuers had their ratings higher than their sovereigns (possible!), time has arrived when they will be impacted too. With a general shortage of collateral, this will make the situation worse.

And of course, if markets start pricing a higher credit risk based on S&P’s opinion, there needn’t be an explanation of how things can go wrong.