Ratings agencies running the show in Europe and US

This post appeared in The Guardian Business Blog on July 20th 2011 and has been reposted here with permission.

The three main credit ratings agencies—Moody’s, Fitch and Standard & Poor’s—are heavily influencing fiscal policy in the eurozone and the United States. Objectively, this is madness. That is what finance ministries and departments are for. Still, the credit ratings agencies are not to be blamed for the debt crises in the euro area or the US.

Why do we care what they say?
Having completely dropped the ball and failed to predict the global financial crisis that kicked off in 2008, the main three credit ratings agencies lost significant credibility. Rather than rely on the big ratings agencies, a number of buy-side investment firms have established their own research teams.

If the credit ratings agencies have been asleep at the wheel and investors are doing more of their own research in-house, why does anyone care what the credit ratings agencies say?

First, a downgrade by a credit ratings agency or a negative outlook provides a tangible signal for investors when intangible things—such as political negotiations—are going badly. Second, ratings downgrades can trigger huge sell-offs for funds that passively track indices based on the big agencies’ ratings.

To compensate for being behind the curve at the outset of the global financial crisis, it seems the three agencies have been over-eager to downgrade or threaten to downgrade countries in Europe and the US in recent weeks.

Flurry of downgrades in Europe
On 5 July, Moody’s downgraded Portugal to junk status with a negative outlook. A week later on 12 July, Moody’s downgraded Ireland to junk with a negative outlook as well. On 13 July, Fitch downgraded Greece to a rating of CCC, just above default.

These downgrades came at seemingly random times. The press release to announce Portugal’s downgrade spoke primarily of developments in Greece. The presser accompanying Ireland’s downgrade referred mostly to developments at the EU level. Fitch’s downgrade of Greece occurred just after EU leaders and the IMF had committed to agreeing a second bailout for the country, a positive development by all accounts.

The specific timings of the downgrades seemed random, but they did reflect two aspects of the euro crisis that EU leaders themselves have not yet managed to fully grasp: the swiftness and force with which the euro crisis can spread from one country to another and the role that dithering at the EU level serves to catalyse this.

The credit ratings agencies have put significant pressure on peripheral eurozone countries already snapping under the weight of harsh austerity programmes. They are also influencing fiscal policy at the EU level. Earlier this month, the main agencies poured cold water on a number of different proposals for involving the private sector in a second bailout package for Greece.

Livid about the influence of the main ratings agencies on investors, European commission president Jose Emanuel Barroso and other policy makers have called for the creation of a European rating agency. The most common argument is that the three main ratings agencies are all based in the US, and therefore have vested interests that are not aligned with those of the EU.

In reality, only Moody’s and Standard & Poor’s are based in the US, while Fitch is majority owned by a French company.

Influence in the US
Furthermore, the three main agencies have proven they are willing to ruffle feathers in the US as well, despite their investor base being largely American.

On 13 July, Moody’s placed the US on a negative watch and said it would downgrade the country if the US missed any debt payments. A few days later, Standard & Poor’s also warned there was a 50-50 chance it would downgrade the US if a deal on increasing the US debt ceiling is not agreed soon. On 18 July, Fitch jumped on the bandwagon to say that failure to reach a deal on the debt ceiling by 2 August would cause it to place the US on negative watch.

The past week has been characterized by tense negotiations between the Republicans and the Obama administration about the debt ceiling, but there has been no particular spark to justify this recent flurry of ratings agency threats. Instead, it seems the three main agencies aim to put pressure on US politicians to find agreement on the debt ceiling.

Still not to blame
While the credit ratings agencies arguably have too much influence over fiscal policy in the eurozone and the US and a downgrade or a threat to downgrade can influence markets, the agencies cannot be blamed for the debt crises on either side of the Atlantic.

As a country comes under pressure in the markets, the onus is on that country’s government to ensure that it implements the policies necessary to restore confidence in credit ratings agencies and investors alike.

Downgrades by credit ratings agencies, no matter how spurious the timing may seem, cannot be considered a fundamental cause of the debt crisis in either Europe or the US. Perhaps Citibank’s chief economist Willem Buiter put it best when he said that blaming the credit ratings agencies was like throwing out a thermometer just because it showed you had a fever. No good comes of shooting the messenger.

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6 Responses to Ratings agencies running the show in Europe and US

  1. Excellent analysis Ms. Greene. Putting the blame on credit rating agencies is a sign of weakness, of inability (or unwillingness) to grasp the true nature of the crisis and its real systemic causes.

    The rhetoric of European Commission President, Manuel Barroso, that credit rating agencies “are biased” has nothing to do with reality. There certainly is speculation (that is what drives the markets after all), but it cannot be based on a mere bias… In the case of the crisis in Europe speculation is established upon the ad hoc, retroactive response of the EU to the crisis.

    Your remark that Credit Rating Agencies are also willing to downgrade the USA should the debt ceiling not be increased by early August is yet again a sign that Mr. Barroso doesn’t really know how these institutions behave.

    At some point you said: “Fitch’s downgrade of Greece occurred just after EU leaders and the IMF had committed to agreeing a second bailout for the country, a positive development by all accounts.”

    A second bailout is positive news for the markets, but back then they only “committed” themselves to a second bailout to Greece. Commitment can differ a lot from reality. Reality is that today there is the summit of heads of states and governments of the euro zone and still there seems to be no consensus over the “commitment”. This uncertainty that exists today and which existed back then, is enough to downgrade an economy that is on the verge of default.

    Thank you for sharing this excellent analysis.

  2. ocaj2000 says:

    Megan:

    As an American, your insight about the situation in Europe is much appreciated. Is today’s announcement of the new Greek bailout and expansion of the EFSF a done deal or does it require approval by the Euro countries parliaments ? If the latter what is the prospect of acceptance, in particular by Finland and Germany ? I would think where would be some sort of constitutional court challenge in Germany.

    • Megan Greene says:

      Thanks for your comment. Unless something has changed today (I’m on holiday and so am not glued to the news flow for a change), any changes to the size and scope of the EFSF will need to be approved by national parliaments, almost all of which are on holiday until September. It’s hard to say whether it would pass in Germany though I think it probably would. The SPD is pro-bailout and pro-EU, so would probably offset any of the governing coalition’s MPs in voting against it. In Finland too, I think it would have to pass (least of all because an inordinate amount of pressure would be placed on Finland by the other eurozone countries to pass it). Still, it means national parliaments will be facing this debate in Sep, the same time that 1) the troika descends on Athens to assess the government’s progress on implementing the terms of the medium-term programme (and finds little positive news) and 2) Greece needs another tranche of funding. Also, in other peripheral country news, a bunch of Spanish cajas will be trying to raise funds in September. This all smacks of uncertainty, and we know how markets respond to uncertainty…

  3. Paul Forrest says:

    ‘Ratings agencies running the show …’? Not really, Megan, any more than you can put a finger on who or what runs life.

    It’s just action, perceived wrong action or inaction on the part of the sovereign that moves the ratings agencies and, in their turn, governments must pay attention to the agencies’ reaction and subsequently react accordingly. Just a series of fairly normal circular events!

    But of course we’re not in normality. We’re in a crisis of incautious lending, flagrant borrowing, inability to repay and money running short everywhere. Perhaps a further programme of quantative easing on a massive, cross-currency scale might help?

    Enjoy your holiday!

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