Tuesday, December 13, 2011

Awaiting the S&P's decision on sovereign ratings

One major overhang on the markets continues to be the threat of sovereign downgrades in Europe by the S&P:
S&P Press Release, Dec. 5, 2011--Standard & Poor's Ratings Services today placed its long-term sovereign ratings on 15 members of the European Economic and Monetary Union (EMU or eurozone) on CreditWatch with negative implications.
The downgrade threat pertains to the usual suspects: Italy, Spain, Portugal, Ireland, and Belgium as well as to nations that were thought to be safe from downgrades: France, Germany, Netherlands, Finland and some others. The main concern is France because of their leadership position and a high likelihood of a downgrade. In fact S&P is threatening to downgrade them by two notches.

Here is S&P’s rationale for the downgrade watch:
(1) Tightening credit conditions across the eurozone;

(2) Markedly higher risk premiums on a growing number of eurozone sovereigns, including some that are currently rated 'AAA';

(3) Continuing disagreements among European policy makers on how to tackle the immediate market confidence crisis and, longer term, how to ensure greater economic, financial, and fiscal convergence among eurozone members;

(4) High levels of government and household indebtedness across a large area of the eurozone; and

(5) The rising risk of economic recession in the eurozone as a whole in 2012. Currently, we expect output to decline next year in countries such as Spain, Portugal and Greece, but we now assign a 40% probability of a fall in output for the eurozone as a whole.
Europe can in fact control 3 out of the 5 factors listed by the rating agency. The first two can be addressed with one action: providing support to the bond market. That will ease tightening of credit limits within banks and may create some demand for corporate debt, taking care of factor 1 (above). Supporting Spanish and Italian bonds will certainly lower the ”risk premiums”, eliminating item 2.  But significant support to the bond market will mean QE, and the ECB is currently not in the mood for that. Hopeful comments to that effect however continue to leak out of the eurozone:
Reuters: Comments from France's candidate for a seat on the European Central Bank's Executive Board, Benoit Coeure, who said the ECB may need to step up its bond-buying to help reduce borrowing costs for some states, were also euro-positive.

Item 3 is actually in reasonable shape as the eurozone's new treaty begins to crystallize. Factors 4 and 5 are long-term concerns and outside of the eurozone’s immediate control.

One may ask - who cares about S&P ratings? The issue goes back to European banks whose capital requirements are linked to the ratings of bonds they hold. And downgrades may increase the “risk weightings”, lowering capital ratios and potentially forcing banks to raise even more capital – beyond the already onerous requirements.

For now we wait as the S&P's decision looms, potentially coming at any time:
S&P: We expect to conclude our review of eurozone sovereign ratings as soon as possible following the EU summit .... Depending on the score changes, if any, that our rating committees agree are appropriate for each sovereign, we believe that ratings could be lowered by up to one notch for Austria, Belgium, Finland, Germany, Netherlands, and Luxembourg, and by up to two notches for the other governments.

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