“Stronger downgrade may create a big one shock” (Bertrand Candelon)

This week Standard & Poor’s donwgraded Portugal’s rate to BBB-, near the “speculative” (junk) status. A IMF working paper from Rabah Areszki, Bertrand Candelon and Amadou N.R. Sy just published yesterday – titled “Sovereign Rating News and Financial Markets Spillovers: Evidence from the European Debt Crisis” – found “evidence that downgrades to near speculative grade ratings for relatively large economies like such as Greece have systematic spillover effects across Euro zone countries (17 and 5 basis points increase respectively for Greece and Irish CDS spreads).”

Janelanaweb interviewed Bertrand Candelon, Professor in International Monetary Economics, Department of Economics of Maastricht University School of Business and Economics.

Interview by Jorge Nascimento Rodrigues (a) 2011

The answers from Dr. Candelon do not engage his co-authors, neither the institututions he is consultant for (IMF and European Commission).

Highlights
« It is thus very unprobable that Portugal will default stricto-sensu.»
« This downgrade decision would affect the other European countries as well as Portugal itself potentially creating a vicious circle»
«If you think about the idea of creating a European CRA (as it was the idea of the European commissaire Michel Barnier), I think it would make sense.»
« Another possibility may be to make the ranking more continuous (i.e. increase the number of ranking classes). The decision to downgrade of a notch should then become less important for the financial stability. Such a controle (I prefer this term to regulation) might be desirable.»

Q: The paper you co-authored clearly refers a systemic impact from the downgrades to near-junk in the case of Greece in the past. Do you think we can have a similar impact now with the case of Portugal and the risk of a downgrade of Ireland from A- to B status after the stress tests of tomorrow?
A: Yes. I think it is probable especially if Ireland is downgraded again. It looks like the Greek downgrade near to junk we have in the paper. My strongest fear at the moment is related to Spain because of the financial amount it represents (difficult to bail out). Stronger downgrade may create a big one shock. Let’s hope it will not be the case.

Q: These recent downgrade movements from the main rating agencies regarding Portugal are justifiable?
A: Let us first remember the objective of a credit rating agency. Rating should indicate for investors the long run economic perspective of the country. It means that they should avoid to modify the rating across the cycle or after any temporary shock. In the case of Portugal, a downgrade would thus mean that the public finance situation becomes critical and is less sustainable in the long run. Foreign investors are thus exposed to higher risk when lending to Portugal. The downgrade is justified if it is the case. Everybody is aware that the fiscal and political situation in Portugal as in Greece is critical in many ways. Nevertheless, 2 arguments may go against the downgrade: First, European Union (alone or with the IMF) has the capacity to bail-out Portugal as Greece (which would not be the case for Spain). It is thus very unprobable that Portugal will default stricto-sensu. Second, as we show in the paper downgrade has an impact on financial markets (pushing down the stock market global and subindices and increasing the CDS rate), that would 1) affect the other european countries as well as 2) Portugal itself potentially creating a vicious circle. In other words, even if Portugal situation is becoming unsustainable in the long run instead of solving the problem, it will add to the financial instability in Portugal and in the whole Europe. The solution will come from the economic side.

Q: In the rating agencies industry, do we need a global diversification of these type of companies?
A: We must realize that CRA [credit rating agencies] are independent firms, with benefits and market positioning. The market is actually oligopolistic and composed by S&P, Moodys and Fitch. So it may be that to get credibility, a CRA decides to lead the sequence of downgrades. For example in the case of Portugal, Moody’s was the first to downgrade followed by Fitch and then S&P. To this respect, one idea would be to create new CRA aiming at creating an efficient rating world. Potential problems may be that 1) it may take some time before a new CRA gain enough credibility on the market to compete with the existing ones, 2) it will not prevent fron selffulfilling mechanisms (a sequence of actions disconnected fundamental factors) and 3) if the country is really suffering from long-run economic problem a simultaneous downgrade of all the CRA will have huger effect on financial stability. Besides in our paper which covers the period 2007-2010 we only find weak evidence of such sequence.

Q: Europe must have companies of this type, like China and Canada has?
A: First, I am not familiar with the CRA organization in China or Canada. If you think about the idea of creating a European CRA (as it was the idea of the European commissaire Michel Barnier), I think it would make sense. 1) it will increase the information space (in Asia 6 CRA are coexisting) and 2) lead the other CRA to focus more on the long-run. Nevertheless, it has to gain sufficient credibility and also to be somehow independent from the political authorities: After all if a country is running unsustainable macroeoconomic policy in the long-run it has to be downgraded, whatever the potential consequences, this is the duty of CRA.

Q: Is it citicial do regulate this industry, regarding what happened during the bubble times?
A: Again the role of a CRA is to rate according the long-run economic situation of the country. Nevertheless, as 1) this objective is debattable and 2) a rating change have huge consequence on financial markets in the downgraded country but also elsewhere, I think some regulation may be wishable. But how to do that? A first idea could be to supervise the models from which the rating are issued to insure they focus exclusively on the long-run. It could be for example feasible to create a European label for the rating model (without making them public of course). Another possibility may be to make the ranking more continuous (i.e. increase the number of ranking classes). The decision to downgrade of a notch should then become less important for the financial stability. Such a controle (I prefer this term to regulation) might be desirable.

Q: Most of the critics of the rating agencies’ recent movements in the sovereigns (downgrading Greece, Ireland and Portugal) didn’t speak against when the same agencies rated AAA or almost the same countries in the bubble epoch, fueling the credit bubble. Would you comment this?
A: Indeed, this is the symmetric problem and the proof that they were rating trough the cycle. A long-run analysis would have revealed that these countries were in a bubble, meaning that in the long run it will, for sure, explode. In such a case, a downgrade or at least a negative revision could have expected. Again, I do not say it would have avoid the explosion of the bubble but it may have limited its volatility.

Recent rating notes from CRA
Last week for Portugal from A- to BBB
March 29 for Portugal from BBB to BBB- (this is similar now to Hungary and
Iceland)
March 29 for Greece from BB+ to BB- (both “junk” status)
April 1 for Ireland from A- to BBB+

Moody’s about Portugal
March 16 from A1 to A3

Fitch about Portugal
March 24 from AA to AA-
April 1 from AA- to BBB-

The other peripheral, not changed recently by S&P
Italy: A+
Spain: AA

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