Tag: Public Debt

What is the role of credit rating agencies in the economy?

Gianlorenzo Zeccolella

Gianlorenzo Zeccolella

UK
Italy

The current financial situation reserves an exceptional role for credit rating agencies, which may actively influence and, eventually, undermine the financial market stability. 

Both in the European Union and in the United States, the number of credit rating agencies is very circumscribed. There are just a few companies that operate in this business with no competition. Moody’s, Standard & Poor’s and Fitch Group, the so-called “Big Three”, hold around 92% of market share[1]. Their role is to assign a credit rating, an essential indicator to gauge both countries’ and companies’ soundness. Ratings contribute to determining the possibility to access new national and international capital resources. 

Ratings as measures of creditworthiness

Several international companies, before issuing a bond, ask the rating agencies to assess the financial instruments and assign a rating (often obliged by legislation), which consequently authorizes the allocation on the market. Moreover, not all the investors assess on their own the credit quality of companies and countries, before investing. Many of them directly rely on the evaluation provided by credit rating agencies.

The higher is the credit quality, the higher will be the rating. Together with the lower cost of capital, a high rating guarantees more accessibility to external debt[2]. The scale goes from AAA the best grade, to D, meaning Default (the scale is slightly different for Moody’s. See the table below). Companies rated at BBB- or higher are in the investment-grade area, while the ones with ratings below the BBB- threshold are in the speculative-grade zone (also defined “junk” or non-investment).

Moody’sStandard & Poor’sFitchDescription
AaaAAAAAAInvestment Grade
Aa1AA+AA+
Aa2AAAA
Aa3AA-AA-
A1A+A+
A2AA
A3A-A-
Baa1BBB+BBB+
Baa2BBBBBB
Baa3BBB-BBB-
Ba1BB+BB+Speculative Grade
Ba2BBBB
Ba3BB-BB-
B1B+B+
B2BB
B3B-B-
CaaCCC+CCC
CaCCC
CCCC-
/DCC
/C
/D

Ratings as risk indicators

The other side that can be captured using ratings is the risk involved in an investment. It is straightforward to understand that a debt issuer – generally a State or a company – with a high credit quality and a high rating will be a safer investment than another with a speculative grade rating. 

Institutional investors, such as pension funds, mutual funds and banks have different restrictions on the amount of risk they can (and they are willing to) bear.

This is partially due to regulation. Savers are investing their money in a pension fund to ensure the possibility to live respectably after retirement, without any interest in being exposed to speculative assets. Also, the investment strategy matters. Indeed, every portfolio is built pursuing certain objectives. In finance, expressed in terms of expected returns and risk. Investors, choosing to use their money to buy financial instruments instead of consuming, should receive an appropriate remuneration, proportional to the level of risk they are bearing. However, most of them would not accept the risk of losing a big portion of their capital chasing unrealistic high returns. For this reason, most of the investors will not be willing to invest a great share of their money in low rating government or corporate bonds. 

The importance of credit ratings for States

When a State is downgraded the impact on its cost of borrowing can be very significant, especially if its previous ratings were already low. Going from the lowest scores of investment grade to speculative grades can cause the exclusion from the main government bond indexes and, thus, from the portfolios of many institutional investors. This generates not only a dramatic increase of the cost of borrowing money on the markets but it can seriously reduce the capacity for that issuer to finance additional spending with debt. Today, according to Moody’s and Fitch, Italy is just one notch above the junk area and the covid crisis risks to compromising its creditworthiness.

CountryS&P’sMoody’sFitch10 years government bond yield
ItalyBBBBaa3BBB-0.49%
GermanyAAAAaaAAA-0.52%
FranceAAAa2AA-0.32%
SpainABaa1A-0.04%
PortugalBBBBaa3BBB-0.03%
United StatesAA+AaaAAA1.12%
United KingdomAAAa3AA-0.29%
JapanA+A1A0.04%
SwitzerlandAAAAaaAAA-0.50%
RussiaBBB-Baa3BBB5.88%
CanadaAAAAaaAA+0.82%
AustraliaAAAAaaAAA1.10%
New ZealandAAAaaAA1.07%
BrazilBB-Ba2BB-7.37%
South KoreaAAAa2AA-1.72%
ChinaA+A1A+3.22%
ArgentinaCCC+CaCCC51.23% (7 years maturity )
BulgariaBBBBaa1BBB0.28%
RomaniaBBB-Baa3BBB-2.94%
GreeceBB-Ba3BB0.58%
SwedenAAAAaaAAA0.06%

Looking at the ratings and the yields on government bonds reported in the table above, it is noticeable that also other factors affect the bond yield. Indeed Italy has similar ratings to Russia, but a much lower cost of debt.

The intervention of the European Central Bank (ECB) has certainly played a crucial role in maintaining low the yield on European countries’ bonds, especially for Italy. ECB implements its monetary policies through different channels. Among them it is worthwhile to mention the Open Market Operations and the Asset Purchase Programmes (APP)[3]. These allow the ECB to provide liquidity at a very low cost to financial institutions and banks of the Eurosystem, in exchange for this liquidity the banks provide a collateral, which can be for example a government bond. Through these instruments, the ECB receives government bonds of the EU countries, relieving the pressure on the countries yield rate. However, government bonds have to meet certain requirements to be eligible to be used as collaterals[4]. One of them is being at least in the investment grade area. Otherwise, in the worst scenario, the ECB would not be anymore allowed to hold and  buy such government bonds. On 7 April 2020, to reduce the possible damages of a downgrade during the covid crisis, the ECB decided to adopt temporary collateral easing measures. Nowadays, all the marketable assets and issuers, which had at least the lower investment grade until 7 April 2020, remain eligible even in case of further downgrades (up to two notches lower)[5]. However, the fact that collateral eligibility for central banks’ purchasing programmes are tied to ratings show the relevance and the weight of these institutions in the financial markets.

 

Credit rating determinants and the main concerns

CRAs assign ratings considering various determinants of the debtor: 

  1. Ability to pay–back the borrowed amount. It includes the principal plus the accrued interests; 
  2. Ability to do it on time; 
  3. Likelihood that the obligor may not pay because of default.

Once analyzed these three broad categories, analysts can attribute a rating that determines the company’s creditworthiness.

Recently, the most important credit rating agencies have acquired greater importance on the capital and financial markets, becoming a target for several critiques. The biggest and most prominent credit rating agencies, namely Standard and Poor’s, Moody’s, and Fitch currently have a massive impact on the capital and financial market. Their assessment of a company’s financial quality represents a fundamental component in determining the pricing of credit risk, which in turn denotes the cost of both internal and external resources. 

However, the debated topic is whether those agencies may have some incentives to assign inflated ratings. The problem springs since agencies are not paid by investors but by the same companies that ask for the credit quality assessment (obligors). The borrower, who pays the agency, is interested in high ratings, which would guarantee stability (to keep the cost of external debt low). It is not complicated to understand that in this scenario, some interests are conflicting. The company that needs the assessments pays the agency that would probably be more motivated to give a high rating.

Structured products, such as Mortgage Backed Securities (MBS)[6], have always been more frequently placed on the market for several years, especially in the United States. Default rates were much more significant than what their intrinsic value was suggesting. Decomposing these structured products would have given assets with awful shapes but with an overall high rating. For this purpose, agencies have been blamed for assigning inflated credit ratings. All these inefficiencies played a critical role in the subprime crisis in 2008.

Furthermore, the insurmountable entry barriers are another crucial issue. The market of credit rating agencies is wholly dominated by three companies, characterizing it as an oligopolistic system. The leading firms may decide to cooperate and create a cartel that would increase the prices and discourage new entrants. Besides, CRAs may offer inflated ratings. In this case, it would be tough for regulators and supervisors to detect whether common shocks or collusive strategies drive extreme assessments.

What can be done to improve the situation?

It is fundamental to create a scheme of incentives where firms are motivated to deviate from such collusive synergies. An idea could be to establish a public rating department in the main global institutions – such as the International Monetary Fund or the Central Banks –  that can assess the companies’ credit quality. Their outcome must be compared with the agencies’ results to notice possible differences. If there are large differences (unfair assessments) not driven by fundamental motivations, the regulators may refuse to grant the license to operate in the credit rating sector in the future period. This action may sound unrealistic. Indeed, even in case of weird and unfair behaviors, rejecting the permission to Moody’s, Standard & Poor’s or Fitch seems improbable due to their market power[7].

Notwithstanding, the conclusions drawn on some undesired qualities and drawbacks of ratings do not have to distract us from the importance of them. Indeed, credit ratings offer a great informational substance that, if not subjected to bias, might be very useful for investor’s decisions. 

Michele Corio and Gianlorenzo Zeccolella

Sources and references

[1] https://www.moodysanalytics.com/regulatory-news/nov-29-19-esma-publishes-market-share-figures-for-credit-rating-agencies-in-eu/

[2] debt held by foreign banks

[3] https://www.ecb.europa.eu/mopo/implement/html/index.en.html

[4] https://www.ecb.europa.eu/mopo/assets/standards/marketable/html/index.en.html

[5] https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200422_1~95e0f62a2b.en.html

[6]Financial instrument secured by a mortgage or collection of mortgages.

[7] Stolper, A., 2009. Regulation of credit rating agencies. Journal of Banking & Finance 33, 1266–1273. https://doi.org/10.1016/j.jbankfin.2009.01.004

EU needs a joint reaction against the covid crisis

UK
Italy

The covid-19 pandemic hit Europe violently. The new coronavirus, which infected the first human in the Chinese region of Hubei, is changing our lives, subverting the political and economic framework. In the initial phase, the response of the European countries was scarcely coordinated and, often, late. The impact of the virus has been particularly severe in the economically most developed regions: Lombardy, Emilia-Romagna and Veneto in Italy; the Community of Madrid and Catalonia in Spain; the region of Paris, Ile de France; Bavaria, North Rhine Westphalia and Baden Württemberg in Germany; the Stockholm’s county in Sweden; Flanders in Belgium. Inevitably, the deep integration among the economies of the various EU countries was also an efficient vehicle of transmission for the virus. In absence of a joint strategy for the reopening, at European level, the risk of new spreading of the infections through these paths will be even higher in the next weeks.

 

Here you can see the diffusion of the virus on the interactive map

 

The most affected countries, Italy and Spain, have adopted very strict measures. They allowed to continue to carry out the production only to the companies producing essential goods and services or involved in strategic activities for the management of the crisis. On the other hand, the majority of EU countries chose a softer lockdown, closing commercial business in contact with the public, leaving most of the production companies open[1]. However, these restrictions, necessary to reduce the sanitary emergency, risk to undermine the European economy. The dimension of the crisis will diverge country by country. Indeed, the strictness of the measures, the direct and indirect damages of the epidemic and the financial capacity of each country to support its economy will make the difference. A precise and punctual intervention from the State is needed, providing the required liquidity to make it through the crisis.

 

The necessity to finance the spending with debt and its critical issues.

 

The main sources of financing for a State are taxation and the issuance of bonds on the markets. In the midst of a pandemic, a short-term increase in taxation is not a sustainable tool. The objective is to safeguard firms and to keep the productive and economic system alive. Instead, it is inevitable to increase the public debt to reduce the impact that an announced economic recession will have on every citizen’s life. As they demand loans on the markets to finance their spending, the States issue debt securities. Like any other loan, also government bonds embed the market risk – a reduction in the market value of the bond may cause losses to the holder – and, in extreme cases, the risk that the capital lent will not be completely reimbursed.
Generally, the more investors – banks, financial institutions, pension funds and households – will find it likely that the loan will not pay off, the more they will demand a high yield for the risk they are bearing. At the same time, the cost of the debt for the State will increase as the risk perception of the investors increases. Political and economic events together with the amount of debt outstanding affect the finances of the States. Moreover, they influence also the investors’ expectations and bond yields. A typical unit to measure the risk on public debt is the spread between a safe asset – usually in EU the reference is the German bund – and another government bond. Besides, to evaluate the dimension of a public debt it is common to use the Debt/GDP ratio (this topic was also discussed here).

The current situation of Public debt in the main EU countries

http://sdw.ecb.europa.eu/home.do;jsessionid=3EE7A0FCAD10FF1B716097B51DEA188E

It seems clear that the European States are not all in the same condition. Spain and Italy currently are facing the hardest consequences from the pandemic, but they are also the States with the highest debt. In the last years Italian GDP grew slowly[2], and its debt reached 134% of GDP in 2018[3]. Similarly, Spain had a Debt/GDP ratio equal to 97.6%[4] in the same year. However, recently Spanish GDP had a consistent growth, 2% in 2019 and an average growth of 2.8% per year since 2015[5]. Nonetheless, before the financial crisis in 2007 Spain had a debt/GDP ratio equal to 35%[6]. The huge increase in debt due to the crisis forced the Spanish government to reduce the public spending and to enforce several additional reforms to increase its competitiveness and maintain the possibility to raise funds issuing debt on the markets.

 

Therefore, Spain and Italy are caught in the crossfire. On one side they are facing an unprecedented sanitary crisis, on the other they have to spend massive amount of money for the reconstruction of their economies. In addition, they may not be able to benefit of cheap borrowing on the markets.

 

Already as 21st April, the yield on 10 years Italian government bond (BTP) was 2.02%[7]. The equivalent yield on Spanish bonds was 0.97%[8]. As a comparison, it is interesting to see that the yield on 10-years German bonds is negative, equal to -0.481%[9]. Germany had a Debt/GDP ratio of 61.9%[10] in 2018. While, Netherlands has a yield of -0,177%[11] and France has 0.06%[12]. Following the increase of these debts, also the related yields will grow. The cost of financing will increase for all the EU countries, but this effect will be much bigger for the States that already have a high debt.

http://sdw.ecb.europa.eu/home.do;jsessionid=3EE7A0FCAD10FF1B716097B51DEA188E

 

The debate about the EU measures against the crisis

 

The sanitary crisis is a global emergency. In front of covid-19, there is no virtuous country, nor vicious. It makes no sense to blame the most affected countries with moral judgements. This crisis is symmetric, differently from the financial crisis of 2008. Notwithstanding, its impact and the timing will be different country by country. Since the beginning of the emergency, there has been a hard debate in the EU. The two factions were the supporters of a joint issuance of debt as common response to the crisis – among them Italy, Spain, France – and the opponents – among them Germany and Netherlands. At least in the initial phase, the opponents, confident on their ability to face the economic crisis on their own, were available to help the other countries only under strict conditions. Their proposal involved rigid rules on the repayment of the public debt and on the duration of the loans – European Stability Mechanism (ESM) with enhanced conditions credit lines.
Meanwhile, the European institutions gave their support to the most damaged countries with the specific Pandemic Emergency Purchasing Programme (PEPP) of the European Central Bank (ECB). So far, this intervention allowed to all the countries to maintain a low yield rates on their bonds. This is especially true for Italian BTP. Additionally, EU allocated other 540 billion euro to support the economy (more info here). Unfortunately, the dimension of the crisis requires further interventions. Issuing common debt – Eurobond or European recovery bonds – to finance the economic reconstruction can be the correct solution. Eurobonds would allow to the countries in difficulty to borrowing low cost from the market, making a step further in the European integration process.

 

Why a joint intervention is in the interest of the whole EU?

 

It’s not only a matter of European solidarity. Facing a recession of Eurozone GDP estimated as 7.5% by the IMF[14], no one is stable. There are not solid countries and individualism is not a feasible option. Furthermore, the European Union is a supranational organization that has shared for many years the benefit of being an open economic area. Freedom of movement for workers, goods and capital generated an interdependence among the member States. This is also confirmed looking at the destination countries for the export of Netherlands, Spain, France, Germany and Italy in the figures below.

Figure 3: Export destinations for France in 2017. Source: OEC.world
Figure 4: Export destinations for Italy in 2017. Source: OEC.world
Figure 5: Export destinations for Germanyin 2017. Source: OEC.world
Figure 6: Export destinations for Spain in 2017. Source: OEC.world
Figure 7: Export destinations for the Netherlands in 2017. Source: OEC.world
http://sdw.ecb.europa.eu/home.do;jsessionid=3EE7A0FCAD10FF1B716097B51DEA188E

The export is a fundamental component of the GDP for all the countries above. Especially for Netherlands that accrued an export/GDP ratio of 82.5% in 2019. Instead, Germany had a export/GDP of 46,9%[15]. Analysing the destination of this export it is extremely evident that the biggest share is directed to other EU countries. Italy is the fifth country for the percentage of goods and services received by the Netherlands and the sixth for Germany. While, Spain is the seventh destination country by dimension of export for Netherlands and the eleventh for Germany. Moreover, Germany and Netherlands are also destination of a significant share of Italian and Spanish export[16].

The European economies are deeply connected. Now it’s time for the European leaders to find an agreement for common and strong measures against the crisis. It will take time. It may require changes in the treaties and the EU budget has to be increased with additional contribution from every single country. This is in the interest of all the member States. Otherwise, the economic crisis will follow the same paths as the epidemic. The risks are an economic depression and the rise to the power of Eurosceptic parties, which may lead to the end of the European project.

 

Michele Corio

 

References:

 

[1] https://osservatoriocpi.unicatt.it/cpi-archivio-studi-e-analisi-coronavirus-e-blocco-delle-attivita-cosa-succede-all-estero

 

[2] https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?locations=IT

 

[3] http://appsso.eurostat.ec.europa.eu/nui/show.do?dataset=gov_10dd_edpt1&lang=en

 

[4] https://ec.europa.eu/eurostat/tgm/table.do?tab=table&init=1&language=en&pcode=teina225&plugin=1

 

[5] https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?locations=ES

 

[6] http://appsso.eurostat.ec.europa.eu/nui/show.do?dataset=gov_10dd_edpt1&lang=en

 

[7] https://www.investing.com/rates-bonds/italy-10-year-bond-yield

 

[8] https://www.investing.com/rates-bonds/spain-10-year-bond-yield

 

[9] https://www.investing.com/rates-bonds/germany-10-year-bond-yield

 

[10] http://appsso.eurostat.ec.europa.eu/nui/show.do?dataset=gov_10dd_edpt1&lang=en

 

[11] https://www.investing.com/rates-bonds/netherlands-10-year-bond-yield

 

[12] https://www.investing.com/rates-bonds/france-10-year-bond-yield

 

[13] https://jeuneurope.com/ue-e-coronavirus-il-punto-della-situazione/

 

[14] https://www.imf.org/en/Publications/WEO/Issues/2020/04/14/weo-april-2020

 

[15] https://ec.europa.eu/eurostat/databrowser/view/TET00003/default/table

 

[16] https://oec.world/en/

Nuggets of Public Finance

UK
Italy
The Government Budget is a complex document that represents in a detailed way the financial and economic condition of a country. In addition, through an accurate analysis of the public expenses, it is possible to find out important information about the culture and the social structure of the State.

Depending on the information searched and the goals pursued, we can distinguish several types of budget statements.

In this article, I will briefly refer to the final budget and the provisional budget to give an idea about the essential content of a public budget statement and about the role of Gross Domestic Production (GDP) in the evaluation of the total wealth produced, of the national income and of the welfare level inside a society.

(more…)
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