The S&P cuts were expected, a disorderly default by Greece won’t be

By Win Thin

With the long-awaited euro zone downgrades by S&P now out of the way, we thought it would be useful to assess just how close current ratings are now to our own sovereign ratings model. To recap, after putting all euro zone nations on Creditwatch negative back in December, S&P on Friday announced cuts to nine countries. The results were largely consistent with those leaked earlier in the day by EU officials. We agree with some, and disagree with others. However, the negative outlooks for virtually every euro zone country suggest that the debt crisis will remain an issue for the markets for much of this year.

Germany, Finland, Luxembourg, and the Netherlands were left at AAA. Only Germany’s outlook is at stable, while the rest of the euro zone AAA countries all have negative outlooks now. Belgium was left at AA, Estonia was left at AA-, and Ireland was left at BBB+, all with negative outlooks. S&P noted that while it affirmed the AAA rating for Germany, it adjusted down its political score for the country, signaling its view that “the effectiveness, stability, and predictability of European policymaking and political institutions (with which Germany is closely integrated) have not been as strong as we believe are called for by the severity of a broadening and deepening financial crisis in the eurozone.”

Austria was cut one notch from AAA to AA+ with negative outlook. Our model has Austria safely within AAA territory, and so we do not view this downgrade as justified. S&P said the reason was due to strong linkages to Italy and Hungary, and that Austrian bank balance sheets could suffer and require government support. The same contingent liabilities from the banking system could haunt most of the other countries too, including Germany, and so Austria probably should not have been singled out.

France was downgraded one notch from AAA to AA+ and the outlook is negative. Our sovereign ratings model rates France at AA+/Aa1/AA+, and we have long felt a downgrade was warranted. S&P noted that another cut could occur if the government deficit were to remain near current levels, which would likely see debt/GDP (estimated at just above 80% in 2011) rise above 100%. The fact that Moody’s downgraded several French banks in 2011 due to Greece exposure suggests that its sovereign Aaa rating will come under pressure, while Fitch has a negative outlook on its AAA. As the second-largest contributor to the EFSF, France’s downgrade below AAA could have negative implications for the EFSF’s AAA rating. However, S&P has yet to clarify its stance regarding this issue.

After France, the next weakest core country is Belgium. Our model has an implied rating of AA/Aa2/AA and so S&P’s decision to keep it there with a negative outlook appears justified for now. S&P said it lowered Belgium’s political score too and that another rating cut could occur if net debt/GDP (estimated at 94% in 2011) were to rise above 100%. Downgrade risk for Belgium remains strong given that a negative outlook was kept by all three agencies. Actual ratings are split at AA/Aa3/AA+.

Italy was cut two notches from A to BBB+. Our model rates Italy A-/A3/A- vs. actual ratings of BBB+/A2/A+, and we take issue with what he see as an excessive move by S&P. S&P said Italy could be cut again due weak growth that keeps debt/GDP in upward trajectory or a failure of the technocratic government to implement structural reforms needed to boost competitiveness. Fitch’s A+ rating is now most out of line with our model, with Moody’s slightly less so at A2. All three agencies have negative outlooks on Italy.

Spain was also cut two notches from AA- to A with negative outlook. Our model rates Spain as A-/A3/A- and so we think the cut was justified. S&P said further cuts would be likely if additional labor and structural reforms fail to materialize and keeps unemployment high, or if the government does not take further measures to meet its 2012 and 2013 budget targets. Actual ratings of A/A1/AA- thus remain vulnerable to further downgrades, and all three have maintained negative outlooks. Here too, Fitch is most out of line with our model now.

Ireland’s rating was kept at BBB+ with a negative outlook. S&P that the government’s response to the crisis has been “proactive and substantive”, but warned that slow growth risks derailing the fiscal program. We note that is implied model rating improved slightly this past quarter to BB+/Ba1/BB+ from BB/Ba2/BB previously. However, it remains vulnerable to downgrade risk. Besides S&P’s negative outlook, both Moody’s and Fitch have maintained negative outlooks on Ireland as well.

Portugal was also cut two notches from BBB- to BB with negative outlook. Our model rates Portugal at BB-/Ba3/BB- compared to actual ratings of BB/Ba2/BB+ and so the cut appears justified. S&P warned of a more severe economic contraction ahead, and that ongoing austerity without improving growth could lead to higher unemployment. With all three agencies keeping a negative outlook, further downgrades appear likely and justified.

Greece was kept at CC and compares to an implied rating of CCC-/Caa3/CCC- from our ratings model. However, we believe actual CC/Ca/CCC ratings are still vulnerable to downward pressure as it appears that the voluntary debt restructuring is not going to be accomplished as planned. S&P has a negative outlook, Moody’s has a developing outlook, while Fitch took Greece off Rating Watch Negative after its last downgrade this July.

Others that were downgraded on Friday were Cyprus (from BBB to BB+), Malta (from A to A-), Slovakia (from A+ to A), and Slovenia (from AA- to A+). While of these moves were in the euro zone, we stress that the UK remains vulnerable to losing its AAA rating despite the aggressive fiscal tightening implemented by the Tory-led government. Austerity is taking a toll on the recovery, which will in turn hurt tax revenues. UK’s implied rating is AA/Aa2/AA vs. actual ratings of AAA/Aaa/AAA. It has gotten a pass from the agencies so far, but we think a slowing economy will bring attention back on the AAA. We see UK downgrades in 2012, as we view AA+ France as a better credit than the UK. By downgrading France and Austria below AAA, we believe relative credit quality will require a cut to the UK in order to maintain consistency across countries.

Despite some euro weakness seen on Friday, the S&P downgrades have been so well telegraphed that the fallout may be limited when markets reopen on Monday. Furthermore, we note that concerns about negative fallout from the US losing its AAA proved to be unfounded. Contrary to Chicken Littles everywhere, the sky did not fall when S&P cut it to AA+ over the summer, and the world instead continued to turn. Indeed, US borrowing costs are lower now than before the downgrade by S&P. This is the lesson that European policymakers should take to heart. Loss of AAA is not the end of the world, and one could make the case that AA is indeed the new AAA.

While the S&P cuts were to be expected, we do not think markets are prepared for a disorderly default by Greece. The breakdown in talks between Greece and its creditors last week over disagreements over the previously agreed exchange suggest that the risks of disorderly default are rising there. While there is posturing to be seen by both sides as talks are supposed to restart Wednesday, markets may have been wrong in recent weeks to look past Greece to Italy and Spain, when the Greek situation has yet to be resolved. While we are hopeful that a disorderly outcome will be avoided, we think that even a reweighting of market risk perceptions may be enough to keep the euro on its back foot this week.

Win Thin


Win Thin is the Head of Emerging Markets Currency Strategy at Brown Brothers Harriman. He has a broad international background with a special interest in developing markets. Win received his Ph.D. in economics from Columbia University in 1995, specializing in international and development Economics. He received an MA from Georgetown University in 1985 and a B.A. from Brandeis University 1983.