The Rating Agencies
Sovereign risk: rules that reign

How the agencies rate a country can be useful, reports SHAYLA WALMSLEY, but they don’t provide the last word on a national economy.

Scandinavia, the Netherlands, Canada, Switzerland and Australia all figure among Standard & Poor’s (S&P) 10 least risky countries. Leaving aside countries with a credit record so poor they’re unrateable, you’re unlikely to be surprised at the countries at the other end of rating agencies’ lists.

Greece is there; so are Spain, Portugal, Ireland and Japan. Yet it’s more nerve-wracking to fall than to scrape along the bottom – that’s the lesson from the recent upping of US sovereign risk. In fact, S&P retained the US’s AAA rating, but cut its outlook from ‘stable’ to ‘negative’, effectively estimating 30-plus per cent likelihood of a downgrade in the next two years.

That rating was based on what the analysts perceived as the absence of a credible plan to address government debt at above 70 per cent of GDP. S&P’s downgrading of the UK sovereign risk to ‘negative watch’ back in 2009 had been a product of the same reasoning.

From a systemic point of view, it matters significantly more that the US has been downgraded than that Hungary has remained, albeit stably, in the doldrums. So what does it mean to be risky? What’s to justify giving the same domestic rating to Hungary and the sovereign doyens of default?

Despite the Hungarian government’s mandate for reform – there isn’t another election due before 2014 – the so-called Széll Kálmán fiscal reform plan is loaded with risk. As S&P credit analyst Trevor Cullinan points out, the government has already limited the independence of institutions with oversight responsibilities for the reform programme. “We believe that economic governance has deteriorated and that the transparency of fiscal policy has been undermined by the government’s extension of state control over the fiscal council,” he says.

Nor is Cullinan’s team acting on gut-feel or pulling data out of the ether: it has already outlined metrics for the next review – whether the government’s targets have been outlined, whether the necessary support legislation is in place, and whether implementation has begun.

Is there a point?

Moody’s similarly applies fixed criteria, distinguishing between government default risk and generic economic or political risk. Default risk depends not just on solvency risk – whether the government has the resources to pay the debt – but also on liquidity risk – whether it can mobilise those resources quickly.

The question is: should the rating matter so much? Not according to Charles Wyplosz, a professor of international economics at the Graduate Institute in Geneva. “Rating agencies do work – insofar as they have private customers and those customers are willing to pay for their services. The problem is when those ratings become official,” he says.

Just as the US and the UK show how significant a risk factor public debt is to a negative rating, cutting public debt is usually the way to restore a reputation with the ratings agencies.

Occasionally, it has the opposite effect. Moody’s in April downgraded Ireland’s government bond ratings, with a negative outlook. This was based on weaker forecast growth, weakened domestic demand and predicted expenditure cuts of 15bn – just under 10 per cent of GDP, which cast doubt on the strength of the recovery.

As with most ratings, this one came with a number of ‘ifs: further economic deterioration would exert more downward pressure on the rating.

For all the surprise exhibited in the market by the US news, sovereigns usually know what to expect. Greek finance minister George Papaconstantinou recently blamed investor perception of imminent default on the Moody’s downgrade. That was “incomprehensible”, he claimed, and over-hasty. In fact, Moody’s lagged significantly behind the market in its assessment of credit default swaps, and effectively bet on countries defaulting.

Bearing responsibility

“Governments bear a big responsibility,” says Wyplosz.“They should understand what the financial markets are and that, once they’re indebted, they depend on panic-prone and fickle financial markets. They need to be extremely careful when they’re indebted but they aren’t careful and they’re prone to denial.

“You can see it right now. Everyone else has known for months that Greece would have to restructure its debt, then the finance minister decides otherwise. The writing was on the wall. The instinct of governments around the world is to blame everyone but themselves.”

One problem with attacking sovereign ratings is that, despite a niggling lack of consensus over the precise grade, they’re usually right. A study recently published by the IMF suggested that all sovereign default since 1975 followed a year after downgraded credit ratings. Japan (see ‘Eastern Extremities’, p20), Portugal, Spain and Greece have all been downgraded this year – none of them much of a surprise.

Marc Auboin, of the WTO’s economic research and statistics division, believes problems arise when regulation – notably Basel II and its successor – stipulates that counterparty risk cannot be lower than sovereign risk. In one sense, this is a simple development issue: in sovereign restructuring, trade has preferential status. If you want a country to turn around its balance of payments, you don’t penalise trade or banks providing trade finance – which is, after all, collateralised, selfliquidating and (relatively speaking) safe.

It’s also counter-intuitive because, even when the sovereign risk is high, the counterparty can be a reliable payer – which is why default rates in Africa are not much higher than they are Europe. In short, argues Auboin, there’s often a divergence between actual risk and the perception of risk.

The problem is that perception and sentiment are closely aligned. At least when it comes to sovereigns, what is also open to criticism is the alacrity with which financial markets jump on ratings bad news. “The market will react to downward ratings because that is characteristic of financial markets,” says Wyplosz. “We have to accept that that’s the world we live in.”

So are they to blame for the US downgrade? Herd behaviour may be characteristic of financial markets, says Wyplosz, but it’s up to sovereigns to acknowledge it. If, thanks to a whopping public debt, you’re in hock to the financial markets, volatility comes with the deal.

Eastern extremities

2011 is proving a pivotal year for the two big Asian champions. Japanese banks grapple with the aftermath of the tsunami, SHAYLA WALMSLEY reports, while China’s megabanks take a great leap forward.

McKinsey, the management consultancy, projects China’s wholesale banking market to grow at more than 10 per cent annually over the next five years. At that pace, it’s set to overtake Japan as the largest in Asia by 2015.

It’s far-fetched to think Chinese banks could rival their Japanese counterparts in the short term, disaster or no disaster. But they are to be watched. Linda McLaughlin- Moore, JP Morgan’s Asia treasury managing director and soon-to-be head of international cash management, reckons that domestic competition to global banks is maturing fast.

“You already have two large global banks emerging from the region and you’re also seeing the emergence of sizeable regional banks,” she says. “China will have a big share of intra- Asia activity. Look at the rapid evolution of Japanese banks 20 years ago.”

As S&P points out, Chinese banking has several structural strengths, including operating profitability, a strong liquidity profile and adequate capitalisation.

Yet Chinese banks face rising credit risks. The loan balance grew 11.3 per cent to US$6.98tn in the first half of 2010 following 33 per cent growth in 2009. Lending to government financial vehicles carries particular risks. Chinese banks’ non-performing loan (NPL) ratio, which S&P forecasts will remain at 3-4 per cent until the end of 2011, will rise in the short term but stay below 10 per cent until the end of 2012.

In any case, China isn’t the only market with a potential NPL problem. Kristine Li, Asia banking credit at RBS, believes the Japanese NPL rate will increase as consumption weakens and a post-earthquake uncertain power supply constrains production. “The reconstruction effort is unlikely to offset the negative impact,” she says. “Rather, it will likely force the government to take on more debt. Banks will suffer in this environment.

“Japanese banks waited for almost 20 years to end deflation,” adds Li. “We expect to see loan demand to pick up on reconstruction. But as the Bank of Japan, the central bank, is pumping money in, the interest rate will stay low.”

Keita Kubota, assistant investment manager at Aberdeen Investment Management, believes regional Japanese banks will perform better than the “megabanks”.

But the disaster will also have an impact on regional banks’ lending, fees and costs. In general, Japanese banks have a low loanto- deposit ratio (LDR) of 70-80 per cent in a market culture that discourages gearing. Much of the excitement over Chinese banking is predicated on Japan failing to deal in economic terms with the earthquake crisis. At the beginning of this year, S&P cut Japan’s sovereign rating for the first time in eight years, citing the lack of a “coherent strategy” to deal with its long-held public debt. However, Moody’s issued a note in March that suggested Japan’s growth would resume in the second half of 2011, and the banking system would remain resilient.

In the meantime, according to McKinsey, to catch up, Chinese banks will have to “move a bit outside their comfort zone” to target infrastructure financing, relationship banking, better intermediation of capital flows, small and medium-sized enterprises and modernisation projects. They have a way to go.

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