Jul 21 2011

How (un)justified are the decisions of credit rating agencies?

by Costas Milas* and Theodore Panagiotidis**

Following Standard & Poor’s decision to brand Greece with the world’s lowest credit rating and Moody’s decision to announce a 4-notch downgrade of Portugal’s debt, and then downgrade Ireland to junk status, European policymakers reiterated their growing dissatisfaction with credit rating agencies.  European Commissioner Michel Barnier noted (on the 11th of July): ‘Every day we are seeing the impact [sovereign ratings] have on countries: rising costs of credit, weakening of states, and possible contagion effects on neighbouring economies’.

When markets are as jumpy as they appear today, the game blame does not help.  In an attempt to provide a careful assessment of credit rating decisions, we note that credit rating agencies cite a number of factors (such as per capita GDP, GDP growth rate, governance and public finance trends) but provide little guidance as to the relative weights assigned to each factor.  Yet, based on modelling techniques, Afonso et al 2011 has concluded that once the above factors are taken into account, a rather large number (up to 40%) of credit rating decisions remains unexplained.  Amongst others, academic work has reached the following conclusions:

First, an annual rise in gross government debt (as % of GDP) by 15 percentage points justifies half a notch downgrade in a country’s credit rating.  Second, an annual drop in government deficit (as % of GDP) by 3 percentage points justifies a quarter of a notch upgrade in a country’s credit rating.  Third, a large drop in government effectiveness (to deal, for instance, with tax evasion) justifies half a notch downgrade.  Fourth, European Union membership, which improves a country’s credibility through continuous monitoring of its economic policies, enjoys a ‘premium’ of 2 notches.

According to European Commission estimates, Greek government debt is expected to rise by some 15 percentage points (from 142.8% of GDP in 2010 to 157.7% of GDP in 2011) whereas Portuguese government debt is expected to rise by some 9 percentage points (from 93% in 2010 to 101.7% in 2011). Greek government deficit is projected to shrink by some 3 percentage points (from 10.5% of GDP in 2010 to 7.6% of GDP in 2011).  Portuguese government deficit is also projected to shrink by some 3 percentage points (from 9.1% in 2010 to 5.9% in 2011). Irish gross debt is expected to rise by some 16 percentage points (from 96.2% of GDP in 2010 to 112% of GDP in 2011). However, Irish government deficit is expected to shrink by 22 percentage points (from 32.4% of GDP in 2010 to 10.5% of GDP in 2011). Based on these fiscal developments, and despite the large drop in Greek and Portuguese government effectiveness measured by World Bank indicators (which EU and IMF officials are trying to tackle by offering expert advice), it is clear that the latest dramatic downgrades appear somewhat unjustifiable.  That said, the ongoing recession in Greece and Portugal risks undermining the fiscal projections above, but even so, only extremely large deviations would justify the latest downgrades.

Finally, assigning Greece with the world’s lowest credit rating appears inconsistent with the credit advantage European Union countries enjoy relative to (non-EU) developing countries.  The very loss of Greece’s 2-notch advantage raises the issue of whether credit rating agencies take Greece’s exit from the single currency bloc for granted, but are unwilling, on self-fulfilling prophecy grounds, to admit so openly.  To increase transparency and avoid misinterpretation, credit rating agencies should move urgently towards providing detailed guidance on the relative weights of each factor affecting their decisions.

*Costas Milas, Professor of Financial Economics, Keele School of Management, Keele University.
**Theodore Panagiotidis, Hellenic Observatory Visiting Fellow; Associate Professor, Department of Economics, University of Macedonia.
Afonso, A., P. Gomes and P. Rother (2011) Short- and long-run determinants of sovereign debt credit ratings, International Journal of Finance and Economics 16, 1-15.
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3 Responses to How (un)justified are the decisions of credit rating agencies?

  1. Miranda Xafa says:

    The latest round of downgrades for Greece, Portugal and Irelnd were triggered by the expectation of “haircuts” imposed on bondholders. Historical relationships between credit ratings and economic fundamentals, including Euroarea membership, do not take this eventuality into account because of the then-prevailing perception that there is no credit risk in the Euro area (hence Greece’s 30bps credit spread back in the 2000’s). It is thus not possible to conclude that “the latest dramatic downgrades appear somewhat unjustifiable”, particularly in light of the fact that Greece will be downgraded further to SD when the debt restructuring agreed in principle at the July 21 summit goes into effect.

    • Theodore Panagiotidis says:

      Thanks for this.
      The article mentioned above demonstrates that by employing historical data you can not justify past decisions let alone current ones.
      Greek economic fundamentals were not that different two years ago when the ratings were completely different.
      Expectations are affected by the ratings so this might be a case of a self-fulfilling prophecy.

  2. Nikolaos Zahariadis says:

    While important, I don’t think the answer (or even an answer) to Greece’s predicament will come by looking strictly at external (non-Greek) factors. I believe the answer lies domestically where the government currently has considerably more control over outcomes than it does over her EU allies (some leverage there) or world markets and credit agencies (no leverage there whatsoever). Hence the point is to remind the prime minister (as the one who is ultimately responsible) that perceptions (be it those of agencies, allies or Greek voters) are formed largely based on what he does and not whether agency ratings are justifiable or not (about which he can do nothing anyways).

    His current policy of balancing interests within his own party is an absolute disaster when it is also accompanied by the urgency of the situation and the direction change must follow. Rather his currently strategy risks falling into the “Gorbachev syndrome,” that of balancing the various groups within his own party without a compass. Balance in politics is never neutral (hence paradoxically a misnomer) in the sense that the needed change must come by favoring structural reform and minimizing opposition. Instead we have a government weakened by its own people (ministers, MPs and others who bicker incessantly) more than the political cost that inevitably comes from governance. I am not talking about disagreements from reasonable people; I am talking about contempt in public without consequences.

    And we all know what happened to Gorbachev and his balancing act. He was popular outside his country and treated with contempt inside it. I don’t believe Greece faces the magnitude of the USSR’s problems, but it is instructive to draw lessons from (unsuccessful) reforms elsewhere.

    All this will go a long way toward changing perceptions and ultimately help revise favorably those of credit agencies.
    Governance with conviction and consequences

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