The decision by Standard and Poor’s to downgrade the debt of nine Eurozone countries last week, followed by the inevitable downgrade of the Eurozone rescue fund two days later, raises important questions about the role of rating agencies and the future evolution of the crisis.
From a market perspective, the downgrading was hardly unexpected. A week before the announcement, the ten-year spread relative to German bonds was running at 1.5% for French bonds, almost 1.6% for Austrian bonds, 3.8% for Spanish bonds and 5.2% for Italian bonds. In other words, the new ratings had been already anticipated, and for quite some time, by the market rates.
There are a few reasons why credit ratings have lagged behind the market curve.
For one thing, in the current situation, the assessment of credit risk seems to be based on information that was publicly available, such as the outcome of EU meetings in December and the expectation of worsening economic and financial conditions in the Eurozone. This seems to go against ratings agencies’ professed informational advantage and their ability to provide insights ahead of markets.
For another, ratings are often characterised by some degree of stickiness. In other words, when countries are given particular ratings, they tend to retain them for reasonably long periods of time. This is because agencies value rating stability and follow a through-the-cycle approach to orientate their policy.
With this approach, agencies only change their ratings in response to substantial changes in the permanent component of the default risk and disregard short-term fluctuations. Consequently, ratings generally move slowly and might at times appear to be too generous for some borrowers or too strict for others.
Yet, the untimeliness of rating decisions may be more harmful than the downgrading itself. Ratings should provide early warning to markets about an increased risk of default. But if they systematically lag behind markets, then they fail their purpose and actually become a mechanism of amplification of financial and economic shocks.
This is what happened during the east Asian crisis in the late 1990s. Rating agencies failed to predict the emergence of the crisis and then reacted to this failure by downgrading countries very harshly, thus aggravating capital outflows and hence fuelling the crisis itself.
The Italian crossroads
In this crisis, the decisive factor will be Italy rather than Standard and Poor’s.
The desperate situation of Greece is certainly worrisome, but the country’s economy is too small to pose a conclusive threat to the entire continent. The same is true for the other Mediterranean nations (perhaps a bit less true for Spain). France is seeing its position deteriorate over time, but it is still hanging on much more solid ground than Italy.
Italy is the third-largest economy in the Eurozone, it has been under heavy speculative attack for quite some time and is now on the edge of financial distress. If its economy were to collapse, then the Eurozone would also likely collapse, possibly giving rise to a “Euro2” consisting of Germany and the solid central and northern European countries (eventually recovering Austria).
The question remains: how likely is Italy to collapse?
Even though Italy has always serviced its debt and would appear to be solvent, fears that the debt-to-GDP ratio might soon become unsustainable have been propelled by the growing bond-yield spread, persistent fiscal deficits, and historically weak economic growth.
In order to redress this critical situation, a technical government headed by Mario Monti was formed in November 2011. The government announced a two-tier strategy consisting of a fiscal austerity plan and a set of policy reforms to relaunch output and productivity growth.
While some criticised the government for being “non-elected” (even if formally supported by an elected parliament), its technical nature was expected to make it easier to undertake unpopular measures and to push reforms through the blocks and bottlenecks of Italian politics.
For now, these expectations have been only partially met. The austerity plan was eventually approved in December. It mobilised a total of about 30 billion euros, mostly through an increase in certain taxes (including some rather regressive taxes, such as the value-added tax). Expenditure cuts were relatively mild. On the bright side, however, the government was able to introduce a long-awaited reform of the pension system.
The set of other policy reforms is still under discussion and this is probably where the destiny of Italy, and therefore the euro, is being decided. The list of items that require attention is long: from the reform of labour market legislation, to the reform of the judicial system, bureaucracy and public administration, to intervention to foster competitions in various sectors.
Different governments, at various turns in the recent history of Italy, have tried to tackle one or more of these items, with generally very disappointing results.
Prolonged negotiations with unions and lobby groups have typically led to a primacy of special interests over the public good, with the result that reforms were either postponed or emptied of their most substantive contents.
The hope is that Monti’s government will not follow the same steps and be able to stick to a reform plan even at the cost of making some groups unhappy and losing consensus. The first couple of months have shown that this is indeed a difficult road to walk: while most groups do understand the need for reforms, each group would like the cost of reforms to fall on the others, which in turn creates a dangerous stalemate.
Important reforms must be extensively discussed and in this sense the government is bound to meet with the various social groups and gather their views. But this discussion should not paralyse the government. If it does, Italy will die from inaction and the funeral of the euro will be held around an Italian negotiation table.