Credit rating agencies are busy downgrading sovereign bonds, from Greece through Spain to the United Kingdom and the United States and Japan. Of course, when there are crises, economic downturns, high debt-to-GDP ratios and political gridlock regarding how much taxes should be raised versus how much spending can be cut, a reappraisal of sovereign bonds becomes mandatory. What is troubling, however, is the fact that the bonds of countries like Greece are being downgraded to junk status. Junk status means that the budget fundamentals and the expected budget fundamentals of the country are so weak that buying the country’s bonds is an ultra-high-risk thing. How damaged can a country’s economy get, how damaged can its growth prospects get, how limited are its options for raising taxes on its successful economic entities and how limited are its options regarding spending cuts that the fiscal future of the country is basically in almost irretrievable trouble ?
For example, if the GDP of a country contracts by, say, 1% in a year in a recession, how much does the central government revenue contract ? And how much extra government expenditure becomes necessary due to additional unemployment benefits payments and bailouts ? Let me take some numbers from Greece. The “ Budget 2011 Draft Law “ document from the Hellenic Ministry of Finance website has the following figures. The nominal growth rate of GDP in 2009 was -1.1%. Or a 1.1% contraction, to put it differently. The deficit went from 22.4 billion Euros in 2008 to 36.2 billion Euros in 2009. In 2010, the nominal growth rate was -1.3%, that is, a contraction of 1.3%. The deficit went from 36.2 billion Euros in 2009 to 21.9 billion Euros in 2010. If one considers 2008 to 2011 as the crisis period, the document shows that the government debt went from about 110% of GDP to about 145% of GDP. The document outlines a plan whereby, with a combination of tax increases and spending decreases, the debt to GDP ratio will stabilize at around 150% of GDP. But these kinds of numbers are increasingly becoming commonplace. Japan’s debt to GDP ratio is around 200%. Its low tax and high infrastructure spending policies have not yielded good results. When one includes the stakes that the United States government has taken up in beleaguered entities, its debt obligations add up to more than 100% of GDP, and are likely to increase to 150% of GDP or even more by 2025. So, what is it about Greece that makes its bonds junk while Japan and the United States receive a less severe or no downgrading ? Japan and the United States have their own structural problems too. For example, the United States has a long-term structural problem of capital flight to China and other countries. India has a sluggish agricultural sector that poses serious human welfare challenges for the country. As for reliance on foreign capital inflows, it has been a recurrent feature of the United States economy also.
Portugal had GDP growth of 0% in 2008 and -2.6% in 2009. The government debt, which was around a stable 65% of GDP till 2008, increased to 76% of GDP in 2009 and 82% of GDP in 2010. I have not come across stabilization plans regarding Portugal, but once again, given the kind of debt-to-GDP ratio that some of the bigger economies are running, it is difficult to understand why fears of default are being raised about Portugal so quickly.
For Spain, the debt-to-GDP ratio increased from 40% in 2008 to 53% in 2009 to 60% in 2010. It is projected to be around 75% by 2016. Once again, it is going to be above EMU stipulations of good fiscal conduct, but to talk about default at these levels of debt-to-GDP may just be gratuitous scaremongering. It can set its own self-fulfilling prophecies in motion. In other words, if credit rating agencies give a more negative rating to a country’s bonds compared to other countries with worse macro-sheets, the country will find it more difficult to raise debt and has to pay exorbitant interest rates. Too much of gratuitous scaremongering can even constrain the government’s ability to borrow so much that it may have to resort to EFSF and IMF loans with strict conditions. Therefore, this kind of scaremongering by credit rating agencies is likely to set in motion spirals that can lead a country’s finances to ruination when it could have been stabilized more easily with a bit of belt-tightening and a pragmatic approach to taxation and spending.
In many ways, a government bond is like a stock when it comes to the psychology of market valuation. If everybody is buying it, the value can remain high despite weak fundamentals. Vague considerations having nothing to do with fundamentals can result in one government’s bonds selling with lower interest rates, but another’s selling with junk rates. Non-uniform standards of credit rating for smaller and bigger economies can lead to an intensification of these irrational elements in the market’s pricing of government bonds.
Economies and countries, and especially economies and countries that follow pragmatic and practical economic policies as opposed to ideologically motivated and hidebound policies, are likely to be able to make the adjustments necessary to recover from recessions without inordinate delay. The United States is one case where intransigent lines of thinking make it difficult to reduce deficits without causing severe disruptions to the public’s welfare. The Greek plan, on the other hand, has displayed more flexibility and pragmatism and common-sense.
The information about the economy and the finances are public information. Each institutional investor and each individual investor that is interested in buying Greek or Portuguese or Irish government bonds can do its own research about the sustainability of the government’s public finances and the likely course of its taxation and spending trajectory and about the risk of default. How much importance should one attach to the ratings done by credit rating agencies ? Should institutional investors factor in these sovereign credit ratings while deciding whether or not to buy the bonds of a particular government ? It seems there is a lack of uniformity in the ratings being given by rating agencies like Fitch or S&P or Moody. Unnecessary scaremongering and unnecessary downward spirals set in motion in a country like Spain, for example, can easily lead to contagion effects for Europe, and thereafter for the world.
by C. Jayant Praharaj
For example, if the GDP of a country contracts by, say, 1% in a year in a recession, how much does the central government revenue contract ? And how much extra government expenditure becomes necessary due to additional unemployment benefits payments and bailouts ? Let me take some numbers from Greece. The “ Budget 2011 Draft Law “ document from the Hellenic Ministry of Finance website has the following figures. The nominal growth rate of GDP in 2009 was -1.1%. Or a 1.1% contraction, to put it differently. The deficit went from 22.4 billion Euros in 2008 to 36.2 billion Euros in 2009. In 2010, the nominal growth rate was -1.3%, that is, a contraction of 1.3%. The deficit went from 36.2 billion Euros in 2009 to 21.9 billion Euros in 2010. If one considers 2008 to 2011 as the crisis period, the document shows that the government debt went from about 110% of GDP to about 145% of GDP. The document outlines a plan whereby, with a combination of tax increases and spending decreases, the debt to GDP ratio will stabilize at around 150% of GDP. But these kinds of numbers are increasingly becoming commonplace. Japan’s debt to GDP ratio is around 200%. Its low tax and high infrastructure spending policies have not yielded good results. When one includes the stakes that the United States government has taken up in beleaguered entities, its debt obligations add up to more than 100% of GDP, and are likely to increase to 150% of GDP or even more by 2025. So, what is it about Greece that makes its bonds junk while Japan and the United States receive a less severe or no downgrading ? Japan and the United States have their own structural problems too. For example, the United States has a long-term structural problem of capital flight to China and other countries. India has a sluggish agricultural sector that poses serious human welfare challenges for the country. As for reliance on foreign capital inflows, it has been a recurrent feature of the United States economy also.
Portugal had GDP growth of 0% in 2008 and -2.6% in 2009. The government debt, which was around a stable 65% of GDP till 2008, increased to 76% of GDP in 2009 and 82% of GDP in 2010. I have not come across stabilization plans regarding Portugal, but once again, given the kind of debt-to-GDP ratio that some of the bigger economies are running, it is difficult to understand why fears of default are being raised about Portugal so quickly.
For Spain, the debt-to-GDP ratio increased from 40% in 2008 to 53% in 2009 to 60% in 2010. It is projected to be around 75% by 2016. Once again, it is going to be above EMU stipulations of good fiscal conduct, but to talk about default at these levels of debt-to-GDP may just be gratuitous scaremongering. It can set its own self-fulfilling prophecies in motion. In other words, if credit rating agencies give a more negative rating to a country’s bonds compared to other countries with worse macro-sheets, the country will find it more difficult to raise debt and has to pay exorbitant interest rates. Too much of gratuitous scaremongering can even constrain the government’s ability to borrow so much that it may have to resort to EFSF and IMF loans with strict conditions. Therefore, this kind of scaremongering by credit rating agencies is likely to set in motion spirals that can lead a country’s finances to ruination when it could have been stabilized more easily with a bit of belt-tightening and a pragmatic approach to taxation and spending.
In many ways, a government bond is like a stock when it comes to the psychology of market valuation. If everybody is buying it, the value can remain high despite weak fundamentals. Vague considerations having nothing to do with fundamentals can result in one government’s bonds selling with lower interest rates, but another’s selling with junk rates. Non-uniform standards of credit rating for smaller and bigger economies can lead to an intensification of these irrational elements in the market’s pricing of government bonds.
Economies and countries, and especially economies and countries that follow pragmatic and practical economic policies as opposed to ideologically motivated and hidebound policies, are likely to be able to make the adjustments necessary to recover from recessions without inordinate delay. The United States is one case where intransigent lines of thinking make it difficult to reduce deficits without causing severe disruptions to the public’s welfare. The Greek plan, on the other hand, has displayed more flexibility and pragmatism and common-sense.
The information about the economy and the finances are public information. Each institutional investor and each individual investor that is interested in buying Greek or Portuguese or Irish government bonds can do its own research about the sustainability of the government’s public finances and the likely course of its taxation and spending trajectory and about the risk of default. How much importance should one attach to the ratings done by credit rating agencies ? Should institutional investors factor in these sovereign credit ratings while deciding whether or not to buy the bonds of a particular government ? It seems there is a lack of uniformity in the ratings being given by rating agencies like Fitch or S&P or Moody. Unnecessary scaremongering and unnecessary downward spirals set in motion in a country like Spain, for example, can easily lead to contagion effects for Europe, and thereafter for the world.
by C. Jayant Praharaj