Wednesday, 9 December 2009

Downgrading Greece

One of the issues not dealt with in the set of agreements that led to the creation of the Euro was a sovereign default. Probably the situation was not taken seriously at that time and it would anyway have led to some seriously uncomfortable questions.

Before the creation of the Euro, a government could issue debt in their own currency or in a foreign currency. Credit rating agencies would normally concentrate on the foreign currency debt, since debt in local currency could always be paid back by printing money. Foreign currency debt, however, has to be repaid (or rolled over) in the same currency. In order to do that one needs some foreign currency income, some government discipline and – in the case of a debt rollover -some market confidence.

With the creation of the Euro, this traditional perception was confounded by the new question: How should a default of government debt issued by a euro member country be dealt with. It is not really local currency debt, since the government has no ability to force the central bank to finance the debt. It is not really foreign currency debt either, since all government revenue and expenditure as well as a large proportion of the foreign trade is in euro.

Ratings agencies have sidestepped this issue by now referring to national debt, and presumably treating all debt as sovereign debt.

The issue remains: Would the members of the Euro-zone allow a national government to default on its debt? So far the official policy is: yes of course. In reality I believe it would be very hard to obtain an agreement to let one of the smaller nations go bankrupt, even if the default would be entirely deserved. The euro-zone members would face the hard choice: let a country default and suffer the blows to the reputation of the euro, or shoulder the bill and bail out the debtor.

My guess is that in the case of Greece or Ireland, a complex series of loan arrangements would be made. The result would effectively be a bailout, engineered to take place over 20 or 30 years. The alternative would, I guess, be too damaging to the entire idea behind a common currency as the ultimate effect might be to force out a membership country.

If this logic holds, the ratings have no relationship to the risk of default. For investors it appears to have more to do with whether Greek government debt is eligible as collateral for repo transactions with the ECB. And here it gets very interesting. Being able to use government debt as collateral is an integral part of the risk management procedures of any bank.

So far, the ECB has used ratings from the three US rating agencies, Standard & Poor's, Moody's, and Fitch. As the independence of these rating companies were shown to be fictional in the sub-prime disaster, several politicians called for the creation of a European rating agency. One could guess that in case the rating agencies were to rate Greek debt sufficiently low that it under the existing definition would not any longer be eligible, the rules would be changed, and a serious effort would be made in order to establish some kind of European rating.

Relying on the three US ratings agencies has long been a thorn in the side of both the French and German governments, since they consider the agencies as potential political instruments for the US government. If a rating would directly lead to a major rearrangement inside the EU or the ECB, my guess is that this issue would be addressed very quickly and most likely, to the detriment of the rating agencies.

So what is all the noise about? Observing that the risk premium in the bond markets had fallen to the lowest since early 2007, I believe that we are heading for a period of general reassessment of the price of risk. But that is a completely different question.



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