Public Debt Downgrades Shake up Spain and the Euro Zone
On January 19 Standard & Poor’s, the credit rating agency, lowered the long-term rating for Spanish debt from the maximum of AAA to one notch below at AA+. “We believe that current financial and economic conditions have revealed structural weaknesses in the Spanish economy that are incompatible with an AAA rating,” the agency wrote.
Standard & Poor’s also noted that this measure reflects its expectations that “public financing will suffer on a par with the anticipated decline in Spain’s growth prospects.” The decision further takes into account that Spain’s response to these circumstances “could be insufficient to effectively counteract the economic and fiscal challenges” presented by the current situation.
The credit rating companies specialize in evaluating the financial strength of debt issuers, their capacity for paying over various investment periods (long and short term), and their vulnerability to potential outside economic events. Debt rated AAA+ means the issuer has minimal risk to adverse economic conditions. Debt rated AA+ applies to financial instruments deemed also to carry superior quality but that are slightly more sensitive to adverse economic events.
Fitch and Moody’s, the other two universally recognized debt-rating agencies, continue to give Spain’s long-term sovereign debt their best rating, and note they are not considering any downgrades, at least for now, though they acknowledge the downward pressures on the country’s economy and budget. Fitch forecasts that public-sector debt will reach 5% of Spain’s GDP in 2009.
So, is S&P’s decision to downgrade justified? Many experts believe it is. Juan Mascareñas, finance professor at the Complutense University of Madrid, notes, “The only thing S&P has done is to reflect what investors had already signaled: Spain’s risk of insolvency is higher than that of Germany.” Mascareñas, an expert in financial markets, recalls that in January 2008 the differential between the returns on Spain’s and Germany’s 10-year bonds was eight basis points (0.08%). By the end of 2008, that figure had reached 0.83%, and then it climbed to 113 basis points (1.13%) in January. That means when these German bonds offer an average annual return of 3.3% over the course of 10 years, for instance, the Spanish bonds must offer a minimum of 4.43% a year in order for investors to be indifferent about buying one over the other. “Both have the same terms and are issued in the same currency, so if they offer such different rates of return it is because the risk of insolvency is not the same.”
Along the same lines, Sergio R. Torassa, professor at Pompeu Fabra University in Barcelona, Spain, argues, “While it is true that the role of credit rating agencies is to measure the credit risk of issuers, it is equally certain that the bond market puts each issuer in its place.” According to Torassa, in the case of Spain, “Questions about the rapid growth in its public debt and unknowns about the sources for repayment create uncertainty.”
Torassa emphasizes that Spain’s Treasury plans to increase its public debt issues by 68.6% -- to 86.5 billion euros in 2009 -- compared with 51.3 billion euros in 2008. The additional financing is to be used by the government to mitigate the impact of the current financial crisis. “Inevitably, the debt – which will reach 54% of the GDP – must be repaid, and so will the interest. In interest alone, they will be paying about 20 billion euros this year. Where is the money for paying off this debt going to come from?” he asks, noting that the IMF forecasts it will take at least two years for economic growth to recover. More immediately, forecasts call for Spain’s GDP to drop by 1.7% in 2009 and 0.1% in 2010. “Obviously, lower growth means lower tax revenues for the budget as well as higher spending in the form of payments for the unemployed,” Torassa says.
Prime Minister José Luis Rodríguez Zapatero has tried to minimize the importance of the lower rating, and Pedro Solbes, Spain’s minister of economics and finance, notes that Spain’s rating overall continues to be high. “It’s never good news for a country to have its rating lowered because it means that it is going to pay more to investors to convince them to buy its debt,” says Altina Sebastián González, professor of finance at the Complutense University in Madrid. “Spreads provide an indicator of what investors are thinking about Spain, and the way spreads are evolving is a symptom of the fact we are not going along the right road.”
“We are no longer in position to say that we are one of the best countries in the European Union when it comes to our public finances, since in 2007 the budget surplus [of Spain] reached 2.2% of GDP, and the public debt only amounted to 36.2% of GDP,” González says. “We no longer inspire the confidence that we used to. One indicator of the slip in confidence is the current price of credit default swaps. These financial instruments enable you to cover the risk that a debt issuer will suspend its payments. At the end of 2008, the cost of covering non-payment of Spanish debt was 153 basis points, or 51% more than at the beginning of the year.”
José Ignacio Galán, who runs Ibero-American corporate social responsibility [CSR] department at the University of Salamanca, notes that on the one hand, “The current economic and financial crisis makes it clear that we need to take a fresh look at the fundamentals of the capitalist system by putting greater weight on responsibility and social justice. Beyond that, it will be necessary to establish a more rigorous and sophisticated framework for measuring risk -- one that does not have the usual defects of the agencies that currently do the ratings.” On the other hand, he notes, “There are differences in ratings between one agency and another, as well as differences in the ratings about one country and another, and within the same agencies, and these ratings are not justified by rigorous analysis.”
However, Galán emphasizes, “These factors do not preclude the need to find new ways to measure the short- and long-term costs for the Spanish economy in the future. That kind of information must be used to draw up and execute an economic policy that is more energetic, rigorous, diligent, efficient and better focused -- one that makes sense for the short, medium and long term – through a combination of coordinated policies on the national and international level.”
Impact on Corporations
The government is not the only party harmed by the lower credit ranking. Markets worry about whether S&P will now cut ratings on Spanish corporations. At the moment, there isn’t a single company in Spain that enjoys an AAA rating. Companies with highest rating in Spain -- which is AA, the third-highest rating available -- include BBVA and Santander.
Mascareñas notes, “Normally, no corporate debt has a better rating than sovereign debt, and if this sort of debt is downgraded, so is all of the corporate debt, including debt from banks, which means that if [companies] want to finance themselves with outside money they will have to pay more for it.” He adds, “Financial costs are getting higher for corporations, and if they want to compete -- not simply by raising prices for their products and services -- they will have no choice but to earn lower profits. Lower profitability leads to the flight of investors from these companies, and toward other companies that are similar but which are more profitable. Our [Spanish] companies will be worth less.”
Torassa believes there are two factors that will lead to the higher cost of corporate financing following the downgrade of Spanish government debt. First, the growing needs of governments will drive up investor returns. Second, “the higher volume of public-sector issues, coming at a time when liquidity is scarcer, will lead to a ‘crowding out’ effect. The private sector will have greater difficulty attracting financing, compared with the public sector.”
Torassa says that in the private sector, “The impact is not the same for every company.” He believes that “big companies, like the top-tier banks, can access capital markets without any need for government guarantees. Small- and mid-size companies are something else – they “suffer” more “at times of drought.”
Lower Euro-Zone Ratings
The high cost of economic stimulus packages and bank bailouts means that budget deficits across the euro region are increasing, feeding fears that governments will find it hard to repay their debts. One result: S&P reduced Greece’s bond rating to A- on January 14, and a week later downgraded Portugal’s long-term debt from AA- to A+. S&P also reduced its forecast for Ireland’s debt to “negative,” from “stable.”
These conditions have created doubts in foreign exchange markets about the future viability of the euro. Jean-Claude Trichet, president of the European Central Bank, was quick to deny such concerns on January 28 at the annual meeting of the World Economic Forum in Davos. Trichet said that the recent increases in government bond differentials in the euro zone represent “no risk” for the future of the euro. “The most important restriction is not necessarily the differentials but the way confidence is channeled. If you don’t build confidence in the long-term sustainability of fiscal policy among your own people -- your own economic stakeholders and people at home -- then they will lose confidence entirely,” he said.
“The loss of confidence hasn’t affected just Spain,” notes González. The perceived sovereign risk is higher in countries like Ireland, Belgium and Portugal, too. “Their increased sovereign risk has translated into higher prices for credit default swaps of their public debt” which are up at an annual rate of more than 50%, he says. The deterioration has been “especially important” in Ireland, since “an investor who wants to be protected from the risk of non-payment of Irish public debt must pay 285 euros a year for every 10,000 euros of the nominal value of the bonds…. Compared with past crises, the current crisis is different because of its global reach; it is not limited to any specific geographical region but it affects, to a greater or lesser degree, the entire world.” Germany and France stand out as the two European countries that have the least risk of insolvency -- the same level of risk as Japan and the United States.
According to Galán, the downgrades within the euro zone “should not, in principle, hurt the euro or the credibility of the region.” Nevertheless, he warns that “uncertainties exist about how long and how intense the crisis will be, and there are other European countries where forecasts call for a greater drop in the economy than in Spain, so everything will depend on how diligently and effectively the crisis is addressed on a global and regional level.”
Mascareñas believes that the credibility of the euro would suffer only “if the governments that contribute the ‘lion’s share’ of the euro zone’s GDP (Germany and France) were to have their debt downgraded. The downgrade in sovereign debt of countries that contribute much less to the [overall] GDP of the euro zone is not that significant. That would be like saying downgrades in the debt ratings of Ohio and Minnesota would damage the credibility of the dollar, which is really the common currency of the fifty states,” he says. Looking for a silver lining in the crisis, he adds: “Who knows? Maybe as a result of the crisis we’ll wind up taking another step forward toward deepening the [European] Union.”