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LETTER FROM EUROPE

European debts and American rating agencies

Chaklader Mahboob-ul Alam
A few days ago, Standard and Poor's, one of the three largest American rating agencies, stripped France and Austria of their AAA ratings. Then it followed up by downgrading not only the debts of several other European countries but also the European Stability Facility, which is in effect the bailout fund for these ailing countries.
We do not know exacdy what criteria are used by the American rating agencies to arrive at their conclusions but what we know for sure is that their decisions have severe repercussions on the economies of the debt-ridden countries, making it harder for them to borrow money and when they can they are forced to do so at very high interest rates. At the same time, they are condemned to a death spiral of austerity measures like raising taxes, cutting public expenditure, lowering salaries and wages, etc. with a view to balancing their budgets. Unfortunately, these measures often stifle their economic growth, making it even harder for them to meet their debt obligations.
Debt level is usually measured as a percentage of gross domestic product. According to conventional wisdom, the higher it is the greater the danger is of a possible default. But is this a fair measure? Should the investors pay so much attention to opinions of these rating agencies?
Before we enter into a discussion on this subject let us, first of all, get some of the basics straight because after reading a number of opinion pieces in various newspapers and journals, I have come to realise that there is a considerable confusion over the meaning of some of the terms used in these articles.
A national budget is no longer a simple statement of estimated revenues and expenditures for a fiscal year. After the advent of Keynesian economics, it is also used as an instrument for regulating the economy as a whole with particular regard to general level of prices and • employment. In an inflationary situation,1 the budget is used to create a surplus of income over expenditure with the objective of withdrawing excess purchasing power from the economy, thereby damping down a rising level of prices. On the other hand, in a recession, a policy of deficit spending is undertaken to give a reflationary impetus to stimulate the economy. The purpose is to increase aggregate demand and create new jobs.
The budget deficit of a fiscal year is financed by borrowings. The sum total of these accumulated borrowings at any one time is known as the national debt.
Although over the years, America's "nationally recognised" rating agencies like S&P's and Moody's have acquired a quasi-regulatory status, they are not government agencies. They provide an independent opinion on the creditworthiness of a country or an institution to the prospective investors. In the United States "their judgments are hardwired into rules governing banks, insurers and funds." Their power stems from this peculiar status.
We must accept the fact that whatever their source of power is, they exercise an undue influence over the debt market across the world. So much so, that they have often been accused of manipulating the data for speculative gains and/or for destroying the euro.
Now, we can go back to the core issues. Should the size of the debt be the only criterion for deciding whether a country is creditworthy or not? Should the investors pay so much attention to the opinions of these rating agencies?
Of course, the size matters, but there are other factors which matter as well. While deciding on
the creditworthiness of a country, the rating agencies tend to look at the total debt level of the country without making distinction between the amount of federal debt and the regional and local government debts. Under normal circumstances the federal debt is more secure than the regional and local government debts because of the simple reason that the federal government has greater power to alter the tax system and raise extra revenues.
As in most cases, the federal government usually bails out the regional governments, it is also important to know how much control is exercised by the federal government over expenditures incurred by the regional governments. The newly elected Spanish government has imposed severe restrictions on the profligate spending habits of the regional governments. The finance minister has even threatened to bring criminal charges against the regional politicians and their officers who spend more than what is authorised under the budget.
At the same time it is also important to know how much of the debt is owned by the foreigners and how much is held internally. The greater the percentage of the debt owned by the foreigners, the greater the danger is of a default. As soon as there are signs of a looming crisis, foreign investors try to get rid of debts held by them causing interest rates to rise, thus making it more difficult for the country in question to meet its debt obligations. For example, Portugal is more likely to default because 80% of its debt is foreign-owned.
Japan's total debt has reached an astronomical figure. It is over 200% of the GDP. Yet, it is unlikely to default because the Japanese are great savers and they own nearly 93% of the debt. Only 7% is held outside of its borders. Therefore, most of the Japanese government debt is owed to the Japanese people themselves.
Going further along this path I should point out that government debt levels alone do not tell the full story either. Runaway private sector debt may create havoc in the financial system and consequently affect its creditworthiness in a negative way. In Ireland, when the real estate bubble burst, most of the private sector debt turned out to be bad. In order to avoid a total collapse of the financial system, the government had to step in and rescue the banks. Unfortunately, in the process, the government itself went broke.
I appreciate the fact that judging the creditworthiness of a country is not an easy matter. That is why it cannot be done in a casual manner. In Europe, most politicians and bankers are wary of the unsolicited verdicts passed by the American rating agencies on the creditworthiness of the EU countries. They also feel that they exercise an undue influence over the debt market and that their hasty conclusions often create huge problems to the countries on which they pass unsolicited judgments.
Angela Merkel, the German Chancellor has threatened to establish one or more European credit rating agencies. To be frank, the track record of these rating agencies is not at all unblemished. After all, they failed miserably in the cases of Enron in 2001 and Lehman Brothers and AIG in 2008, and in a way are partially responsible for the current global financial crisis.
Actually, they are not very popular in the United States either. The G20 Financial Stability Board and America's Dodd-Frank act have called for major changes in this field to reduce the role of these somewhat shady organisations. Let us hope that these changes come into effect in the near future.
The writer is an officer of the Order of Queen Isabel I of Spain and a life member of the Institute of Chartered Accountants in England and Wales.