Five ratings myths [CINKCIARZ.PL ANALYSIS]
For the past few months we have had broad discussions regarding the ratings. There appeared to be many myths regarding the general reasons for verifying a given country's loan credibility, as well as future actions from the rating agencies and their hypothetical impact on the economy. Those most common are presented by Marcin Lipka, Cinkciarz.pl analyst.
1. Positive indexes equal high ratings
Loan credibility is, to a significant degree, dependent on factors such as economic growth, the relation between debt and the GDP, as well as the costs of its service. Authorities find it easier to regulate obligations to creditors when the economy is growing and the debt is low. Moreover, these countries are more resistant to the global business cycle shocks. However, the countries’ current or future economic condition are not sufficient enough to sustain or upgrade the rating.
All three main agencies (Standard & Poor’s, Fitch and Moody’s) emphasize that a rating is “an ability and will” to regulate financial obligations to commercial creditors. As an example, Moody’s shows the case of Ecuador. In 2008 there was, “no political will to repay the debt,” and the country was considered insolvent.
Ecuador went bankrupt eight years ago, despite that the relation between the debt and the GDP was approximately 20%. Since the beginning of the year 2000, the country had a budget surplus. Moreover, the annual economic growth was within the range of 4-6% shortly before insolvency had been announced. However, President Rafael Correra of Ecuador claimed that the foreign debt is “against the law.” Additionally, he called the creditors “true monsters.” As a result, the country received the SD rating (selectively defaulted on some obligations) by Standard & Poor's (S&P).
2. Rating downgrade: catastrophe vs. calm
A downgrade of loan credibility is certainly not a positive event. However, its effects in the case of Poland have been relatively mild so far. This is mostly because of a neutral external situation.
One of the most dramatic examples of the rating downgrade's impact on a local currency, is South Korea. Due to the progressive Asian crisis, Standard & Poor's downgraded the Korean loan credibility by ten ranks (from AA- to B+) during the fourth quarter of 1997. The downgrade was from a strong investment grade to a highly speculative grade. At the same time, the dollar's exchange rate increased from approximately 900 won to 2000 won.
Moreover, it was not until 2015 that South Korea returned to the level it was before the Asian crisis. This also goes to show how long a sudden breakdown of loan credibility burdens the debtor.
3. Downgrade costs: millions or billions?
It is extremely difficult to make a precise estimation of the future downgrade costs. This is mainly because it is dependent on external situations, as well as the future condition of the Polish economy. However, we may compare the differences between the debt service for the countries with different ratings.
To do so, we will select German bonds (their credibility is at the highest possible level), Polish bonds (six ranks lower than the German bonds), and Spanish bonds (seven ranks lower than the German bonds). In order to show changes of hypothetical cost for the national budget in the best way possible, we will compare profitability of 5-year bonds that are denominated in the euro.
The difference is approximately 0.7% between the Polish and the German bonds, and approximately 0.85% between the German and the Spanish. In order to make things simpler, we may assume that each rank is approximately 0.10-0.15%. Since the Polish gross loan needs (new debt, as well as purchase of bonds from previous years) were at the level of 182.7 billion zloty in 2016, each 0.1% equals approximately 200 million PLN higher financing costs in the year on year relation.
However, if an internal or external crisis appears, these calculations will not differ significantly. At the time of anxieties over the condition of the euro zone in 2011, the profitability of the euro-denominated Polish 5-year treasury bonds increased from 3.5% to 4.7%. On the other hand, the Spanish bonds increased from 3.5% to 7.6% in 2012, during a crisis in Spain. This causes the budget costs to grow rapidly, which is a burden for the future loan credibility.
4. Controversial in Poland only
Controversies regarding decisions of the rating agencies have been appearing since the beginning of their activity. It can be seen especially in the case of evaluation of the given country's loan credibility. This is because it basically concerns every citizen. Additionally, sometimes the tensions are being increased by the fact that the main agencies were founded in the United States.
Russia has claimed many times that a downgrade of its rating was based on political matters. In 2011, the European Commission was planning to authorize the European Securities and Market Authorities (ESMA) to “temporary limit or forbid to issue ratings in exceptional cases”.
Standard & Poor's downgraded the American rating for the first time in 2011. This coincided with the local election campaigns. As cited by the Washington Post, Mitt Romney, the republican candidate for president at that time said that, “a downgrade by Standard & Poor's is a deeply disturbing sign of our country's downfall during Obama's presidency”.
5. Decrease in perspective equals an unavoidable downgrade
Poland received a negative perspective of loan credibility from Standard & Poor's, as well as from Moody's. According to the S&P announcement, this means that, “a probability of downgrade within the next twenty-four months is one against three, if credibility of the monetary policy wears-off, or public finance deteriorates beyond our current expectations”.
However, even though the fiscal situation remains tense, there are no serious signals for the GDP deficit to significantly exceed the level of 3.2% in 2016, as well as 3.0% in 2017 for the time being. Moreover, economists are not convinced that the credibility of the monetary policy is endangered. Thus, the chances for a downgrade on July 1st are minor.
On the other hand, the announcement from Moody's regarding Poland does not estimate the probability of downgrade. However, the “Rating Symbols and Definition” document states that loan estimation hits the observation list during one year in approximately 50% of cases of the rating's negative perspective. If a country is on the observation list, this means that its rating will be changed within 180 days in more than half of the cases.
Just like Standard & Poor's, Moody's mentions the reasons that may contribute to a decrease in loan credibility. In the case of Poland, these reasons are a deterioration of the fiscal situation, a clear disturbance of investment climate and “extended conflict between the government and Constitution Tribunal, which leads to a clear capital outflow that may cause pressure on the rating as well.”
Thus, a downgrade is not a foregone conclusion. It is worth noting that when it comes to countries dealing with a recession (Brazil), or countries with significantly lower incomes caused by a decrease in raw materials prices (Russia), a rating's negative perspective translated to actual depreciation quite rapidly. Getting back to Poland, if the economic growth is stable and the external situations are neutral, the possibility of a negative scenario should significantly decrease.
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