The Cedar Lounge Revolution

Ratings agencies… July 10, 2009

What of the latest from the fabulous ratings agencies, those heroes who year after year gave the all-clear to financial institutions, and more importantly their policies such as the use of sub-prime lending, who later… er… collapsed.

Not only but also they comprehensively failed to anticipate the further collapse of the Icelandic economy (in fairness that was Standard & Poors).

All that as a given, what then of their prognosis for the future of this island, or at least a part of it?

Moody’s has cut Ireland’s government bond rating to Aa1 from AAA, making it the last of the three main agencies to strip Ireland of its top credit rating.

It’s odd though, because…

“Moody’s concluded that there was a case for only a moderate rating downgrade at this stage in light of the decisiveness of the policy response as well as the government’s strong balance sheet position prior to the crisis,” it said.

Hmmm… strong balance sheet position? Decisiveness of policy response. Only a moderate rating downgrade… This doesn’t quite sound like the fiscopalypse (try saying that quickly… go on, give it a try) we’ve seen trumpeted here there and everywhere. How one earth could they possibly take away that sort of a reading of our situation?

And how then to explain Moody’s colleagues in the ratings game and their analyses?

Standard & Poor’s cut its rating last month for the second time this year to AA, while Fitch has downgraded Ireland by one notch to AA+ so far.

Well, you won’t find it in the Irish Times piece which then continues…

The euro hit the day’s low against the dollar and the spread between Irish and German government bonds widened after Moody’s cut the rating and said the outlook was negative.

Which is curious given the ‘strong’, ‘decisive’ and ‘moderate’ comments earlier. So both negative and strong etc…

If one cares to mosey across to the wiki page on Moody’s one will discover the ratings schema…reflect both the likelihood of default and the probability of a financial loss suffered in the event of default.

And what are these ratings like?

Investment grade
Aaa

Obligations rated Aaa are judged to be of the highest quality, with the “smallest degree of risk”.[1]

Aa1, Aa2, Aa3

Obligations rated Aa are judged to be of high quality and are subject to very low credit risk, but “their susceptibility to long-term risks appears somewhat greater”.[1]

A1 (Czech Republic as of February, Estonia as of April, Romania in May 2008), A2 (Poland as of February), A3 (Lithuania as of April)

Obligations rated A are considered upper-medium grade and are subject to low credit risk, but that have elements “present that suggest a susceptibility to impairment over the long term”.

Baa1 (Iceland as of February, Hungary as of March), Baa2, Baa3 (Latvia, as of April – worst economic contraction in the EU in the fourth quarter of 08, Bulgaria as of February)

Obligations rated Baa are subject to moderate credit risk. They are considered medium-grade and as such “protective elements may be lacking or may be characteristically unreliable”.

The reality is, though, that from the point of view of the ratings agencies AA1 isn’t great. It’s not great at all, and while it is true that despite everything that has happened, global financial crisis, collapse of tax revenues and rising unemployment, partial meltdown of our banking sector and NAMA, despite all these we remain at the second highest rating with Moody’s, let’s not get overly happy with that truth. The first step down the rung is slippy, so to speak.

By way of comparison let’s consider Speculative grade, or how low could we go?:

Speculative grade (Also known as High Yield or ‘Junk’)

Ba1 (Brazil, 2007), Ba2, Ba3 (Turkey as of February)

Obligations rated Ba are judged to have “questionable credit quality.”[1]

B1, B2 (Dominican Republic 2007), B3

Obligations rated B are considered speculative and are subject to high credit risk, and have “generally poor credit quality.”[1]

Caa1 (Belize, 2007, Cuba 1999), Caa2, Caa3

Obligations rated Caa are judged to be of poor standing and are subject to very high credit risk, and have “extremely poor credit quality. Such banks may be in default…”[1]

Ca

Obligations rated Ca are highly speculative and are “usually in default on their deposit obligations”.[1]

C

Obligations rated C are the lowest rated class of bonds and are typically in default, and “potential recovery values are low”.

Yeah, we really don’t want to be down there with the bottom feeders – or to be more accurate on the next level beneath them. No doubt about that at all. And whether one considers the agencies an appropriate means of determining our ability to provide assessments of bond ratings we are as it stands stuck with them to some degree – particularly those of us who believe that borrowing is central to any recovery. I certainly wouldn’t be glib about the reality that such ratings even such relatively small movement does make the argument for borrowings more difficult.

Their assessments are far from uncontroversial, and one look at the wiki entry will raise eyebrows as regards certain actions and reports.

In that light note the thoughts of centrist Democrat Matt Miller who noted on KCRW’s Left, Right and Centre on the 19th of June that…

We ought to take seriously the ratings agencies who were totally in bed and driving their own earnings by essentially taking a fall on pumping up the ratings of these securities they were at the heart of this mess and which led everybody to buy these with some sense of confidence – or at least cover their rear ends – because they were supposed to be AAA rated…

And again, last weekend…

Matt Miller:… the way the credit rating agencies… which were given by the government little specialised oligopolies essentially and that became the marker that everyone else covered their rear ends…and it was sort of if you had a AAA rating it was okay for all these institutions to hold all this crappy debt… and it’s not even being touched in the regulatory reform

Ariane Huffington: That is a major thing, that they’re letting the ratings agencies continue to be funded in the same way by the very people they’re supposed to be monitoring…

It’s heartening to know that the way they’re viewing these matters is different to the way they did last year… for the EU has agreed new rules that apply to credit-rating agencies. Thing is those rules come into effect next year, although the rating agencies claim they’re already implementing them.

Still, it’s also interesting to see where others further afield lie on the scale, so for Moody’s currently Japan and Hong Kong are on Aa2.

Here though is an interesting paragraph from Moody’s analysis of Aaa governments dating from last February…

Government activism compounds exposure to medium-term economic vitality
The effect of financial stability operations and fiscal stimuli is more subtle. Since the autumn of 2008, governments have repeatedly interposed their balance sheets to shelter the private sector from liquidity risk and to prop up the capital base of banks. These financial operations have resulted in an increase in financial and other liabilities (government debt) that is more or less matched by an increase in assets (equity ownership in, or loans to, banks and other institutions, potentially ownership of ‘toxic’ assets, etc.). Initially, there is no material net impact on the government’s net worth.

However, these operations create a mismatch between the financial characteristics of the assets and liabilities of the government, exposing it to a fiscal loss – or gain – over time. What will determine the size and sign of the net impact on government net worth is the performance of the assets, ultimately linked to the performance of the whole economy.

The same effect applies to contingent liabilities arising from the guarantees that governments are granting liberally to borrowing undertaken by banks and now other institutions. The eventual impact of these guarantees on the government’s balance sheet depends on the financial performance of the guaranteed entities and therefore, by extension, on the macroeconomic performance of the whole economy.

Through financial operations and the expansion of their balance sheets, governments have therefore
compounded their dependence on the medium-term ability of their economies to regenerate and grow out of the current recession.

Similar reasoning can be applied to the successive fiscal stimulus plans unveiled by governments. These plans entail a direct increase in government primary deficits, and therefore also an increase in government debt. This has no direct counterparty on the asset side of the balance sheet. If, however, these plans do succeed in preserving the productive potential of the economy (the original aim of Keynesian policy was to do so through government investment), then fiscal stimuli would enhance the government’s main asset, the power to tax, and thus generate the resources to cover the increase in debt. Fiscal stimuli, therefore, again compound the exposure of government debt affordability to the underlying vitality and regeneration capability of the economy.

And here is more…

The adjustment capacity of governments: assessing “fiscal space”
The extent to which a government can generate fiscal margin for manoeuvre can be summarized in two simple questions:

By how much can government (further) raise tax pressure on the economy?

By how much can government (further) cut expenditure?

The answers provide the range by which a government should be able to improve its primary balance when the crisis abates. In each case, the assessment depends on the current level of taxation/expenditure, and the tolerance of the society for higher tax pressure or lower provision of public services. France and Germany have a similarly (high) tolerance for taxation, but as Germany’s current tax pressure of 44% is lower than France’s 50%, its ability to generate resources from a higher tax rate should – all other factors being equal – be higher. Historical experience is a guide in this case, but not proof of future capability. A government that has been able to generate large primary surpluses in the past, especially in a period of not particularly buoyant economic growth, is likely to be able to do so again (Canada, Finland, Sweden, etc.). But that may be less true if either its past fiscal performance owed to structural factors was eroded by the crisis (such as high growth fuelled by rising household indebtedness) or if new structural influences materialised (such as ageing, a trend of material significance in most advanced economies, or the lengthy absence of global trade stimuli) that create new constraints in coming years and decades. Against this background, we do not aim to provide accurate measures of adjustment capacity for each
government, but rather a credible order of magnitude.
This is achieved by scoring the margin for increasing revenues and reducing expenditure on a five-notch scale. We then combine the scores to derive a total adjustment capacity for the government’s primary balance. The resulting score represents a broad estimate of the fiscal space that a government might be able to generate when the crisis abates, on condition that the economy’s productive capacity is not permanently dented. A government with a low adjustment capacity may only be able to improve its primary balance by a couple of percentage points of GDP, while a government with a very high adjustment capacity should be able to improve structurally its primary balance by at least 5 percentage points of GDP.

Interesting in the figure that comes with this paragraph the ability to raise tax or cut expenditure can be either medium to high and set against Tax Pressure and Government Spending/GDP to arrive at a Fiscal adjustment capacity rating. So, for example, Austria has a Tax pressure of 48, has a Medium ability to tax further, has a Government spending/GDP of 48 and a Medium Ability to cut expenditure further. It’s Fiscal Adjustment capacity is therefore Medium. Of the states rated only the US comes lower than us on Tax pressure at 33 which is rated Medium. And on Government spending/GDP we are at 40 which is below the median and the average and is also rated Medium, which gives us an overall Medium. This isn’t great.

Another factor that impacts on governments’ adjustment capacity in a crisis environment is the degree of national cohesion. In countries that benefit from a very high degree of social and political cohesion, and strong allegiance to the central government, people can be expected to be more willing to make an additional effort to support their government. Where that level of cohesion is weaker, a higher tax pressure is more likely to be met with resistance, emigration of workers or tax evasion. There are numerous historical examples of societies where substantial borrowing in times of national emergency (including wars) have been first raised and then paid off through popular support. To some extent, we therefore give ‘the benefit of the doubt’ to countries where we believe that national cohesion in the face of national emergency is unusually high.

There’s more, it’s well worth a read even if one has reservations about the analysis and conclusions. On the Economic Adjustment Capacity Scorecard it is competitiveness which is regarded as ‘questionable’ in the Irish case, not economic diversification (and it’s interesting to see how we are just behind Singapore on most rankings except for competitiveness, where we’re 15th out of 18).

Finally, it’s also worth considering Annex A: Moody’ past downgrades of Aaa sovereigns.

Only a handful of Aaa sovereigns have been stripped of their top ratings during the past 25 years. The short list of “fallen archangels” comprises Norway (1987), Finland (1990), Sweden (1991), Canada (1994), Japan (1998) and Iceland (2008). Of those downgraded prior to Iceland’s downgrade last year, all but one (Japan) regained their Aaa status within a decade or less.

A reflection on the circumstances and assumptions that led to past Aaa downgrades as well as the reasons for their subsequent re-accession to Aaa status provides helpful information in the current context.

The common thread underlying all past Aaa downgrades was a rapid and severe deterioration in government balance sheets. More than that, Moody’s believed that there was a very low likelihood that the countries could implement the considerable adjustments necessary to stabilize the fiscal position, much less reverse the vicious trajectory of public debt by returning the primary fiscal position to balance or surpluses, within a roughly 5- to 7-year time horizon.

In Norway’s case, the initial driver for the one-notch downgrade to Aa1 was the government’s over-reliance on oil revenues, which imperiled the fiscal position as well as the country’s economic growth model when oil prices fell precipitously in 1986. Despite initial progress in adjusting to the oil price collapse, Norway’s fiscal situation was further weakened by the financial crisis which struck as well as Sweden and Finland in 1990. In turn, the impact of that crisis on Swedish and Finnish government finances was the trigger leading to those sovereigns’ one-notch downgrades in late 1990 and early 1991. The depth of the recessions in Sweden and Finland and the sheer speed of the deterioration in those countries’ government finances due to the relatively short-term maturity structure of their government debt led to additional one-notch downgrades one to two years later (indeed, Sweden was downgraded yet again in early 2005).

The reasons for the subsequent regaining of Aaa status in each of these cases (Norway in 1997, Finland in 1998 and Sweden in 1999) was a concerted sacrifice by all segments of the society in response to the initial crises, including mutually agreed wage restraint, accompanied by significant structural adjustment, in particular of the fiscal framework through tax reform and the establishment of fiscal rules. The economies were also able to benefit from the gains afforded by improvements in the competitiveness of their tradeables sectors, and this progress was consolidated by continued fiscal discipline even after the worst effects of the crisis had faded.

Canada’s foreign currency rating was downgraded to Aa1 in 1994 when its general government debt/GDP ratio was approaching 100%, and when the federal government’s interest payments consumed nearly 30% of its total revenues. As with Sweden and Finland, Moody’s expected that the effort involved in bringing the deficits down – which were prevalent at all levels of government – would need to be so profound and maintained for a relatively long time, that it would prevent a return to Aaa-range debt metrics within the medium term and leave open the possibility that both policymakers and the population would develop “reform fatigue.” Also, as in the Nordic countries, Canada’s debt was relatively short term, and the heavy presence of cross-border investors in the local debt market increased market volatility, so the foreign currency rating was downgraded by another notch to Aa2 a year later along with a one-notch downgrade in the local currency rating.

Canada regained its Aaa ratings on both foreign and domestic currency government debt in 2002. In all of these cases, Moody’s had, in retrospect, perhaps underestimated the growth regeneration capacity of both the Nordics and Canada as well as the determination of these societies to recover from crisis through common sacrifice. These characteristics are some of the most important factors behind Aaa ratings: it is why no Aaa country is assessed as having a payment adjustment capacity lower than medium in Moody’s sovereign bond rating methodology.

Japan’s downgrade from Aaa occurred later than the others and went much further over the course of three years, falling to A2 for the government’s local currency rating. This was motivated by similar concerns about worsening debt affordability when a protracted recession compounded by persistent deflation took the debt/GDP ratio well above 100%. Although the actual payments burden represented by debt was extremely modest because of ultra-low interest rates, Moody’s assumed that ongoing large deficits and the continued
rise in government debt would eventually result in a meaningful rise in interest rates that would translate into a considerable increase in payments pressure. Also important were the considerations of the very poor demographic trends – which would translate into an even more burdensome payments responsibility on a per capita basis and erode private savings – and the expectation that once Japan liberalized its capital account, risk-averse Japanese would shift part of their investment portfolios outside Japan. Among the reasons why the government’s ratings were subsequently upgraded in two steps to Aa3 was that both assumptions regarding interest rates and portfolio diversification never materialized – it turned out that the Japanese can live with a larger debt burden than previously assumed.

Interesting, that last statement, is it not, particularly in light of the piece during the week referencing Will Hutton.

Riddle me this… the Irish Times and capital expenditure. July 8, 2009

From the IT editorial on Monday.

WHEN THE building boom reached its peak less than two years ago, one in six of the labour force worked in the construction industry. Since then, the numbers employed in the sector have fallen sharply and the Construction Industry Federation (CIF) has warned that a further 100,000 may lose their jobs unless a decline in public investment is quickly reversed.

The Government, in its emergency budget last April, again cut the public capital programme and this year capital spending is likely to be one fifth lower than in 2008. CIF director general, Tom Parlon, presenting his mid-year review, said that as house building and commercial property projects remain stalled, the Government’s infrastructure programme offers the construction industry its only hope.

Well, it’s true that the construction industry did rather too well, to be kind, out of the boom. But doing well hasn’t been an impediment to the current largesse of the state to say… the financial sector. And while it is also true that a functioning financial sector is necessary…what of this?

The Government aims to bring the public finances into greater balance over time. This requires major spending cuts – both current and capital. A sharp contraction in the construction sector is part of the necessary adjustment to achieving a healthier and more balanced economy in future. And financial constraints now impose difficult choices. For the Government this means, as a recent Economic and Social Research Institute working paper has suggested, that “public capital projects should be undertaken on the basis that they have a long-run return to the whole economy”. Any other basis is likely to prove wasteful of taxpayers’ money, and counterproductive.

But…

This year the economy is likely to shrink by 8 per cent, while from 2008 to 2010 the International Monetary Fund has forecast a cumulative decline of 13.5 per cent – the largest contraction among advanced economies. By year-end the budget deficit could reach 12 per cent of Gross Domestic Product. These figures clearly demonstrate the Government has very limited scope to help a sector struggling to adjust to a new and painful economic reality. In any downturn, governments find it much easier to cut capital spending, rather than current spending. Lower capital spending, affecting the provision of roads, schools and hospitals, results in a poorer public infrastructure – but the repercussions are delayed. On the other hand, lower current spending has an immediate and direct impact.

So, is the IT arguing for or against capital spending? Is the point about repercussions being delayed meant to indicate a positive or a negative. Ad likewise with ‘lower current spending’ having an ‘immediate and direct impact’…

After all, it’s hardly an original thought that the poor standard of many areas of our public infrastructure has in the past and currently, as for example those of us with even a passing familiarity with our primary and parts of our secondary, education sector is an embedded problem. Sure, we could put off expenditure on these areas… and no doubt for some ‘repercussions will be delayed’, although again only for those who have been blind to the continuing protests about that infrastructure during the ‘boom’ and how many areas haven’t even been addressed. But isn’t that precisely the sort of short term thinking that has plagued this state since its foundation?

And isn’t it fascinating the way the public discourse is shaped as regards certain areas of the private sector, for that, after all is what the construction industry is and the financial sector too. Favoured and less favoured. And we pay for it either way.

Or is this another classic IT editorial which skillfully evades settling down in a specific ideological position while tilting a certain way?

Mind you, in view of the thoughts about the budget deficit reaching 12% of GDP interesting to read in the Observer this weekend an article by Will Hutton which, while admittedly dealing directly with the UK experience (and there are obvious divergences from that in our own case), engages with the thoughts of Japanese economist, Richard Koo of the Nomura Research Institute… whose…

…prognosis is alarming. The Americans, British and especially the mainland Europeans are far too complacent. We simply don’t understand what happens to firms and economies after a credit crunch.

And that…

We are anticipating green shoots and sustained recovery far too early. Indeed, unless western governments spend and borrow beyond anybody’s current imagining, the risk is that the west – and Britain with it – could still topple into a 1930s-style depression. David Cameron’s Tories insist Britain has to reduce its budget deficit fast – just like German fiscal conservatives – but they are basing their judgments on fair-weather times and fair-weather economics. What we are living through is so abnormal it requires abnormal responses.

Koo believes that the Japanese experience of crunch and aftermath provides us with a better template of how things will go.

Koo observed that Japanese firms in the 1990s and early 2000s had changed from profit maximisers to debt minimisers. Between 1970 and the early 1990s during the long yang (“sun” or “light”) upswing, they had steadily built up their debts to finance investment and growth; from the early 1990s on they used every spare yen to pay these off. Even as interest rates fell to zero and firms seemed to have profitable opportunities for growth, they would still pay off their debts rather than invest. Japan’s $15tn collapse in asset and share prices – equivalent to three years’ GDP – traumatised them, because it meant that their grossly devalued assets no longer matched their liabilities. To restore their balance sheets to health they had to reduce their debts. Demand from Japan’s corporate sector dropped by 20%.

But he also notes something that is intriguingly familiar…

Japan is criticised widely for allowing its national debt to rise to 180% of GDP after year after year of high budget deficits. Koo’s reply is that, given the scale of the shock, without government deficits Japan would have experienced a 1930s-style US depression. Indeed, in The Holy Grail of Macro Economics (2008), he explains the Great Depression as a result of US companies becoming debt minimisers in the wake of a property crash and banking collapse that was not compensated by sufficiently large increases in federal spending and borrowing. Koo’s “super Keynesianism” applies in the downward yin [downswing] phases of the cycle; he is much more orthodox on yang phases [upswing]. Don’t worry about debt-rating agencies marking down high-spending governments’ debts, he says; investors will buy public debt in yin phases – just as they will Britain’s or the US’s.

And here are other echoes…

Companies may be less indebted than Japan’s in the 1990s, but by British standards debt is high. Lending to companies fell in both April and May. Part of the problem is that loans are astonishingly expensive because of Britain’s monopolistic, risk-averse banks charging the highest margins and fees in the G7. The result is that companies are repaying debt and not investing. As in Japan, low interest rates are having little traction.

The pound’s huge devaluation and starting with low levels of public debt means that we are better placed than others. Yet, looking around the North Atlantic economy, it is clear that debt minimisation strategies are becoming commonplace. This is the story in the US and in Germany. Indeed, as Paul Krugman argued in my interview with him last month, Germany could become “Nipponised”, relying on exporting its problems to the rest of Europe.

And Hutton concludes…

Even if Koo is only partly right, the economic debate in Britain and beyond is out to lunch. The consensus is to assail Gordon Brown for dishonesty and political disingenuity for still arguing that the state can maintain spending and borrowing despite a budget deficit this year of £175bn; leader-writers across the political spectrum congratulate themselves for their economic literacy in damning him for not saying where and what he is going to cut. A more telling criticism is that he is not spelling out how serious the situation is – and has lost his nerve over the radicalism that will still be needed to get through.

Obviously Britain cannot run deficits of 12% of GDP indefinitely – but cutting them aggressively in a world of debt minimisers will prompt a depression. The correct policy is three-pronged. The government must spend and borrow radically until the downward phase stabilises – but in such a way that spending commitments can then be radically reduced in stabler times. New banks need to be created and old banks broken up to deliver more competition, more credit flows to business and less systemic risk.

It’s an interesting question, is it not, as to how long a state can run a 12 – 13% deficit? We don’t, I’d hazard, have the luxury of being able to sustain it as long as the UK (albeit Michael Taft believes it is sustainable to borrow €16bn per annum for at least two years above our current levels and still not be hitting the Eurozone average). But nor does it seem like we can avoid running deficits larger again than 13% for quite some time. Quite a conundrum.