US Downgrade Shines A Light On Other Weak AAA Credits

By Win Thin

With the US downgrade now out of the way, we think market attention will swing back to other DM countries that are facing downward pressure on ratings too. Here is a summary of our most recent ratings outlooks for DM.

Our model has the US as a weak AAA/Aaa/AAA credit, and we did not think that the downgrade was entirely justified on fundamental grounds. Our model gives the US score a small boost due to the dollar’s standing as the world’s reserve currency. Taking that out drops the US down to AA+/Aa1/AA+, but at this juncture, we see no end to the dollar’s premiere status. However, now that the move has been made, it brings into question other AAA ratings.

The UK has to us long been a candidate for downgrades, as our model has it as AA/Aa2/AA vs. actual ratings of AAA/Aaa/AAA. S&P had the UK on credit watch negative during the financial crisis, but took it off last year after the incoming Tory government instituted fiscal tightening. With growth prospects dimming, we think the agencies will take another look at the UK’s AAA standing and start to talk about downgrades.

The next weakest AAA credit is France, which has slipped into AA+/Aa1/AA+ territory. By most metrics, France is a weaker credit than the US, and so we think agencies will have to reassess this AAA/Aaa/AAA rating as well. The recent move to downgrade some French banks due to heavy exposure to Greece is likely a warning shot that will be followed up with sovereign pressures in the future.

Belgium has AA/Aa2/AA status in our model, below its AA+/Aa1/AA+ actual ratings. Being without a government for over a year surely qualifies Belgium for a downgrade, since S&P took pains to note that the broken political process in the US was a factor in its downgrade. If any of these three non-peripheral European countries come under downgrade pressure, the euro zone debt crisis will have moved into a totally different (and more worrisome) phase. With global growth rolling over, we think it is only a matter of time before these three are downgraded.

Moody’s recently cited the BOJ’s failed FX intervention attempt and the stronger yen as potential for another rating cut on Japan. We do not agree with that rationale, but our model does point to downgrade risks for other fundamental reasons. We view Japan as A+/A1/A+ compared to actual ratings of AA-/Aa2/AA. Fitch in particular looks out of line.

A word about the euro zone periphery. We continue to believe that Spain, Italy, Ireland, and Portugal are all still facing significant downgrade risk. Only Greece at CC/Ca/CCC is close to correctly rated. And with euro zone growth slowing, these peripheral countries are likely to be downgraded too.

Lastly, we note that the supply of true AAA credits is dwindling. In Europe, there is still Germany, but we believe that as it takes on more and more countries to backstop, Germany’s debt ratios and fundamentals will deteriorate too. Now, it is a solid AAA credit, but the future is not so bright. The dollar bloc, the Scandinavian countries, and Switzerland are left as very solid AAA countries, along with the Netherlands and Luxembourg. But taken together, these countries are a very small slice of global GDP and so investors have few options with regards to AAA safe havens.

Source: Bloomberg, BBH

1 Comment
  1. vzopf says

    A very well researched article. It is giving a good overview. Thank you for all the work you put into this and you are sharing.

    As for the outlook – as far as I can see – there are the following factors that need closer observation and I can’t see from your article if any of these are built into the “BBH implied rating”

    1) Japan’s bond yields show a massive distortion of their bond market. One day when the market readjusts it will be massive and backfire into Japan’s rating.

    2) The US downgrade by S&P should also be seen as a system downgrade of the world currency system with the US Dollar being the world reserve currency.

    3) Downgrades of the US, UK, France, Japan and others can also be seen as telling the market to reassess the risk components built into the interest rates. This has the potential to counteract the manipulation of interest rates by CenBanks and governments as the market will find a way to work on correcting the implied misallocation of capital.

    4) In the Euro-zone the bailouts continuing in various ways can be seen as a redistribution of bad credit quality from the periphery states to the stronger and solvent euro zone core states.

    5) The past bailouts of Greece, Ireland and Portugal were mostly in the form of guarantees and only relatively small amounts (part of the first Greece bailout and cash funding of the EU Bailout Fund) were actually paid up in cash. These guarantees will most likely come due and when they do will have significant impact on the government finances of the stronger euro zone states, dragging them down too. In essence the whole bailout exercise by the EU has in effect only been buying some time and achieved this by a complex smoke & mirrors drama.

    6) The ECB buying up bonds of Spain and Italy is following a similar script. It is buying time by having the ECB buy their bonds redistributing bad credit quality from these states to the ECB and turning the ECB into a Bad Bank for the euro zone periphery.
    If and when the ECB marks its bond holdings to market it will have lost all its capital and will need to be recapitalized in cash by the euro zone states, its shareholders. (A similar situation exists regarding the financial assets of the Fed) Where are Greece, Ireland, Portugal etc. going to take these extra billions of Euros from ? At this point the bad credit quality of the ECB is being redistributed to its shareholders and then from the states to the tax payers. It is a dwindling spiral grinding on.

    7) The various CenBanks are holding currency reserves in the form of debt instruments issued by governments usually. This makes downgrades of countries issuing the major currencies a way of transmitting the bad credit quality from the downgraded countries to the holders of their debt instruments. This is a global phenomenon ! Even the most healthy countries have already been impacted by this knock on effect. The effects are similar as shown in 6) for the ECB.
    Let’s take Switzerland as an example. Two years ago the leverage ratio of the balance sheet of the Swiss National Bank was 50%+. On June 30, 2011 it was only below 10% anymore. The reason for this development are the huge write downs on their currency reserves, consisting mostly of euros and US$, in conjunction with the extremely strong exchange rate of the swiss franc. At the end of Q1-2011 the capital of the Swiss National Bank was 44 bill. CHF and at the end of Q2-2011 it was about 33 bill. CHF. But since then the swiss franc has been rising much further. And these numbers do not include a write down to market on the basis of the low credit quality of the bonds of euro zone countries, like Greece, that are part of their currency reserves.
    And this is Switzerland !

    A closing question :
    8) How will the balance sheet of the Peoples Bank of China look like one day not too far away ?

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