By Win Thin
The three notch downgrade of Greece from Ba1 to B1 by Moody’s was a bit surprising, even to jaded followers of rating agency behavior. While we have remained negative on the country, is it really as bad off as Mongolia, Sri Lanka, Belarus, Lebanon, Vietnam, Bolivia, and Paraguay (all rated B1 by Moody’s)? Clearly, we are seeing some overshoot to the downside, which we have long warned about as rating agencies try to win back some credibility. In light of today’s action and last week’s warning by Fitch of a potential Spain downgrade, we thought it would be helpful to summarize our ratings outlook for the euro zone. To us, the interesting thing is that FX markets have basically shrugged of these recent ratings moves. Bond markets have not, however, and yields in the periphery continue to reflect significant restructuring risk for many sovereign issuers. Please note that we are in the process of our quarterly ratings update, and that fresh scores will be available toward the end of this month.
We view Greece as a BB/Ba2/BB credit, but actual ratings of BB+/B1/BB+ are vulnerable to further cuts due to the above-mentioned overshoot risks. Our model rates Ireland as BBB/Baa2/BBB vs. actual ratings of A-/Baa1/BBB+ and so further downgrades are likely. Moody’s A1 and Fitch’s A+ ratings for Portugal need to be adjusted downward as our model rates it at A-/A3/A-, while S&P’s A- looks correct. After losing its AAA status from all three agencies, Spain still remains vulnerable to further downgrades. Our model rates Spain as A+/A1/A+ compared to actual ratings of AA/Aa1/AA+. Italy has so far escaped any rating action during this cycle, but is somewhat vulnerable as our model puts it at A+/A1/A+ compared to actual ratings of A+/Aa2/AA-. With regards to the core euro zone, note that our sovereign ratings model puts France as a borderline AA+/Aa1/AA+ credit, so there is a rising risk that France falls below AAA/Aaa/AAA in the coming quarters. Because France is on the borderline, the case for an immediate cut is not compelling but certainly needs to be monitored closely. We believe Belgium is correctly rated at AA+/Aa1/AA+, but is vulnerable to downward rating pressure if the political deadlock continues much longer.
Important euro zone summits are coming up this month, and we continue to view the base case scenario as muddle through. We do not expect any sort of game-changer, with policy-makers likely to kick the can further down the road. Bond markets are telling us that they are unhappy with the signals coming out of the euro zone. Portugal 10-year yields have remained about 7% for 22 straight days now, and markets are expecting it to go to the EFSF within the month. Greece and Ireland yields continue to march higher too, so even getting EFSF money has not provided any relief. For now, Spain bonds have held up and so the country at this point is not being lumped in with the other three. However, will pressure remain away from Spain if Portugal goes to the EFSF and the euro zone summit disappoints? It may not happen immediately, but contagion could eventually hit Spain bonds as well. If so, that will be the true test for the euro.
