Ratings Agencies take notice of deteriorating finances
Debt ratings agencies may not have the power they used to possess before the 2008 global financial crisis, but they still carry influence. Thus, the recent decision by Fitch Ratings to downgrade France from AA to AA- has received some attention.
The factors emphasised in the decision included:
- Weak fiscal metrics
- Expenditure rigidities
- High government debt
- High interest expenses
Also mentioned, although given less relative importance in the decision, were a worsening growth outlook and a high level of social unrest. No doubt the recent public demonstrations against raising the pension age played a role.
As an anchor economy of the euro-area, a downgrade for France implies a downgrade for all. Indeed, France’s Fitch rating now is the same level as Ireland and the Czech Republic, economies with only marginal impact on the overall health of the Eurosystem.
Notwithstanding the above negatives, Fitch also mentioned some relative positives for France. These included a “sound and stable” banking sector. Fitch states that banks have a “stable and diversified funding base” which should enable them to deal with higher interest rates. Moreover, French mortgage loans are primarily amortising rather than interest-only, so less leveraged against low interest rates and rising property values.
Should this be reassuring? After all, the ratings agencies badly missed massive exposures in mortgage, banking and financial markets generally heading into 2008 in Europe as well as the US.
Obviously a rating is an opinion. As with auditors who give a clean bill of health to firms that subsequently go bust, ratings agencies can make mistakes. They can also only pass judgements based on that which is disclosed. If liabilities are hidden, or assets not marked down when they should be, then a reliable assessment of a company’s, or country’s credit standing, becomes impossible.
But do the ratings agencies even see the full picture?
It should thus be of concern that, according to a recent report by independent bank accounting expert and IREF’s research fellow Bob Lyddon,1 the euro-area member countries are understating their general government gross debts by over 40%. When contingent liabilities are included, such as guarantees for the credit of sub- or supranational entities, the figure rises to 70%.
As Bob explains:
It is a threat to financial stability where a major set of participants in the system understate their liabilities, because that leads on to the public credit rating agencies over-rating the respective entities’ debts, and in turn to other participants in the system setting aside too little capital to account for the risks they are running by doing business with these entities…
The euro currency is structurally weaker than it is made to appear, and both eurozone and non-eurozone member states in the EU have higher liabilities than Eurostat reports.
If the above holds true, then the view of euro-area finances from all angles is distorted. On the fiscal side, only a few countries are in compliance with the Stability and Growth Pact, which limits the deficits and debts that members are allowed to incur.
On the monetary side, the Target2 imbalances do not show a complete or detailed picture of how much one country’s banking system owes another, nor of the ECB’s position. In effect, Target2 liabilities are uncollateralised, yet financed at comparable cost. This enables weaker creditors in the system to ‘free-ride’ on low funding costs without any effective restraint.
Were the above points all fully disclosed, one wonders what the ratings agencies would conclude. Would the euro-area in general be downgraded? Certainly an increase in net liabilities on the order of 40-70% should trigger a response.
Whether that would have any impact, however, is unclear. Ratings agencies do not set funding costs in the market. In the euro-area, ultimately it is the ECB that decides what it will accept as collateral, and at what cost. The collateral basket has only expanded since the euro was launched (although there have been times when the ECB threatened to disallow one or more banks or sovereign entities from posting collateral eg Cyprus, Greece).
The growing politicisation of euro-area monetary policy
One of the original 1999 concerns held by Germany and other, relatively ‘hard-money’ founding members of the European monetary union, was that the central bank would not be sufficiently independent. In particular, there were concerns that an easy-money majority would eventually prevail and would facilitate the financing of chronic budget deficits and growing debts. Monetary policy would become captured by and subservient to fiscal policy.
Indeed, over the past two decades the ECB has strayed far from its original, narrow mandate to maintain price stability in the euro-area. At launch, the ECB even had an explicit ‘second-pillar’ of monetary policy, namely a focus on growth in money and credit. This was inherited from the Bundesbank, which traditionally had a somewhat Monetarist orientation.
Under the insistence of its first Chief Economist, former Bundesbanker Ottmar Issing, the ECB’s regular monthly press conferences traditionally began with a discussion of money supply growth, narrow and broad, and the impact that this might have on the price level in future. In retrospect, this almost certainly contributed to the ECB’s strong track record during its first few years of operation, as its price stability targets were consistently met.
Following the explosive growth in the euro-area money supply during the crisis of 2008 and thereafter, as the ECB fought against a prolonged credit crunch, any meaningful focus on money has long since been dropped. More recently, even price stability itself has been downgraded in importance relative to maintaining financial stability. The various extraordinary fiscal and monetary policy actions taken in response to the Covid crises contributed to the ECB moving yet further from its original mandate.
Over the years, various legal challenges in this regard have come before the German Constitutional Court. The one that advanced the farthest challenged the ‘disproportionality’ of ECB bond purchases. For those unfamiliar, the ECB Charter, part of the 1992 Maastricht Treaty, requires that the ECB purchase bonds proportionally, so as not to favour one member country’s bonds over that of another—an implicit financing subsidy.
Yet the ECB now openly operates a ‘stability mechanism’ which de facto requires disproportionality in order to function. A strict interpretation of the Charter would disallow any disproportionality, even in times of crisis. In the case mentioned above, the German Constitutional Court, acknowledging this apparent violation of mandate, asked the Bundesbank for clarification of what ‘proportionality’ meant.
As the Bundesbank and ECB explain it, the ‘stability mechanism’ is still in keeping with the ECB Charter. But this is only because the ECB has subtly changed the definition of ‘proportionality’ to refer to effective financing costs, rather than the scale of purchases. They claim that, if financing costs diverge between member states, this interferes with the transmission of monetary policy in the euro-area which, ex-post, appears disproportionate.
Given the large debt burdens carried by many euro member governments, sharply higher funding costs would require possibly severe fiscal austerity, quite possibly forcing one or more members into recession, even if Germany and other governments with lower funding costs had more healthy, growing economies.
In such a situation, the ECB is in a bind. They can lower rates for all, but that could be inflationary and would not necessarily even help the affected governments, if their funding costs continue to diverge. Hence the ‘stability mechanism’ is more a form of fiscal subsidy, cloaked as a ‘proportionate’ monetary policy.
This reinterpretation, which turns the entire principle of proportionality on its head, completely defeats the intent and purpose of the proportionality clause in the first place, but this just serves to illustrate how politicised ECB policy has become.
There is thus no mechanism, other than the politics of euro-area monetary policy, that could change the way in which euro-area accounting is conducted, or the funding cost implications of an evident deterioration in credit quality.
The Ukraine war is making a bad situation worse
And so the euro-area muddles through. Debts are incurred, yet not properly accounted for. Member state governments run chronic deficits, but these don’t add proportionately to systematically understated debts. Financing costs for uncollateralised, cross-border bank liabilities—Target2—are as low as those for collateralised borrowings, implying a general deterioration in the credit quality of the Eurosystem.
Such a system cannot be expected to allocate capital efficiently. Long-term savings and investment are unlikely to add to the scale and productivity of the capital stock. Stagnation is the inevitable result.
The Ukraine war may be a tragedy, but all of the above was unfolding prior to the negative economic shocks associated with the largest European war in eight decades. Now that the euro-area faces generally higher economic ‘input’ costs in the form of energy and other necessary materials, the export engine is no longer profitable.
Germany, the euro-area’s largest exporter by a wide margin, is being squeezed. If Deutschland AG and a few other, smaller net-exporters cannot make a profit, they cannot carry the weaker euro-area member states. The euro-area is left unable to grow its economy. Yet it is accruing huge future liabilities in the form of pensions, healthcare and other welfare-state provisions.
It may be mere coincidence, but another ratings agency, Standard and Poor’s, recently affirmed the UK’s AA rating but upgraded the outlook from negative to stable. While no doubt there are subtle differences, the methods used by S&P and Fitch are broadly similar. Factors cited by S&P include stronger than expected economic performance and expectations of more contained budget deficits in the years ahead.
It would be a mistake to conclude that the UK’s economic prospects are fundamentally improving. But they are arguably easier to observe and to evaluate than those of the euro-area, obfuscated as they are by the way in which liabilities are hidden.
Photo by Antoine Schibler