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Rising government debt puts credit ratings of some countries at risk
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Financial failure or bankruptcy is a situation where an individual or a legally-constituted body cannot meet the payments that must be made. Among those bodies are companies, foundations, associations and even states. As in the case of companies, states have the capacity to borrow in capital markets in order to finance the spending programmes they carry out.
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Nevertheless, there is a fundamental difference between states and other entities. States have the coercive capacity to collect taxes. That is to say, they can impose or raise taxes if their financial situation so requires so that theoretically their credit profile should be among the highest. In spite of this, we could draw up a long list of states that have not met payment of commitments taken on. We have simply to recall the bankruptcies of Latin American countries in the period 1982-1986 or the case of Russia in 1998.
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The reasons behind bankruptcy are quite varied. For example, at times a state may imprudently borrow above its possibilities. In other cases, an unexpected negative shock in its economy may bring about a severe depreciation of its currency and, having its bonds issued in a foreign currency may have suddenly increased the debt load and this takes it into bankruptcy. Another fairly typical case takes place when most of a country’s debt is held by foreign investors and a situation of financial panic beginning in another country spreads over to it, thus preventing a refinancing operation and taking the state to a failure to pay.
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It is obvious that those states that go to capital markets to obtain financing have different credit profiles. Not only the larger credit rating agencies, such as Standard & Poor’s, Moody’s and Fitch, but all those investors who acquire government bonds of states study this credit profile and assign it a rating.
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An AAA rating is assigned to those countries with the highest credit quality. The rating scale runs from AAA to CCC. The latter is the worst a country can obtain before being assigned a D rating which signifies that the country is in a situation of bankruptcy. Generally, a country comes out of this following intense negotiations to restructure debt and negotiate waivers. That is to say, by obtaining a remission or exemption of part of the debt made by the creditor in favour of the debtor.
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What are the most important criteria for deciding on the credit strength of a country? While an analysis may involve an exhaustive study of many kinds, most fit into the following broad areas: political risk, economic structure, growth prospects, the flexibility of monetary and fiscal policies, the stock of existing debt, liquidity and foreign debt of the country.
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The above table gives a résumé of the main characteristics countries must demonstrate to those awarding any specific rating. Furthermore, some examples are added of countries currently standing at each of these levels, according to Standard & Poor’s rating agency.
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When possible, these attributes are expressed quantitatively through various ratios and measurements in order to establish the country’s credit profile. One of the ratios commonly published is the government debt of a country in relation to its GDP. The following graph sets out in order the countries that belong to the OECD in relation to this ratio. At the end of 2007, Japan’s government debt reached 170% of GDP while Spain’s was under 45%.
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Most countries took advantage of the economic boom at the end of the Nineties to reduce their stock of debt although not all were able to do so. The question is when is a country very much in debt and must be considered to be showing a high credit risk. There is no final answer. One guide may be the convergence criteria of the EMU (European Monetary Union) which lays down that this ratio must not go over 60% although we know that if a country does exceed this level it may be allowed to do this so long as the course of the ratio is downward and close to the limit.
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High fiscal deficits that continue over a period of time impose a course of government borrowing that may be unsustainable. For this reason, supranational bodies, such as the IMF, the European Commission and the European Central Bank (ECB), insist on their concern about current fiscal deficits. While these deficits may be explained by the sharp world recession, the various countries are being asked to bear in mind the sustainability of their government finances seeing that over the medium term there is the risk of a serious worsening of credit profiles.
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But do the financial markets take into account a country’s credit risk? Of course. Investors demand a higher return on government bonds that show a higher risk, that is, a higher sovereign differential. The following graph shows that investors act coherently, demanding a higher return for carrying higher risk.
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It may be shown that, for bonds of those countries with a higher relative fiscal deficit than Germany, investors want a higher interest rate differential compared with German bonds of the same maturity.
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This graph, however, serves to underline that the expected course of the public finances of each country is more important than the current deficit. For example, if we compare the case of France with that of Italy, we find that a higher differential is demanded from Italian bonds in spite of the fact that France currently has relatively higher fiscal deficit. The explanation for this lies in the worse prospects for Italy’s public accounts as is also shown in the ratings assigned in the above table.
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In addition it is very important to keep in mind that the differential in interest rates demanded for a government bond does not only reflect credit risk but also the bond’s liquidity risk. Those national bond markets that show greater liquidity, that is to say, those markets with a huge turnover and those where the volume of bond issues is large attract investors more and therefore have lower differentials.
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To be precise, the ECB(1) recently published the results of a survey according to which the most relative variable for explaining sovereign differentials within the EMU in the most recent months of the financial crisis is the different liquidity levels of national markets and not so much the differences in credit risk premiums between countries.
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In conclusion, large and persistent fiscal deficits bring about drops in ratings that reflect the credit profile of a country and increase sovereign differentials that the country must offer in capital markets in order to obtain financing. In some cases, the severity of these deficits may even lead to failure to pay on its bonds.
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(1) ECB Monthly Bulletin, July 2009, «The Determinants of Long-Term Sovereign Bond Yield Spreads in the Euro Area», pages 71 and 72.
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This box was prepared by Alejandro Gisbert Mir
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Financial Markets Unit, ”la Caixa” Research Department
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