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Credit Ratings and the Euro

August 15, 2011

Bond ratings have been in the news a lot on both sides of the Atlantic, as ratings agencies weigh the credit worthiness of the country’s most advanced and indebted countries.  As figure 1 shows, the countries of the European Union have among the highest bond ratings in the world, with nine countries receiving a AAA rating.  In addition, with the exception of Greece, Standard & Poor’s (S&P) has rated all of the EU countries’ debt as investment grade.  While both Moody’s and S&P agree that Greece is the least credit worthy nation in the world at the moment, just a few notches above default, they disagree on many of the other PIIGS (Portugal, Ireland, Italy, Greece, and Spain).  Moody’s has downgraded both Ireland and Portugal to below investment grade, but it is more optimistic about Italian debt than S&P.

Source: Standard & Poor's, Moody's

These bond ratings could soon become as newsworthy in Europe as they were in the US last week when Moody’s downgraded US Federal debt from Aaa to Aa1, as there is strong talk about the creation of “euro bonds” to save the euro.  While this idea has been around for over a year in some form, recently Italy and France have come out in support of the idea.  The idea is that by creating a common bond for all of the countries using the euro, the risk would be reduced for everyone, as many northern European countries’ economies are doing fairly well right now and their governments have been maintaining strong fiscal discipline.

If a euro bond was created, it would probably cost Germany dearly.  As Der Spiegel reported today, German borrowing would probably cost an additional €47 billion (about $68 billion) as its interest rates would increase.  As the below chart shows, while Germany is the dominant European economy, it is not necessarily the dominate debt market.  As figure 2 shows, Germany does account for about a quarter of all Eurozone government debt, and 48% of all AAA government debt in the Eurozone.


Source: Eurostat, Standard & Poor's

However, Italy and France also account for much of the debt, and these two countries’ ratings are under threat.  Italy is already rated as A+ or four notches below Germany.  France is still AAA, but there have been rumors for the last week that it is on the verge of being downgraded.  So, what rating would a Eurobond receive?  I am sure that the European leaders would like it to receive AAA, as 55% of Eurozone government debt is currently AAA.

However, a weighted average of bond ratings among the Eurozone debt would produce a rating closer to AA- or AA.  This is two to three levels lower than AAA, and ironically, the rating of troubled Spain. While Greece’s very low rating is no doubt dragging down this composite average, a non-AAA rating might reflect the situation more accurately than just giving Eurobonds an AAA rating.  After all, bundling subprime mortgage loans with AAA bonds and then calling them AAA helped create the global crisis back in 2008, and Greece is definitely today’s equivalent of the subprime mortgage.

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