A More Painful Downgrade than in the United States

Should Standard and Poor’s removal of France’s triple-A credit rating this past Friday be taken seriously? From a relative point of view, or in light of recent events in the history of the downgrading of sovereign debt, absolutely not. Indeed, on this January 13th, not only was the French currency involved but that of 16 other euro zone countries; S&P downgraded nine countries at once. So this is a problem specific to the euro zone, where the notes of the major economies have continued to be downgraded for the past two years. In addition, out of about the 160 rated countries in the world, the fact remains that half are rated AAA.

Going down a notch to AA is not derogatory. However, there are also other opinions: for example, Fitch said it would maintain France’s AAA rating until 2013. Markets had widely expected the different borrowing gap between French and German bonds, which had been widening since the summer of 2011. At this announcement worthy of a Friday the 13th, the stock markets have in turn shown little response. Based on this some would argue that this continuing optimism is a recent American precedent.

The United States lost its triple-A status five months ago. Having been demoted to double-A, as France just was, it has had one result: the almost instantaneous lowering of their financing costs. This was the reverse of what might have been expected and a masterful snub to the agencies’ rating. As if their backs were against the wall, the markets were no longer confident that their level of aggregate information, which incorporates many other elements than notation, and their basic instinct ultimately marginalized the weight of the rating in their final decision. As a result, this invalidates the previous argument so often used by politicians that the rating agencies have such a great influence in the markets. Despite the rating level equivalent of double-A, the markets continue to display more confidence in the debtor “America” than the debtor “France,” which has already been funding for several months the greater debts of the triple-rated American and German governments. Thus the rating is based on many other factors than just good scores.

What is so serious is that it’s not just the loss of the AAA rating; it is precisely the criteria other than the rating, that simply reflect the degree of market confidence in a particular issue, which are considered less favorable for France and Germany in the euro zone area than for the United States and England independently. Despite all these relative reasons, the loss of AAA seems so much worse than in the American case.

What are the reasons for all of this? First, according to S&P’s announcement, there is greater investor confidence in the euro zone area with respect to the United States and England. Moreover, when comparing the borrowing rate between the three highlighted areas for several months, it revealed much higher funding costs for the euro area. The markets or rating agencies will not be stopped from considering that the absence of a lender of last resort is a structural weakness of the euro area, compared to the capacity of money creation by the Fed and the Bank of England.

Secondly, due to having an equal rating (AAA) for months, investors lent at a higher rate to France than Germany, the heart of the euro area, showing that investors have more confidence in the economic and financial policies of Germany than those of France. Another element the agency has taken into account by lowering the “political score” of France has to do with the five pillars of its approach to sovereign rating, i.e. one notch. It will not only be more expensive for the French state to borrow, but all French banks will be affected in turn by the downgrade, because their own scores are highly correlated with those of France. And all those whose structure depends directly or indirectly on that state may also be downgraded according to the general principle applied by agencies that a borrower cannot be rated higher than the country of origin.

As a result, financing costs of these agencies will increase and these costs will be passed on to consumers and taxpayers, who are already going through a difficult time of budget adjustments in an growth-less environment. The results may therefore be different from conventional wisdom: It is not markets who are under ratings’ influence, but rather the states and their political representatives who, together with national regulators and Europeans, are addicted to the notation. They all have shown, including France, that they are influencing public opinion with the idea that the main objective was to maintain the triple-A rating. They imposed the rating agencies approved by bank regulators as a key element of banking regulation, so that even the new liquidity ratios in Bâles 3 depend on the rating agencies’ approval. In addition, they have always used the AAA bond as proof of their competence.

It is vital that they begin a massive detox. For months, the United States has done so by removing any reference to the rating in any financial regulation whatsoever, leaving each player in the market, including borrower states, to rely on notes as marketing tools and in setting their goals. If this is the path they choose to pursue, then they should manage the negative consequences more effectively, rather than blaming their accredited assessors.