1st February 2011
What's in a downgrade? Egypt's debt was downgraded by Standard & Poor's today, following Moody's downgrade yesterday. It tells investors little that they didn't know already – political tensions have increased, it is a more dangerous place in which to invest and the troubles are likely to impact economic growth. So do downgrades matter?
Egypt's downgrade is a predictable response to the recent troubles in the region, reported here from FT Alphaville. Ultimately, while it may turn investors off Egypt, it is unlikely to be significantly destabilising for global markets. However, it comes hot on the heels of a recent downgrade in Japan (see BBC news story), which may create more waves.
Japan's downgrade has raised the possibility of a second wave to the credit crunch, discussed in this FT article. This would see a chain of developed market sovereign defaults. This is not an isolated view as some economists become increasingly fearful over the US's lack of any clear deficit reduction programme (see Bloomberg article).
What would be the likely impact? Countries are usually fearful of a downgrade. A desire to cling to its AAA-rating is the ostensive reason why the UK Government is implementing its current austerity measures. Downgrades usually mean that governments have to pay more for their debt as the income demanded by international investors rises in line with a country's perceived risk. The rating agencies are an important input into this. Downgrades are often issued on the back of a country increasing its debt burden and paying more on a large debt burden is unwelcome.
Japan is a good case in point. Its debt is now almost 200% of GDP. Any rise in the costs of servicing that debt will leave government finances significantly stretched. Higher costs of government borrowing can filter down into the corporate market as well, making it more difficult and more expensive for corporates to borrow and thereby hurting equities.
But – as this article from the Wall Street journal demonstrates – it does not always work like that. As Japanese government bonds are tightly held by domestic investors, the rating downgrade has had little impact. On the day of the downgrade, the Nikkei barely registered an interest.
The downgrades in peripheral Europe have had more impact. The same would be true of any potential downgrade in the US or UK. Government bonds are more widely held and there is a greater risk of contagion. These markets are also more vulnerable to sentiment. Everyone knew Japan was in trouble and its problems have been widely flagged. Investors either believe its asset base is strong enough to cope, and invest, or they don't, and they avoid the country altogether. The situation in countries such as Portugal and Spain is more fluid and unclear, as such the uncertainty over the countries debt ratings has exerted more of a long-term drag on equity markets.
Should investors sell out on news of a downgrade? Usually downgrades will have been well-flagged by the rating agencies, so are likely to be factored into equity prices. There may be a blip downwards on the news, but it will usually be short-lived. The time to sell out has usually come long before the downgrade.
Some downgrades matter more than others. The markets may have shrugged off Japan. They are unlikely to be so sanguine about the US.
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