Skip to main content

What does a credit rating downgrade mean?

What do credit rating agencies do?
Credit rating agencies are independent bodies which assess whether a company or country has the resources to pay back money loaned. An AAA rating indicates that the market is confident the money will be paid back. 

The big credit rating agencies (Standard and Poor's, Moody's etc) have had a patchy record in recent years. Lehman Brothers, for example, had an AAA rating right up to their collapse. But few doubt that they are essentially correct in their current analysis. This can be summarised as: too much debt and too little growth to ever pay it off.

What difference does this make?
Credit rating has two key financial consequences. The first is in the yield or dividend offered on bonds or fixed term loans. Because investors value security, particularly in a volatile market, a government or company can pay its bond holder a lower rate of interest to reflect the lower risk.

The second and more immediate impact is on the ability to raise money on the international markets.  Put simply, the lower your credit rating, the more you pay in interest. For Greece and now Portugal that interest rate is a ruinous 7%. That is why they have approached international financial institutions for emergency loans aka bail-outs.

Does US now risk default?
The market doesn't think so because the US has the money to pay its debts. For this reason US treasuries still pay a low yield or rate. US Treasury Bonds (Treasuries) were considered one of the safest investments in the world. They had the highest (AAA) credit rating. When this was downgraded to (AA+) this might have adversely affected the yield on its bonds. So far this has largely not happened because the US Dollar is a 'reserve' currency but the long-term risk remains. Everything depends on the confidence investors have in the capacity of the US to repay its debts.


What about European countries?
In the case of the sorry collection of European downgrades (French, Italian, Portugese, Spanish, Austrian etc) there is a more imminent threat caused by the need of these countries to borrow on the international markets.

For France and Austria the biggest impact of the downgrade is psychological. The Eurozone 'solution' depends on the idea of France and Germany sharing top-billing as the rich, financially stable guarantors for more wobbly economies. The downgrade damages confidence in this assertion, though perhaps not fatally yet.


So countries like France and the US are not effectively bankrupt like Greece? 
The situation is very different in Greece because Greece does not have the capital to repay its loans. That is why Greek bond rates are so high - the markets assess that loans to Greece have a high risk of default. The Italian situation is closer to the Greek one and is further intensifies the Euro crisis.

So the US is doing fine?
Not exactly. President Obama was right in one sense when he said that America 'will always be AAA country' but the downgrade recognises the increasingly unsustainable debt levels  in the US economy.

The Italian economy also has significant assets but is more vulnerable. What particularly spooks the markets is the uncertainty regarding the extent of public and private sector debts.

What does a debt default mean?

Comments

Popular posts from this blog

Which countries do not have an official language?

According to Henry Hitchings Language Wars (2011) these nations do not currently have an official primary language:

Why is English not the official language of England?

58 countries list English as an official language - but not the UK.