Recent ratings action from Moody’s has once again brought the euro crisis into sharp focus. For all the volatility in bond yields and concerns about artificial thresholds, Moody’s has spelt out how the euro crisis could evolve, and what the impact could be.
Simply put, Moody’s thinks that if Greece leaves the euro, or if Spain and Italy need large-scale external support, then that will put the balance sheets of the strongest euro nations under pressure. Apart from Finland, which has negative net debt, the prospect of further substantial support could affect Germany, the Netherlands and Luxembourg, and as such Moody’s has put their Aaa ratings on negative watch. This implies that, if the crisis doesn’t miraculously resolve, then Finland could be the only Aaa rated country in the euro in a year or two.
Some will be tempted to heap scorn on Moody’s move. At one extreme, archetypal City traders may condemn it as another example of rating agencies being behind the curve. At the other end of the spectrum, European MPs are likely to rail against rating agencies ‘making things worse’ by heaping further pressure on the euro.
While the ratings agencies clearly got things wrong before and during the crisis, I suspect those criticisms may be less applicable in this instance. Moody’s, like everyone else, is trying to guess how a massive set of structural changes will unfold in the euro area. No one knows exactly what will happen, how long any developments will take, or what the critical triggers might be. This is one reason financial markets have been volatile and Spanish and Italian bond yields so high – risk premia are very elevated.
At the same time, it would be remiss of any analyst not to think through the potential end-game in the euro area. From my perspective, one of three things will eventually have to happen. First, Greece or Italy or Spain might need help but not get it, and go bust. The wider economic and financial contagion would be dramatic. Second, Greece or Italy or Spain need more help and get it, but that puts pressure on those countries supplying the bailout. Third, the ECB steps in and monetises a lot of the debt (by the back door), relieving credit risk but raising the (admittedly small) risk of inflation.
The eventual outcome could be some combination of the three scenarios above – so Greece could exit the euro, but Spain and Italy get more support. But, fundamentally, scenarios 1 and 2 are “credit negative” for euro area sovereigns. They would put pressure on Germany, the Netherlands and even Luxembourg if they arose. Only scenario 3 offers any hope of a near-term improvement in creditworthiness, and thus far the ECB has refused to get meaningfully stuck into sovereign bond markets this year. The prognosis is not great.
To be fair, Moody’s analysis is not all doom and gloom. The agency points out that institutional reforms within the euro area could strengthen the credit rating of most or all euro area countries. But the transition period during which those reforms are enacted could be several years, and during that period the risks are likely to remain high. As such, the analysis is a reminder to all players and commentators that the economic fate of euro area members is closely entwined, even if the euro does break up. And even though things are very uncertain, we need to think about what implications different scenarios could have.