September 21st, 2011
12:05 PM GMT
Editor's note: Elisabeth Afseth has worked in bond markets for 17 years, starting out at Williams de Broe. She currently works as a fixed income analyst for Evolution Securities. She has an economics degree from the London School of Economics and a masters in economics from Oxford University.
London (CNN) – Just when everyone was waiting for ratings agency Moody’s Investors Service to downgrade Italy, Standard & Poor’s gets in first with what is a much more damaging downgrade. S&P’s rating of Italy was already lowest of the three major agencies, and its downgrade from A+ to A, with a negative outlook, puts it three notches below Moody’s Aa2 rating (on watch for downgrade) and two notches below Fitch Ratings' AA-.
The financial markets largely shrugged off the downgrade. While bond yields on Italian sovereign debt - an indicator of risk - rose slightly, European equity markets were positive through the day.
Some have argued a downgrade was expected so therefore priced in. But it wasn’t this downgrade that was expected or priced in. It came from the agency with the lowest rating, which did not even have the sovereign on credit watch, but merely a negative outlook. Negative outlook generally means there is a one in three chance that the issuer may be downgraded within two years - it is much less of a warning of an imminent downgrade than a watch for downgrade.
To illustrate the point, S&P's has the U.S. rating on negative outlook after its controversial downgrade in August; I think it would be fair to say most market participant would be very surprised if the ratings agency downgraded the U.S. in a couple of months.
So how much does the downgrade matter?
It doesn’t alter the eligibility of Italian bonds as collateral for the European Central Bank, which banks need to borrow funds. It doesn’t cross any key ratings thresholds, therefore is unlikely to trigger automatic selling.
What we need to watch is investors’ confidence in Italy, and if those investors continue to buy the country’s sovereign debt.
Italy needs to raise about €380 billion of funds by the end of 2012. After the recently added austerity measures, Italy is expected to run a deficit of 1.2% of gross domestic product next year (though the ratings agency in yesterday’s report questioned the government’s budget savings projections). This is not a large deficit by global comparison.
Also in Italy’s favour is its debt maturity profile - the average life of government debt is just over seven years, which is longer than most, though there are quite hefty redemptions over the coming five years.
Italy’s main problems are lack of economic growth and a very high debt burden, at 120% of gross domestic product, which almost inevitably means large rollover of debt every year and therefore sensitivity to interest rate levels. The first problem needs to be addressed by politicians implementing structural reforms; the second requires investors' confidence so that they keep buying the bonds. These issues are interlinked, as that confidence will be very difficult to maintain if the resolve for reforms is seen to be falling short.
The €380 billion Italy needs over the next 15 months would pretty much wipe out the current European bail-out fund, or European Financial Stability Facility - even if the modifications to the facility are approved to allow it to increase its lending capacity to €440 billion. Italy is the third largest euro area country, generating about 17% of total eurozone growth (compared to Greece, Ireland and Portugal which combined account for about 6%).
Any contagion effect would be extremely serious. If markets decide not to fund Italy it is very likely that the fourth largest country, Spain, will also need support. Spain needs about €200 billion to cover redemptions and deficit funding requirements between now and the end of 2012.
The Italian and Spanish have benefitted from central bank support in the bond markets over the last six weeks. The ECB has bought up about €80 billion of the debt - which keeps the country’s funding price down - since it started intervening in the market.
We know that there is opposition to the program which enables this intervention, both within the ECB and amongst European politicians, but for the time being it looks the closest we are to a solution to the European debt crisis.
The ECB keeps repeating it cannot solve the euro area’s problems - that is the job of politicians, and will require financial and economic changes. But the ECB and expanded bailout funds can buy the high deficit/debt countries much needed time.
We can than just hope that this time is then used more efficiently than S&P’s revised outlook suggest.
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