Standard & Poors Downgrade Serious but not Catastrophic
“I don’t think we should be slaves to the ratings agencies. What we’ve seen is, the action they took recently did actually have no impact on the yield that people in the market were willing to lend to the UK government…” — Mervyn King, governor of the Bank of England in an address to British lawmakers, February 29, 2012.
Last Tuesday’s announcement of S&P’s downgrade of Barbados’ long-term foreign- and local-currency sovereign credit ratings to BB+ from BBB- was unwelcomed and disappointing but not entirely surprising. S&P also lowered Barbados’ short-term ratings to ‘B’ from ‘A-3′ and reckoned that Barbados has a 50 per cent to 70 per cent chance of recovery in the event of a default.
A BB+ credit rating is considered to be the highest speculative grade by market participants. Regrettably, Barbados’ credit quality is now among the class of speculative grade; commonly referred to as “junk”. This negative assessment report came on the heels of a bleak Central Bank economic outlook for the rest of 2012.
Following the March laying of the 2012/2013 Estimates of Revenue and Expenditure in the House of Assembly, I warned in these pages that Barbados was courting another credit rating downgrade. I was hoping that the Government would have noted that its planned expenditure for the coming year was too high, and recalibrate its planned spending.
The 2012 Budget presentation could have been used to present to the people of Barbados a credible programme of government restructuring; designed to accelerate current expenditure cuts, slightly increase capital spending to spur growth and in the process, initiate the creation of a far more effective public sector. That was not to be.
I wish that my warning was misplaced. The unprecedented downgrade of Barbados’ creditworthiness to “junk status”, though not catastrophic has serious implications. Before I discuss those implications, I believe it is in the public interest to emphasise what the downgrade is not.
Though rating agencies are quite influential, that influence is limited to the sphere of debt issuers (governments, corporations and financial intermediaries) and financial market participants (subscribers, buyers and sellers of fixed income securities such as bonds). A sovereign debt credit rating is not an indication of whether or not a country is a good or bad destination for foreign direct investment or domestic investment.
Quite frankly, credit rating agencies are not the appropriate barometers of a country’s past, current or future economic performance. Assessing a country’s economic fortunes is not their primary area of expertise and they like the rest of us, rely on the official sources of economic information and analysis — sources such as central banks, national statistical agencies, finance ministries, reputable non-profit think tanks, the IMF and the World Bank.
As a matter of fact, the credit ratings from rating agencies are not intended to be indications of the merit or suitability of an investment. What they speak to is the credit quality of the borrower.
It is unfortunate that those who do not quite understand the relevance of credit ratings or the role of rating agencies perceive S&P and Moody’s country assessments and credit ratings as authoritative arbiters of a country’s economic strength, performance or future prospects. Yes, the economic assessment of any country which is provided by a rating agency serves as a useful independent opinion of a country’s economic performance
However, it is important to recognise that the more a rating agency strays away from its core competence, that is, to appraise the relative risk of credit default and losses, the more it enters the realm of speculation as it unwittingly yields to the temptation of seeking to unduly influence public policy. That is a classic manifestation of occupational hazard.
Regrettably, in Barbados the myths associates with the credit ratings of S&P and Moody’s are also perpetuated by political operatives who choose expedience in an attempt to exaggerate the significance of changes in sovereign credit ratings when it suits their purposes.
Just as a bank or credit bureau conducts a credit assessment of a potential loan, mortgage or credit card applicant in order to determine their creditworthiness (risk profile), a credit rating agency provides a credit rating (score) of the credit worthiness of a company or government. The past and future financial performance of the corporate or sovereign and the stock of its outstanding debt (loans, bonds etc.) are the primary factors which determine creditworthiness or default risk.
Since the economic circumstances and business environment invariably impact on the finances of governments and companies, they are taken into account when evaluating credit risk. It is akin to a credit bureau taking an individual’s job prospects and job security into account when appraising his/her credit risk.
S&P is no more an authority on a country’s economic prospects than a credit bureau is an authority on an individual’s job prospects. Both the credit bureau and the credit rating agencies are paid to provide an independent, reputable credit rating which conveys the relative risk of default or losses to prospective and existing lenders. The rating outlooks provided by credit rating agencies signal to financial markets the likely direction of a future credit rating. The outlooks also signal to governments and companies whether or not it is necessary to change course or stay the course.
It is against this background that the governor of England’s central bank recently suggested that policymakers should not be slaves to ratings agencies, after all the remit of makers of public policy is much broader than that of the rating agency. They have to balance good financial management with desirable economic and social outcomes.
Moreover, according to a Bloomberg study, “almost half the time, government bond yields (implied future interest rate on new bond issues) fall when a rating action suggests they should climb, or they increase even as a change signals a decline”. IMF research on the effectiveness of credit ratings found that prices moved in the expected direction 45 per cent of the time for developed countries and 51 per cent for emerging economies.
What this means is that credit ratings downgrades do not necessarily result in higher interest costs on future bond issues since the international financial markets also take other key factors into account when pricing bonds. In some cases the cost of future debt falls following a credit rating downgrade. The caveat in applying these findings to the Barbados case is that the countries which were studied are much larger than Barbados, their currencies are traded internationally and their monetary policy arsenals are more robust.
Barbados’ credit rating downgrade by S&P will most likely result in higher interest costs whenever the Government of Barbados finds it necessary to source financing on the international capital markets. At least one year ago, the Government indicated that it will finance its fiscal deficit exclusively from domestic sources and multilateral development agencies. It has remained committed to that policy.
During the Central Bank’s press conference, the governor reiterated the policy while emphasising that the government had no intention of going to the international capital markets to raise funding to finance its deficits in the foreseeable future. It therefore means that there are no immediate adverse financial implications for the Government or people of Barbados.
However, Barbadian companies with operations predominantly based in Barbados will face higher capital costs if they seek to borrow outside of Barbados. Higher costs of capital could reduce the rate of return on investment. It could also necessitate higher prices for the goods and services that would eventually be sold to customers as a result of the investment.
I am subject to correction but I do not think that many of Barbados’ companies source debt financing abroad; thus any fallout from the downgrade is unlikely to be widespread. Some examples of companies or projects which would have been affected if they had not already secured foreign debt financing are the Four Seasons project, Banks Holdings plant upgrade and the Barbados Light & Power.
S&P’s “speculative grade” rating of Barbados’ credit instruments also means that institutional holders of Barbados’ outstanding foreign- and local-currency bonds are likely to offload (sell) those bonds and replace them with “safer” instruments in order to remain in compliance with prudential risk management controls. Many pension funds and portfolio managers are required to invest exclusively in investment grade (low risk profile) securities and risk free assets. If the majority of Barbados’ exiting FX bond holders fall into this category of investors, the prices on those bonds are likely to fall thus increasing their yields (the implied interest rates that will be demanded on future bond issues).
In short, the implications of the recent S&P downgrade are higher interest rates and debt servicing costs for future Government and corporate borrowing. Similar to an individual, a high debt burden is made more onerous by higher interest charges; and Barbados’ debt is already high.
Additionally, it is likely to become more onerous to raise capital on the international capital markets due to a plausible reduction in the pool of investors with an appetite for Barbados bonds. These developments will reduce Barbados’ fiscal policy space i.e. the country’s capacity to cope with external shocks (deterioration of the external environment or natural disasters).
The ability to borrow foreign exchange is an important policy tool to have in the toolkit in the event that it becomes necessary in the future; this option has been undermined by the downgrade to “junk status”.
Barbados will be no less an attractive destination for FDI than it was before the S&P downgrade. The downgrade definitely isn’t good news but the sky is not falling. There are no imminent devaluation prospects and the Government of Barbados is not likely to default on its debt obligations now or in the near future.
The downgrade of Barbados’ credit rating on domestic debt is more like to invoked dire consequences as the vast majority of the public debt is domestic and there is evidence that local investors in domestic government paper were already becoming more and more apprehensive about investing government securities. S&P has now validated those fears. The Government of Barbados’ reliance on short-term debt for cash flow purposes has also been cited as a red flag.
A lot of the reaction to the S&P downgrade has been overblown, but the downgrade to “junk” is certainly a wake-up call. The fiscal deficit is still too high, efforts aimed at fiscal consolidation have been to slow/shallow and the current policy framework to clean up Government’s finances and pivot the economy towards sustainable growth has been so far insufficient and inadequate.
It is clear that Barbados’ risk of a sovereign default is increasing rather than decreasing. The trend must be reversed. Barbados’ weakening economic fundamentals and structural and competitive shortcomings stem from a high cost structure (compounded by high indirect taxation), poor service standards, an aging tourism product and lost competitive advantages in the international business and financial services sector. The implication is that though Government must lead; all sectors of the society and economy need to substantially change how business is done in Barbados.
The scale of the challenges before our country requires bold, decisive and timely adjustments to the structure of government and its finances, and the way we do business. Hopefully the Government will be up to the task before it is too late. The clock is ticking and the days have been shortened.
(References utilised in this article: Bloomberg News.com, http://www.bloomberg.com/news/2012-06-18/austerity-doesn-t-pay-as-debt-markets-ignore-rating-cuts.html)
Carlos R. Forte is a Commonwealth Scholar and Barbadian economist with local and international experience. C.R.Forte@gmail.com