Ratings agencies, sovereign credit, structural factors and the French presidential election are all contained in the latest thoughts of César Pérez, EMEA chief investment strategies at JP Morgan Private Bank.
Understanding Sovereign Credit Ratings
To get an inside perspective on a rating agency’s approach to sovereign ratings, we thus invited Fitch Ratings to present to some of our clients and investment professionals in Europe.
Below are some key take-aways from these meetings. Like other rating agencies, Fitch assigns the largest weightings in its sovereign creditworthiness assessment to structural factors (breadth of the economy, rule of law, and political stability); this has historically justified higher ratings in the developed world, where the quality of institutions is on average higher than in the emerging world and where sovereigns are accustomed to issuing debt in their local currency. But with the current crisis, public finances (debt level and budget deficit), and financial flexibility (debt currency denomination), are receiving increasingly more attention. Hence, there has been heightened concern over debt dynamics in Europe’s periphery.
In assessing a country’s structural factors, rating agencies do not limit themselves to a review of financial indicators only. Instead, they look for a balance in various key economic indicators such as per capita income (see chart below), unemployment, and the diversity as well as volatility of government revenues (see chart below). The latter is an important factor to consider, because the more volatile a government’s tax revenues, the less debt it can safely borrow and service. Consequently, policies aimed at improving one or more factors at the expense of another need to be evaluated diligently in order to derive their eventual impact on a country’s rating.
In their explanations for recent downgrades of periphery countries, rating agencies have regularly voiced concern over future growth and labour market inefficiencies. Besides targeting shrinking budget deficits and thus creating better debt dynamics, European policy makers have given a lot of attention to policies aimed at improving the structural growth prospects of these economies. The newly introduced labour market reforms by Mario Monti are a good example of a structural initiative aimed at exactly this.
The quantitative indicators that we described above are supplemented with qualitative factors such as rule of law, political and social stability, business environment, or government effectiveness. Unfortunately, including such factors in a numerical model can be relatively complex. Therefore, rating agencies use a range of rankings mechanisms including the World Bank governance indicators (see chart below) to account for these qualitative factors. In this example, the blue line represents the average scores of AAA rated sovereigns. With lower scores on the different indicators, the overall sovereign rating decreases accordingly.
While the VAT is a major contributor to government revenues, we note that overall the French tax burden is one of the highest in Europe (43.8% of GDP in 2011). Social security contributions make up 60% of tax revenues (against 35% in the early 1970’s). In the long term, this could constitute a hurdle to the economy’s competitiveness on an international level.
In the short term, the upcoming austerity, the 10% unemployment rate and the elevated savings rates also suggest there will be no significant improvement in consumption in Q1 2012. Based on these structural factors, private consumption is expected to remain weak for the remainder of 2012.