02 February 2012

Charles A E Goodhart: Sovereign ratings when default can come explicitly or via inflation

The authorities in Britain are proud of the fact that over the last three centuries there has been no default on British government debt, despite debt-to-GDP ratios climbing to high levels (near or over 200 per cent) after each of the three main wars. But that did not mean that holders of such debt were necessarily paid back in full in real terms. At the start of 1946 the nominal value of 3½ per cent Consols was £104.7; at the start of 1986 its nominal value was £34.75, and in the meantime the price level had risen from 27 to 385.9 (1974=100), about 13 times. So the real value in 1986 was about 1/40 or 2½ per cent of its 1946 value, a real haircut of some 97½ per cent, though this ignores interim coupon payments. Inflation, especially anticipated inflation, can destroy real value as quickly and surely as default.

Explicit default versus real default by inflation

Credit ratings do exactly what is claimed on the tin – they measure the risk of default. Indeed credit rating agencies have done conspicuously well in the recent sovereign debt crisis, downgrading Greece before the market caught on and speaking truth to power. But such ratings do not, and have never claimed to, measure the probable loss of real value from holding nominal government bonds owing to inflation.

In the last three years, for example:

• Inflation in France has averaged 1¼ per cent compared with 3⅓ per cent in the UK.
• Expectations of future inflation, as measured by the margin between indexed and nominal bonds are 1.6 per cent in France and 2.5 per cent in the UK.

Given the respective positions of the two countries, it is arguable that inflation might be higher in the UK than in France. But the UK will hold and France has now lost its AAA rating, because the danger in the UK is inflation, not default, whereas there is a tiny danger of default in France, offsetting its greater likelihood of price stability.

By this single criterion of the probability of default, it would seem that any country with command over its own printing press should be AAA, since it can always inflate its (nominal) debt away. “Not so”, claims S&P as it downgrades the rating of the US, since one must consider willingness as well as the ability to pay. But that position has some absurd logical implications.

A government that came into office promising inflation rather than price stability should on that criterion be given a better credit default rating; thus if Greece should leave the euro and re-adopt the drachma, the logic of the S&P stance is that its government bond rating should rise sharply, as long as its bonds were all in nominal form. If a country issues both nominal and indexed bonds in its own currency, then an increased tendency towards greater inflation would simultaneously lower the potentiality for default on nominal bonds, but raise it for indexed bonds.

A supplementary government debt credit rating

The implication that I draw is that government debt credit ratings should be augmented with a second rating measuring the potential loss of real value, whether by inflation or default. While this would involve a continuous adjustment of inflationary expectations, the market for indexed bonds, and surveys are already providing masses of data on this; it should not be particularly difficult to do or to defend.

Where countries issue all their debt in foreign currencies, notably all eurozone countries, the domestic inflationary option is not open to them, so their rating comes much closer to a true measure of the potential loss of real value. In cases where countries issue nominal debt both in local and foreign currency format, there is a tendency for the ratings agencies to adjust the foreign currency rating a notch or two above that of domestic debt. This is wrong because a greater proclivity to inflate lowers the default risk on local currency nominal bonds, but raises it on foreign currency bonds. It is only when the risks are assessed in real terms that the ratings should move in tandem.

Financial institution reactions

Financial institutions would not be happy with such an additional (real value) rating. Their own liabilities are generally also in nominal format. The second rating of government debt, adjusted for inflation, would be lower than the present credit rating for all countries with their own currencies, with the possible exception of Japan. The ratings of banks are usually below that of their sovereign, so the inflation-adjusted ratings of British and US banks would fall further. But from the viewpoint of a creditor of such banks, so they should; if inflation remains above the interest rate offered on such deposits, they lose real value continuously. Hyperinflation destroys the value of fixed income claims as surely, and almost as quickly, as default.

The French claim that the credit rating of government debt in the UK should have been downgraded before that of France is wrong under present practice, but has some considerable conceptual validity. If an investor had $100 to spend on either French or British bonds today, which offers the greatest probability of paying back more in dollar terms in five years’ time? How far is a slightly greater chance of French default offset by a somewhat greater probability of British inflation and concomitant exchange-rate decline?

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