05 August 2013

Reuters: Europe's downgrade diary flags up new market pressures

New European rules requiring credit agencies to announce their rating decisions to a pre-set timetable are likely to expose the region's shaky sovereign borrowers to more bursts of market pressure.

Under the CRA III rules taking effect at the start of next year, credit rating firms will have to make the dates of their sovereign reviews - when downgrades, upgrades or outlook changes usually happen - public in advance. Ratings are a key part of the financial system because investors use them to judge how likely they are to get their money back, but the financial crisis has led to unease that the market is relying on them too much. Europe's changes aim to make the secretive ratings process more transparent, reduce the clout of big firms like Standard & Poor's, Moody's and Fitch, and stem the constant downgrade rumours that unsettle investors.

But behind the scenes, some policymakers are warning that the plans could end up creating what one called a "downgrade diary" that speculative traders could use to target vulnerable states. Regulators and rating agencies are worried too, concerned that having specific dates for moves risks producing "cliff effects" whereby markets gyrate in anticipation of possible rating changes and then correct on the news. 

Analysts are not exactly sure how big the pre-rating decision price swings will be under the new rules. Mario Draghi's "whatever it takes" promise last year on behalf of the euro has reduced market sensitivity to ratings, but traditionally it has been high, especially if a move or outlook change takes rating in or out of investment grade territory, or makes such a move likely. The ECB's two-tiered lending system, where banks are allowed to borrow 5 per cent more if the bond they put up as collateral is rated in the AAA to A- band, also plays a big role.

When Moody's downgraded Portugal by four notches in July 2011 following Greece's debt restructuring, Portuguese and Irish bond yields leapt almost 250 basis points and European shares lost 3.5 per cent in the space of two days. And an International Monetary Fund study last year showed that a top agency putting a country's rating on "downgrade-watch" on average leads to a 100 basis point widening in Credit Default Swap Spreads (CDS) in advanced economies and one of 160 bps in emerging borrowers.

"We would have to adjust what we do and start thinking about who is vulnerable as those dates approach", said Deutsche Bank senior eurozone economist Mark Wall.  "If you have deteriorating fundamentals, if there has been disappointing progress on structural reforms, then there is the risk of a downgrade and the market is going to be looking at that."

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