Sarkozy Gets His Respone: A Latvian Sovereign Debt Downgrade

Yesterday I wrote what was in the event a reflective, and possibly excessively guarded, post on the issue of the proposed EU Commission investigation of the debt rating agencies like Standard and Poor's and Moody's. (But then again, these are troubled times, so perhaps guarded comments are in order). Anyway the response from the ratings agencies wasn't long in coming. Yesterday Moody's warned of a potential LTCM-scale hedge fund collapse (hardly likely to pour soothing oil on troubled waters that) and today Fitch has cut Latvia's country rating to BBB+. None of this is going to help stabilise things, but I really can't see what else people expect the ratings agencies to do if you start to pile the pressure on them.

So why am I pointing the finger at Nicolas Sarkozy? Well, according to the Financial Times:

In a letter to Angela Merkel, the German chancellor and acting president of the group of eight industrialised nations, which includes the G7, Mr Sarkozy highlighted his concerns over the weaknesses of the international financial system revealed by the present crisis.

He called for G7 finance ministers to draw up proposals for their meeting in Washington in October to address transparency and risk awareness among market participants and regulators.

He said the G7 should join the European Commission in investigating the role played by credit ratings agencies in the crisis, and said that bank involvement in credit markets should also be addressed.

Now obviously, in general terms, there may be little to disagree with here. A nice theoretical discussion of transparency, and the role of the ratings agencies (which could also be extended to the role of the EU Commission and the ECB when it comes to the tricky question of the sovereign debt ratings of some delicate EU member states) may well be in order. But, I ask you, is now, precisely now, the moment to be airing all this. Isn't the number one priority for everyone right now to settle the markets down, and to try and pass through this storm without any excess damage?

But no, we need a scapegoat, and the scapegoat it would seem is to be the ratings agencies, forgetting conveniently in the process that only last week they were being regarded as the last firewall of collective defence.

So what do you expect, the agencies themselves hit back, at least to cover themselves. Yesterday it was Chris Mahoney, vice chairman of Moody's who responded in kind:

Moody's Investors Service fueled concern that the global credit crisis is worsening by speculating that a hedge fund collapse on the same scale as Long-Term Capital Management LP in 1998 is possible.

Hedge funds face potential losses on collateralized debt obligations, securities packaging bonds, loans and other assets, Chris Mahoney, vice chairman of Moody's, said on a conference call today. The funds are unable to agree on prices to sell riskier assets, causing the market to seize up, Mahoney said.

Then today it was the turn of Fitch:

Latvia's long-term sovereign rating was cut to BBB+ from A- by Fitch Rating Service as government plans to keep the economy from overheating are ``insufficient.''

``The Latvian economy is severely overheating and Fitch considers the policy reaction of the government to be insufficient to restore the economy to a sustainable growth path,'' David Heslam, director of Fitch's Emerging Europe sovereigns groups said in an e-mailed statement.

Fitch left the outlook at stable. The Baltic country had its credit rating cut by Standard & Poor's in May to BBB+ on concerns the country's growth was accelerating out of control, resulting in a so-called ``hard landing.''

Now this decision by Fitch also begins to put the ECB in an interesting situation. Let us go back to November 2005, and the ECB decison to only accept bonds with at least a single A- rating from one or more of the main rating agencies as collateral in its financial market activities (and the original article here).

Well technically Latvia still has an A2 rating from Moody's, and this is equivalent to an A- (as has Italy in the case of Moody's), so the ECB will in theory continue to accept Latvian paper, but at this pace it would only seem to be a matter of time before Moody's downgrade too, especially with Sarkozy loading on the pressure. This will, apart from making it much more difficult for the Latvian government to raise credit, effectively take away the guarantee which underpins the present structural distortion in the Latvian economy, put even more distance between Latvia and membership of the euro, and complicate the task of the Latvian government in trying to steer the economy forward. Bottom line: is all of this a good idea. Answer: what you ask for is what you get, so my advice in future is to think first before opening your mouth.

The principal point I want to make here is that while in the normal course of events such downgrades - or the threat of them - may serve a useful purpose by putting pressure on governments to change course, in the current climate these very same downgrades may only serve to provoke the very situation which they are intended to avert, and that is the danger now. Let us remember what Buttonwood wisely, and possibly presciently, said:

As central banks lose authority, might credit-rating agencies play the watchdog role? By acting swiftly to downgrade debt, they would constrain companies (and countries) from borrowing too much. But the agencies tend to lean with the wind, rather than against it. They upgrade debt when the economy is booming and downgrade it when recession strikes. If the central banks do eventually slam on the brakes, therefore, the rating agencies will only exacerbate the downturn. As asset ratings fall, investors will be forced to sell their holdings and credit will be withdrawn from the system. Thanks to the financial markets, central banks now struggle to police the economy. But this may imply that the bust, when it comes, is as hard to control as the boom that preceded it.