Comparing Sovereign Ratings to Reality

by Elliott R. Morss


I never had much use for financial ratings. I view them as second best reference points for lazy financial sector workers and people who are unable to research investment possibilities on their own. And as we learned in the recent banking collapse, the raters have no idea what is going on. So what do we draw from the S&P rating change for the US? Well, at least the ratings change does focus attention on the US financial condition.

US fundamentals have not suddenly changed. The country is still in a recession. Sound fiscal policy calls for another stimulus package that would increase its government debt. How does the US compare with other countries on ratings and real economic conditions? Read on.

Country Comparisons – Financial Indicators

Three key indicators of financial problems for any country are its government deficit, government debt, and a current account deficit. Government deficits increase government debt, and debt can get become unsustainable, e.g., Greece. However, if countries run large current account surpluses, e.g., Japan, they can continue with large deficits and debt. Foreign investors know that if either becomes too onerous, the government can pay them off with foreign exchange reserves. However, current account deficits must be financed by capital inflows, and the need for continuing large capital inflows can become problematic. Greece is again the prime case: foreigners are not interested in either loaning or investing in Greece, and hence its capital inflows do not offset its current account balances, and hence – crisis.

These indicators are presented for 23 countries in Table 1. To make comparisons possible, they are expressed as a percentage of their GDPs.

Let’s now look at how the governments of these countries are rated for foreign investors by Standard and Poor’s. In Table 2, I present the S&P ratings. In the third column, I convert the ratings to a quantitative index. In my index, the best rating (AAA) gets a 10 while S&P’s worst (D) would get a 1 (AAA=10, AA=9, etc.). In my table, “+” adds .4 to a rating and a “-” subtracts .4 from a rating.

Now, let’s see how the economic conditions compare with the ratings. For this, I have taken the average ranking of 23 countries on the three economic conditions indicators, and compared it with my numerical indicators for the S&P rating. The results appear in Table 3.

I have listed countries in the Table by their economic condition rating. Note that the US ranks just above Greece and lower than Ireland, Portugal, and Spain. And yet, S&P gives it a 9.4 (AA+) ranking for foreign investors. Hmm. Well, of course, the S&P ratings include political risk. Political risk???  What?  With what is going on in DC, the US is a safe political risk????

Well, I have never thought much of rating countries, and my view has not changed. Incidentally the R2 (correlation between the two indicators) is only 0.19.

For more than two years, I have advised investors to get their money out of Europe, the US, and Japan. Even though the emerging stock markets get hit whenever a new crisis appears in the West, my view has not changed.

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The Sovereign Debt Crisis and Currency Sovereignty by Edward Harrison

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2 replies on “Comparing Sovereign Ratings to Reality”

  1. This comment was left on LinkedIn by Bill Harrison, Independent Financial Services Professional, Raleigh-Durham, NC:

    “As a long term Financial and Credit Analyst I agree with your opinion such ratings are for lazy financial sector workers and institutional investors.In October 2008 I confirmed that major global investors had invested in seventy three trillion dollars of poorly performing and poorly documented tranches of First and Second Mortgages, Cross Defaults, and “synthetics” , only because these investors, and Standard and Poor, assumed if endorsed by Freddie Mac or Fanny they were “U S Government Guaranteed” ” Legal Reserve” investment grade (AA or AAA)I called State Insurance Commissioners, University Endowment Managers,state and federal investors; all said rated AA/AAA by S&P they did nothing.”

  2. The whole purpose of the ratings agencies is to substitute for investors’ due diligence. In so doing, they screw up the market. With buyers each expressing his or her own intelligence, information would have to be accessible to their examination. Instead investors rely on the questionable intelligence of the ratings agencies’ staff, who if they were any good, would be working somewhere else. Case in point, downgrading the U.S. when the U.S. can print money. I suppose it is possible that we could refuse to pay our debt, but it is not possible that we could be prevented from paying our debt by some sort of fiscal predicament. It is certainly absurd that the same voices that got us into the last mess — the ratings agencies — are being listened to now.

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