The meaning behind the AAA Credit Rating
A credit rating is supposed to assess the chances of a firm or country defaulting on its debt. These are decided by credit rating agencies, of which the biggest three are Standard & Poor’s, Moody’s investor service and Fitch ratings, of which most people would have heard of at some point in the news. The credit rating of a country can have an impact on who buys their debt, which is sold using government bonds (Glorified I.O.U’s). The top rated countries belong to North America and Europe, while countries in Africa, South America and Asia are downgraded due to political instability and lack of modern infrastructure (i.e. transport, healthcare etc).Standard & Poor ratings
So what does the AAA credit rating (the highest rating a country can be awarded) actually bring to a country? The rating means it is believed this country can pay its debts (aka is reliable), which means the country has a better chance of borrowing money (through bonds)and also borrowing it cheaply with vice versa for badly rated countries. Each credit rating agency can disagree though, with Standard & Poor choosing to downgrade USA to AA rating, but the other two agencies deciding against it. Surprisingly, some might say, China and Japan do not have AAA rating. Japan lost theirs in 2001 after poor economic growth and an ongoing problem with deflation, which is ironic because Japan as the biggest net creditors are rated lower than the world’s biggest net debtors, USA. With China, the world’s second largest economy, it is harder to see why they do not have the top ranking. But the fact is China hold a lot of debt and though debt to GDP ratio looks a comfortable 20% this climbs much higher to around 80% when local government debt is included. Local governments borrowed money from banks during the financial crisis, with the knowledge that the national government could bail them out, but there is uncertainty over the amount of debt and whether the national government can do as they say, which leads the rating agencies to decide against giving out AAA credit ratings.
Showing China’s hidden debt, which when other factors are considered rises to around 70-80%
There has been recent rating changes in Europe, with France downgraded by Standard & Poor (though they kept their AAA rating with the other two agencies). This was followed by downgrades for Spain, Cyprus, Portugal, Austria, Slovakia, Slovenia and Malta by Standard & Poor. The UK was also warned recently by Moody’s that they could face a downgrade in the near future due to poor growth, rising debt and exposure to the Euro crisis. The USA lost its AAA credit rating by Standard and Poor because of rising debt and an inability to decide on future action to lower their deficit. Are these countries now less reliable?
Japan lost its AAA credit rating and was hardly affected; the government borrows mostly from the public, so the rating did nothing to harm the economy. The same thing happened to the USA, but more was expected to happen, they rely heavily on selling their treasury bonds to the World, which before the downgrade was basically known as risk free, with prices even going up during the financial crisis as markets looked to invest in something rock solid. But even after the downgrade, markets still believe in the US, and still believe there is little risk in buying their debt. This is because, the sheer size of the USA means if they were to ever really default, it would topple the capitalist market, as each country is inter-connected. The Euro zone could only just about survive Greece defaulting, so it is hard to imagine the enormous impact a US default would bring. This fact keeps the USA safe from the effects of downgrading, with many criticizing Standard & Poor for merely pulling a publicity stunt, as in reality the US debt is still seen as risk free as it ever was before.
If America were to ever default…
So is the AAA credit rating flawed? The answer is yes in many ways. The three biggest credit rating agencies are all US based, with accusations over the fact that USA kept their AAA credit rating for years despite having an unsustainable deficit. Another criticism thrown at the credit agencies is that their downgrades can become a self-fulfilling prophecy, with Greece, Portugal and Ireland’s debt crises accelerated after being downgraded. This gives the agencies a lot of power over markets; their mistakes can lead to some very negative outcomes and the fact that the big three agencies rarely agree means there must be errors in their decisions. Another criticism is that the bad debt that helped crash the markets in 2007 (sub-prime mortgages) was given AAA rating when it was pooled together, leading many investors to buy into it. The fact they are paid for their services means they can’t be impartial, especially when they are paid by the firms they are investigating. Europe has been critical during the euro crisis, stating the agencies have been too quick to downgrade countries with Greece, Portugal and Ireland given “junk” statuses in 2010. This argument flared up again in 2011 when Standard & Poor announced any restructuring of Greek debt would be classified as a default.
To conclude, maybe one day we won’t have to be so reliant on a few credit rating agencies to rule the markets, maybe investors could decide for themselves whether particular debt had too much risk and maybe… maybe one day our markets won’t be too reliant on debt in the first place, though that day seems a long while off.