Risks in Europe’s Ratings Merry-Go-Round; It’s Not Easy Being a Ratings Firm, Particularly When it Comes to European Sovereigns

Risks in Europe’s Ratings Merry-Go-Round

It’s Not Easy Being a Ratings Firm, Particularly When it Comes to European Sovereigns

RICHARD BARLEY

March 28, 2014 11:30 a.m. ET

Ratings firms are facing calls to upgrade euro-zone sovereigns again. Investors seem likely to be disappointed if they are hoping for swift actions.

It’s not easy being a ratings firm, particularly when it comes to European sovereigns.

First firms such as Moody’s, Standard & Poor’s and Fitch came under fire for moving too slowly as the euro-zone crisis developed, with markets discounting southern European government bonds ahead of downgrades. Then they were criticized by politicians and policy makers for overreacting to the crisis and contributing to its acceleration. Now, some investors are asking the ratings firms to dish out upgrades, arguing that sovereign assessments are too low.

That is a red flag that the search for yield is acting as a more powerful force on investors than the assessment of risk, just as in the precrisis days. Back then, the ratings firms faced pressure to upgrade Greece — which was then rated in the single-A category. Investors wanted to take bigger exposures to Greece, whose bonds yielded some 0.2-0.4 percentage points more than Germany in 2004-2007. The search for yield meant that this was seen as an attractive pickup in returns. But a single-A rating for a government meant that some investors faced limitations on how much they could hold.

Now the search for yield is on again, and calls are being made for Spain and Portugal, in particular, to be upgraded. Ratings are much lower—in Portugal’s case, the country is stuck well below investment-grade status, meaning that its bonds are off limits to many investors. UniCredit UCG.MI +0.62% this week estimated that based on economic statistics, Portugal and Spain should both be rated a whopping five notches higher than they currently are.

And the returns this time are mouth watering. Portuguese bonds have returned 11.6% year-to-date, according to Barclays, BARC.LN +0.19% with 10-year yields falling by over 2 percentage points to below 4%–still some 2.5 percentage points above German yields. Spain has returned 5.9%.

True, the situation in the euro zone has clearly improved since the dark days of mid-2012. Liquidity pressures have receded—even Greece seems likely to return to market funding soon—and the economic outlook has improved too. The risk of another Greek-style government debt restructuring appears minimal. Spain and Portugal have made progress on reforms and are back to growth. That would argue for higher ratings.

But debt burdens are still rising, and in several cases stand above 100% of gross domestic product. Concerns remain about long-term debt sustainability unless governments continue with economic policies that are likely to boost growth potential. With markets no longer pressuring governments into action, the risk of complacency has risen. Even for countries that have made good progress on reform, like Spain, there is further to go. Italy and France have yet to start.

Ratings firms have reflected the stabilization in Europe by lifting negative outlooks—but only to stable in most cases. That looks sensible given the remaining risks: investors lobbying for swift upgrades deserve to be disappointed.