The real meaning of Fitch's downgrade

The credit ratings agency Fitch has downgraded the UK's sovereign debt by one notch to AA+ from AAA.

This was not unexpected: the UK has been on "negative watch" for some time and was downgraded by Moody's not long ago. However, the terms of the downgrade are distinctly odd.

Firstly, let's remind ourselves what the purpose of a credit rating is. For sovereign debt, it is supposed to give investors an indication of the risk of loss due to default. Therefore it will assess the conduct of fiscal and monetary policy in the country concerned in the light of key macroeconomic indicators. Neither the indicators themselves, such as the projected path of GDP, interest rates and debt/GDP, nor the economic policies alone are a sufficient indicator of default risk. Both are needed to give a reasonable assessment of the likelihood of sovereign default and/or debt restructuring.

Credit ratings are NOT intended to give a general indication of the health of an economy. Nor are they intended to indicate risk of indirect losses due to inflation or low interest rates.

So the downgrade indicates that the UK is considered slightly more likely to default on its debt than countries such as Canada and Norway that still have AAA ratings.

The justification for this is the UK's weak economic performance, which despite government's best efforts to contain public borrowing is creating a rising debt trajectory - now expected to peak at over 100% of GDP - and large fiscal and current account deficits. Fitch correctly notes that the rising proportion of debt/GDP increases the financial fragility of the UK economy, making it less resilient to economic shocks.

That seems reasonable, doesn't it? Except that Fitch then goes on to undermine the entire justification for this downgrade by pointing out that there is virtually zero chance of a "self-fulfilling fiscal financing crisis" because of the UK's status as a reserve currency issuer and the Bank of England's willingness to "intervene in the government debt market" (i.e. buy sovereign debt). If there is virtually zero chance of a fiscal financing crisis, then there is virtually zero chance of debt default. In which case, what exactly is the point of this downgrade?

Fitch implies that, rather than allowing the UK to default on its debt, the Bank of England would monetise it. Now, the risk from monetisation is inflation. But a credit rating does not assess the risk of losses due to inflation. It is supposed to assess the default risk. If, as Fitch suggests, the Bank of England would as a last resort monetise debt, there is ZERO risk of default.

It is worth pointing out at this point that Fitch's implication that as a last resort the Bank of England would monetise debt ignores the fact that the UK is a member of the EU, and monetary financing of government is explicitly forbidden under the Lisbon Treaty. Whether or not the UK's debt does indeed have an increased risk of default therefore depends on the UK's commitment to the EU. The current government is perhaps a little wobbly on that: it may well be that, as a last resort, it would break the Lisbon treaty to prevent debt default. In which case there is still zero risk of default, though there might be considerable political and economic instability from such a course of action. However, if the UK chose to abide by its treaty commitments (not to mention its self-imposed limits on the extent of sovereign debt purchases by the central bank), then there would be some risk of default as large-scale monetisation of debt would not be an option.

But there is a more fundamental issue here. Fitch notes that the UK's public debt is denominated exclusively in domestic currency. A sovereign currency-issuing government should never default on its domestic-currency sovereign debt obligations, since it can always create money to settle them. Debt default for a sovereign currency issuer is a therefore a POLITICAL decision, not an economic one. Fitch's downgrade amounts to a vote of no confidence in the Cameron government, and particularly in the Chancellorship of George Osborne. And the timing of the announcement is exquisite, coming as it does at the end of a week which saw bad labour market figures, criticism from the IMF of the Chancellor's economic strategy, and the exposure of fundamental flaws in an economic theory frequently used to justify  aggressive deficit reduction measures.

For this reason, illogical though it seems, the Fitch downgrade should be taken seriously. The Government does not give the impression of being competent. Frequent U-turns on changes to taxes and benefits, poorly thought-out reforms of entitlement programmes, lack of coherent investment strategy, propping of an overblown housing market, failure to tackle bank reform, undermining of expansive monetary policy with ill-considered fiscal tightening.....none of these look like the actions of a Government that has the faintest idea what to do with a stagnant economy and damaged financial system. What is worrying is there is little evidence that the Opposition's ideas are any more coherent. Only today the Labour party outlined changes to the unemployment benefits system that would leave people in debt when they found a job: it was billed as "putting 'insurance' back into National Insurance", but I've never heard of an insurance system that forced people to repay money paid out under the scheme.

The biggest risk to the UK economy, and therefore to the safety of UK sovereign debt, is the clowns running our political system. Heaven help Mark Carney. He has a simply horrible job to do.

Related links:

Fitch downgrades United Kingdom to AA+ , Outlook Stable - Fitch Ratings (press release)
Moody's downgrades UK's government bond rating to Aa1 from Aaa: outlook now stable - Moody's (press release)
UK unemployment rises to 2.56m - BBC
A Bad Week for UK's Osborne - CNBC
Reframing Reinhart & Rogoff - Coppola Comment
Labour plans student-style "salary loans" for the unemployed - Guardian

Comments

  1. "The biggest risk to the UK economy, and therefore to the safety of UK sovereign debt, is the clowns running our political system."

    Bit harsh on clowns

    ReplyDelete
    Replies
    1. Yup, at least clowns try to entertain....

      Delete
  2. "... it would break the Lisbon treaty to prevent debt default."

    Frances, I think during the crisis (maybe in 2008 end/early 2009) the UK government made use of the ways and means advance of the Bank of England. If the Lisbon treaty were to apply, even limited overdrafts would have been strictly prohibited.

    ReplyDelete
    Replies
    1. Data here http://goo.gl/MRRGS

      Check late 2008/early 2009.

      Delete
    2. Article 123 explicitly forbids central banks from providing overdrafts and other credit facilities, and from participating in primary debt auctions:

      http://www.lisbon-treaty.org/wcm/the-lisbon-treaty/treaty-on-the-functioning-of-the-european-union-and-comments/part-3-union-policies-and-internal-actions/title-viii-economic-and-monetary-policy/chapter-1-economic-policy/391-article-123.html

      The usual fudge adopted by failing Eurozone countries is for domestic commercial banks to buy their debt using ELA or LTRO funding. This technically avoids breaking the Lisbon treaty. I suppose as a last resort the UK would go down this route - but as it dangerously leverages commercial banks with junk debt it is hardly going to prevent a fiscal financing crisis as Fitch suggests.

      Delete
    3. Yes I have seen it but still unsure whether it applies to the UK or just for the 17 EA nations.

      At any rate, the BoE data I linked says that the Bank of England did directly lend the UK government.

      Delete
    4. It applies to all signatories of the Lisbon treaty - which is the E27, not E17. I'm not sure what the terms of the "ways & means" advance are or how the treaty was circumvented in this case.

      Delete
    5. The ways and means advance is an overdraft to the government - direct lending by the central bank.

      Delete
    6. I know. I'm just not sure under what circumstances it can be used. Perhaps use in 2008/9 was allowed exceptionally because of market failure. There is no way it could be used to fund government in the event of a buyers' strike though - clear breach of Treaty terms.

      Delete
    7. The Ways and Means advance was used in 2008 temporarily to refinance loans made by the Bank of England to Bradford & Bingley and the FSCS. So really it was used for temporary commercial bank financing, not government financing. It facilitated the transfer of the funding for those institutions from the Bank of England to HMT and was in due course replaced with debt instruments by the DMO.

      http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb100102.pdf

      Delete
    8. Okay had seen it earlier but thanks for making me revisit it. It does say:

      "The facility remains available for use and at the end of December 2008 HM Treasury borrowed temporarily from the Bank using the facility to fund the refinancing of loans that the Bank had earlier made to the Financial Services Compensation Scheme and to Bradford & Bingley"

      So the HM Treasury did borrow directly from the Bank of England whatever the purpose.

      Delete
    9. I do agree that the fact that the facility remains available suggests that as a last resort the Government would break the Lisbon Treaty. In which case Fitch is correct about the fiscal financing risk and wrong about the default risk.

      Delete
    10. Yeah understand.

      I was just trying to find how the 2008 end thing worked without anyone complaining! Not that I complain but would have expected someone to.

      Delete
    11. Would the UK be the first to break the Treaty if it went this route?

      Delete
  3. What I find amazing is that all the economists, advisers, soothsayers and commentators berate this feeble government for its failings yet are unable to put together anything better for the opposition to turn into a coherent financial and economic plan. Or so it seems.

    ReplyDelete
  4. There has recently been a lot of blogging in USA about trillion dollar coin (and many variations) being minted as being a legal way for Obama to solve their debt issues.

    Would a similar strategy be legal in UK and get around any problems caused by the signature of the Lisbon Treaty?

    ReplyDelete
    Replies
    1. As the coin would presumably be minted by the Royal Mint, I suppose it could be considered legal monetisation under the Lisbon Treaty. Interesting.

      Delete
    2. Good Money drives out bad?

      Coin as iou to same entity.

      MMT arguments couched as accounting arguments are false. Their accounting leaves important stuff out. They have cooked the books, and are recommending the same.

      Delete
  5. I may disagree in some of your posts, but you are absolutely right about the clowns.

    It is really disappointing that this coalition that came with so many hopes has turned out to be the same as the previous goverment.

    There is no direction and a lack of fairness all around. Wellfare benefit must be decreased and some really bad cases stopped but why oh why, are they still allowing mansions/BTL to not be taxed?
    The housing costs are rising and this coalition of clowns along with the opposition of clowns do not care.

    As for the debt monetization, it is already happening. See the fact that the Treasury has decided to take the interest gains of the Asset purchase facility for QE. Guess that means that the bonds will never make it back to the market and the debt will be written off (other ways of saying default)

    ReplyDelete
    Replies
    1. Both sets of clowns are working for the Establishment, by which I mean the banks and the landowners, and are therefore taking care of their interests and not those of the electorate. I broadly agree about Osborne using the interest from the APF, the UK seems to be running with the hares and the hounds in this regard.

      Delete
  6. This comment has been removed by a blog administrator.

    ReplyDelete
    Replies
    1. Spam, in case you hadn't realised.

      Delete
    2. I had noticed. It will be deleted.

      Delete
  7. For all of the shouting about "austerity", there really has been little to none in the UK.

    The UK's economy is weak primarily because of the euro-crisis, that isn't party political.

    Ratings are meaningless. Greece was A rated in 2009.

    ReplyDelete
  8. @BlackRaven

    The UK's economy is weak because it is being allowed to drift.

    ReplyDelete
  9. Frances,

    What do you mean by “the Bank of England would as a last resort monetise debt..”? It’s already monetised a quarter of it (via QE) according to this source:

    http://www.economicshelp.org/blog/1407/economics/who-owns-government-debt/

    ReplyDelete
    Replies
    1. Ralph, there is a world of difference between buying government debt instruments to change the composition of liquidity in the monetary system and buying government debt assets to finance a fiscal deficit or reduce the debt/GDP burden. In the first case, the debt assets remain in existence and are recorded on the Bank of England's balance sheet: in the second case, they are redeemed. The Whole Government Accounts of course eliminate the gilts bought under the QE programmes as part of the consolidation of the Bank of England's accounts with those of the Government. But that is simply an accounting consolidation and does not change the fact that the gilts in question still exist in reality. I would expect you to understand this, really.

      Delete
    2. I’m well aware of the fact that the Gilts bought back via QE still exist in the vaults of the Bank of England or as you put it, on the BoE balance sheet. But what do those Gilts actually mean? As I suggested in the Financial Times a few months ago, and as others have suggested, they might as well be torn up. They’re meaningless.

      They’re simply a debt owed by on arm of government (the Treasury) to another (the BoE). If the Chancellor and governor of the BoE met over a pint of beer and decided to shred those Gilts, the economic consequences would be zero.

      Delete
    3. The economic consequences would be very far from zero, Ralph. Funnily enough, what bond investors think DOES matter. And bond investors are likely to take a very dim view indeed of outright monetisation of large amounts of public debt. The fact that the Government does not have control of these debt instruments is one of the things that keeps investors happy and therefore keeps yields down. Sorry, but that's reality.

      Delete
    4. I quite agree that what bond investors think has a very real effect. For example if bond investors believe the sort of drivel we get from the Rogoffs of this world (and many of them do) then to that extent it’s important to give weight to Rogoff type ideas. Or to take a more extreme example, if bond investors thought the Earth was flat, we might need to pretend we all thought the Earth was flat.

      As distinct from unrealistic beliefs adhered to by investors, there are the real economic effects. My basic point is that simply tearing up the Gilts held by the BoE would have no “real economic” effect.

      It could be argued against my point that if it proved necessary to substantially reverse QE, then the BoE would have no Gilts to sell. But my answer to that is that if the BoE wants to withdraw money from the private sector and doesn’t have any Gilts, it can simply announce it is willing to borrow at above the going rate. And as to interest, and with a view to getting an even bigger deflationary effect, the BoE could ask government to raise taxes so as to raise the money to pay the interest.

      The latter strategy might well not be allowed under present rules or laws. But that’s just legal technicalities. I’m concerned with “real economic effects”.

      Delete
  10. Coppola Twitter:

    " Frances Coppola ‏@Frances_Coppola 23h

    I wish politicians would STOP tinkering with automatic stabilisers such as unemployment benefits. They're rocking the boat.
    Retweeted by Steve Keen "

    You are right to want to defend the good idea of unemployment insurance.

    Isn't unemployment insurance a much more accurate description if people pay into the system with premiums. I'm sure it is fact unemployment insurance.

    Why would economists particularly in the media call it a benefit? Calling unemployment insurance a benefit might be a slippery slope to theft.

    It is important we call it what it is, an insurance, and correct the misrepresentation.

    ReplyDelete
    Replies
    1. As it stands, unemployment benefit is not insurance in any normal sense of the word. "National Insurance" is a tax: the "premiums" do not go into any sort of fund but go to pay existing claims, and future claims are unfunded. Therefore it is correct to describe entitlements under the National Insurance programme as "benefits".

      As I understand it, Labour wishes to change this to a funded scheme - in which case it would then be insurance. But they also want to force the unemployed to repay any claims once they have found work. I have never heard of an insurance scheme that expected claims to be paid back with interest, have you?

      Delete
    2. Sorry, we are from different parts of the world.

      What if we ran a "National Insurance" in the private sector that way?

      Here we have been paying for required insurance. Economists here on TV say, "benefit", almost with out fail. Some of the economists give examples of individuals as cheaters than then make the argument that every one should loose their rightful unemployment payments.

      But, to us it is insurance. Even, if some one wants the funds absconded or appropriated away. That would be a default to the unemployed who already payed.

      Delete
  11. Frances, interesting post.

    Not really on point, but what happens if/when the B of E starts selling the gilts it has bought? I am guessing that the official amount of Govt debt stays the same. But what does B of E do with the cash it gets? Does it give it to the Treasury? If so, what then? I s that a windfall for the Govt?

    Sorry to lower the intellectual tone.

    ReplyDelete
    Replies
    1. Crikey, Luke, it's not so much that you've lowered the intellectual tone as that you've opened a whole can of worms.

      Putting it as simply as I can, selling gilts back into the open market is monetary tightening - it's the equivalent of raising interest rates. The money the BoE gets in return simply "disappears", since the BoE can both create and destroy money. The position for the Government is neutral.

      Delete
    2. Thanks. ALso interested to see the exchange below.

      Delete
  12. Frances, is there any point to sovereign credit ratings for the major economies, beyond generating publicity for the ratings agencies? The bond markets barely care, because they think they know better already.

    ReplyDelete
    Replies
    1. None whatsoever. These ratings are already priced in. Sovereign credit ratings are completely pointless.

      Delete

Post a Comment

Popular posts from this blog

Game theory in Brexitland

Crypto-tulips

True patriotism