Wednesday, January 13, 2010

Moodys on Japan and the Eurozone - Stating the Obvious

By Claus Vistesen: Copenhagen

I shall openly admit that I have always found the exact role of the rating agencies a bit odd in the global financial system. I mean, do we really need them to tell us which bonds are good and which are not? I am not sure and what is more; rating agencies sometimes, if not all the time depending on their ability to stay in front of the curve, seem to wield a tremendously amount of power relative to their role as private actors (after all) in financial markets. For example, they may ultimately decide whether bonds of a given Eurozone economy may be eligible for collateral at the ECB or, even more importantly, they may decide which sovereign bonds that are investment grade or not and thus whether big institutional investors can allocates there or not.

Yet, this reservation notwithstanding, the rating agencies do seem to be some of the only big ticket private market actosr who are able to state the obvious. Specifically in this context, the obvious is directing our attention to the the ongoing travails of some economies in terms of figthting the current crisis with fiscal stimuli while the yoke of population ageing and its effect on public finances steadily pushes the economy's long term prospects into the sinkhole.

In this way, I don't think people should be, or indeed that they have a right to be outraged by the continuing comments (and inevitable) downgrades. How could they possible act otherwise given that they are here and do what they do?

In this sense, the recent messages from Moodys on Japan as well as Greece and Portugal respectively sounds extraordinarily timely to me even if it is stating the obvious;

(Quotes Bloomberg, first Japan and then Portugal/Greece (Eurozone))

The replacement of Japan’s finance minister four months into the government’s term increases concern about the commitment to contain the world’s largest public debt burden, Moody’s Investors Service said. “Japan’s fiscal strategy unknowns deepen” with the appointment of Naoto Kan last week, Thomas Byrne, senior vice president of Moody’s in Singapore, wrote in a note yesterday.

Byrne’s stance contrasts with analysts at Goldman Sachs Group Inc. and Morgan Stanley, who said Kan has indicated a willingness to repair Japan’s finances. The 63-year-old deputy prime minister last week replaced Hirohisa Fujii to become the country’s sixth finance chief in 18 months, tasked with preventing a relapse into a recession while containing the debt. “The revolving door for leadership at the Ministry of Finance does not engender confidence that Japan will put together a credible fiscal strategy to reduce deficits and stabilize the massive government debt overhang in the medium term,” Byrne said.

Kan said on Jan. 7 that it will be a “challenge” to maintain fiscal discipline this year and he will try to secure funds to fulfill the ruling Democratic Party of Japan’s pledges without exacerbating the debt burden. The role change also “raises doubts” over the administration’s commitment to a 44 trillion yen ($480 billion) cap on new Japanese government bond sales for next fiscal year, Byrne said. Kan may “seek to further boost fiscal stimulus to an economy hamstrung by renewed and stubborn deflationary pressures,” he said.


The Portuguese and Greece economies may face a “slow death” as they dedicate a higher proportion of wealth to paying off debt and investors demand a premium to hold their bonds, Moody’s Investors Service said.

While the two countries can still avoid such a scenario, their window of opportunity ”will not be open indefinitely,” Moody’s said in a report today from London. Portugal, with a negative outlook on its Aa2 rating, has more time “to reverse this trend” while Greece “has significantly less time.” Moody’s cut Greece’s rating to A2 from A1 on Dec. 22.

The premium that investors demand to hold Greek debt instead of German equivalents is six times more than it was two years ago, and the spread has doubled since 2008 in the case of Portugal. Greece had the largest budget deficit in the euro region last year, more than four times the European Union limit of 3 percent of gross domestic product. Portugal’s debt load will account for 85 percent of GDP this year, according to the European Commission.

Naturally, the case of Japan and the Eurozone periphery diverges in a number of notable ways. For starters Japan has its own central bank which will be duly deployed to provide funding for the issuance of government bonds to the extent that private (or foreign) savings are not enough to satisfy demand. Moreover, and as Moody's point 94% of Japanese debt is held by the country's own residents. I find this point less convincing as a mitigating factor since a country may very well go bankrupt with the majority of debt owned by domestic actors. Think about this as simply marking Japan to market given the demographic outlook and thus scything the face value of all those bonds they issue domestically. I.e.e Japan would move from the third/second biggest economy in the world to the "". However, since this would ultimately occur internationally through a sharp depreciation of the JPY, it would also boost Japan's competitiveness considerably. More importantly Japan has a large external surplus which means that she is building up claims on the rest of the world in stead of the other way around.

This is not the case for the Eurozone periphery and apart from the obvious fact that Greece, Portugal, Spain etc do not benefit from their own central bank which they could collaborate with in the context of quantitative easing or a prolonged commitment to ZIRP, they are also net external borrowers. According to the data from the IMF, the average annual current account deficit as percentage of GDP between 1999 and 2008 in Greece, Portugal, and Spain was -8.6%, -9.1% and -5.9% respectively.

On this point I agree with Moodys and others that the risk of a sudden balance of payment crisis leading into short term default is not relevant at this point. Rather, the main issue lies in how to make headway on the public debt/fiscal front at the same time as correcting the external deficit which has to correct since these economies are now effectively export dependent. It is very important to understand the very dangerous and decidedly unattractive cocktail that these economies must now swallow and why it is exactly so because of the inability to use nominal exchange rate depreciation as a tool to correct the external deficit. In this sense, what these economies now have to do is to travel the ill-wanted route of an internal devaluation in which domestic price and wage deflation are deployed in order to restore competitiveness. But this is not all. They are consequently also now effectively forced, vis-à-vis the nudge and pressure from Moodys et al, to take serious steps to rein in public deficits and put long term finances back on track. Now, the dilemma should be clear at this point since, as we know, deflation increases the real value of debt and thus it is difficult to see how these economies are exactly to pull this off. We could say, that the Eurozone does not allow them the leisure of inflation to ease their path to recovery.

Now at this point, the Austrian police aka haters of Fiat et al will probably be flashing their badges and tell me to pull over. And so, as I pull over I will tell them that anyone seriously arguing that the inability of Greece et al. to use nominal exchange depreciation to correct is not an aggravating factor simply do not have the faintest idea of what export dependency means modern growth dynamics of ageing economies stuck in a fertility trap about to become a liquidity trap. Really, it is as simple as that and while not everyone can devalue at the same time to become dependent on the same exports (i.e. the real underlying problem as we move forward) we are about to find out what happens when the entire weight of adjustment has to fall on the domestic economy.

Having said this however, I would like to emphasize that while the Eurozone, for reasons just mentioned, may be far from perfect we cannot let it fall apart and thus an internal devaluation in Greece, Spain etc it is. As with the Eurozone itself, it will be a great experiment to see how and whether it will work to salvage these economies.

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