Credit Rating Woes

Credit ratings are used to determine whether a certain individual (or in this case, a country) is creditworthy or not. You see, the higher a country’s credit rating is, the less likely that it will default on loans or government securities. This makes countries with poor credit ratings have higher borrowing costs. In fact, a really bad credit rating can sometimes lead to an outright loan refusal.

There are many credit rating agencies per country but the commercial agencies that operate worldwide are usually the ones that garner the most attention. These are Moody’s, Standard and Poor’s, and Fitch Ratings.

Sovereign credit ratings are important for currency traders because they provide a good starting point to analyze the economic health of a certain country. Although somewhat simplistic, putting the sovereign credit ratings of countries side by side would enable currency traders to see whether one country is doing better than another.

Generally speaking, government bonds with a high credit rating are considered more attractive compared to those with a poor credit rating. I mean, an investor would rather lend to the government that has very little default risk, right? The possibility of a sovereign default is unlikely, considering how governments have piles and piles of moolah, but it did happen for Argentina back in 2001…

Now, I’m sure you’ve all heard of Dubai’s debt problem, which prompted credit rating agencies to downgrade several Dubai companies’ debt. This took place after Dubai’s government asked for an extension of their debt repayments, consequently raising concerns that the probable sovereign default could have a ripple effect on other nations.

If Dubai defaults on its debt obligations, not only will it have a negative implication on its creditworthiness but it will also have a damaging impact on the UK. The reason behind this is that the UK has a whopping $50 billion stake on Dubai’s $123 billion foreign debt. That’s about 40.65%! In other words, the $50 billion in cash or cash equivalents can suddenly turn into ashes if Dubai defaults. Not only will it be a financial loss for Dubai but it also puts serious implications on UK banks and, of course, to their clients and investors as well.

Just as traders started to get over Dubai’s credit woes, news of another sovereign debt downgrade caused a ruckus in the markets. Greece suffered a credit rating downgrade from Fitch, which pinpointed the weak credibility of Greek fiscal institutions as a major default risk. The prospect of Greece’s government debt reaching 125% of its GDP next year was enough reason for Fitch to cut the nation’s rating to BBB+. This marked the first time in ten years that Greece received a credit rating below A, making Greece’s sovereign debt the lowest-rated in the entire euro zone.

If the ratings on Greece’s government bonds remain unchanged for a long time, then Greece might no longer be able to borrow from the ECB. That’s because, by the end of 2010, the ECB plans to tighten its credit policy and only accept collaterals with a rating of A- and above. Greece’s government will then be forced to find another financier. But with a lower credit rating, they will have to offer a much higher interest on their loans, placing further pressure on their debt obligations.

Spain soon joined the credit woes bandwagon as Standard and Poor’s lowered their debt grade outlook from “stable” to “negative,” citing that Spain will undergo further deterioration in its budget amidst a prolonged period of economic weakness. Ouch! Spain’s budget deficit is currently the largest in the euro zone, comprising 11.2% of its GDP and estimated to balloon to 66% next year. News of their credit downgrade shook the markets then… But, wait a minute, how exactly does this affect the currency market?

Judging from what’s been happening during this recession, every time the poop has hit the fan, we’ve seen traders and investors become risk averse. They become afraid to put their money in those attractive and higher yielding assets and look for something a little more “safe.” And we all know what this means… They run back to the beloved US dollar!

But hey, doesn’t the US have debt problems of its own? Isn’t this a primary issue that’s plaguing the greenback right now? Yes, the “kings of credit” definitely have a big problem at hand, but my guess is that they won’t have to deal with it for some time. Amongst the major economies, it’s likely that rating institutions deem the US government as “too big to fail.” Chances are that credit rating agencies will probably downgrade most European nations first before heading across the pond to deal with the Big Debtor.

Metaphorically speaking, the global economy is like a line of dominoes where Greece is at the beginning of the line followed by the other European countries. At the end, we have the US. For the meantime, if we do see credit ratings continue to fall, the US dollar will probably continue to provide some safety to traders and investors. For how long? I’m not quite sure…