Borrowers are wondering how European monetary union (Emu), if it happens, will affect their credit ratings.
Rating agencies Ibca, Moody's Investors Service and Standard and Poor's all intend (on different timetables) to assign a single ceiling rating to the whole of the Emu area. Given the strength of the area as a whole, this will be AAA, which will in effect become the sovereign rating. Governments will still receive ratings but these will be used purely for measuring the creditworthiness of each government's debt, not that of the whole country. As a result, all borrowers across the European Union will, in theory, be able to aspire to the AAA rating assigned to the bloc. An individual sovereign rating will no longer be a ceiling for other borrowers from that country.
This points to a fundamental shift in the way that EU governments will be assessed for ratings. At present all three agencies assign two ratings, one for domestic borrowing and one for foreign currency borrowing. After Emu, all plan to have just one rating for each country. At Ibca and Standard and Poor's the plan is to use the foreign currency rating, the reasoning being that Emu will deprive individual governments of much of their monetary authority - they will not be able to print their way out of debt, nor borrow from the central bank. The euro will therefore not be a purely domestic currency in the sense that the Deutschmark or sterling is now.
Moody's, on the other hand, takes the view that the euro will be the domestic currency, and that its local currency ratings already offer a fair representation of the underlying creditworthiness of each government. It will therefore use these and dispense with foreign currency ratings.
For countries such as France, Germany and the Netherlands, which have AAA ratings for local and foreign currency debt from each agency, the changes will have no direct relevance and they will continue to receive AAA ratings (downgrading aside). But for some governments the new approach could cause discrepancies, even confusion. Following Moody's' methodology, both Finland and Ireland would have Aaa ratings upon entering monetary union, but Standard and Poor's and Ibca allocate them AA/AA and AA/AA plus. The spread for Greece - which is unlikely to be in the first wave of Emu - is even more marked, with Moody's assigning a rating of A2 whereas the other two both give BBB minus.
And this is not the only difference in approach. The three agencies do not concur on when to change over to single ratings and an Emu ceiling, and this time it is Ibca that stands alone. Pointing to the risk of countries leaving Emu after it starts, Ibca's plan is to leave the domestic and foreign currency ceilings in place until Emu has established a track record, which may not be until national currencies are removed altogether in 2002.
The other two agencies plan to have the Emu ceiling and the single government ratings in place as soon as they are confident of which countries are joining Emu and when it is going ahead. "Their view is that by then individual countries will effectively have lost the flexibility in monetary and exchange rate policy underpinning the rating distinction," explains Gary Jenkins, one of the authors of a BZW report on the subject.
However, all is not lost for those governments that receive differing ratings, as the initial phase of Emu will coincide with the drive to comply with the Maastricht criteria, which are viewed as being rating-friendly because they are designed to reduce a government's indebtedness and control inflation. So there could be an upward shift in ratings for those countries that join Emu, whether in the first wave or later.
Beyond the medium term, however, upward convergence of ratings is unlikely to continue. As the various governments in Emu lose control over monetary and exchange rate policy, there will have to be a shift towards other tools as a means of maintaining a check on regional disparities. "In other monetary unions, fiscal policy and transfers are important tools in countering regional divergences," says Jenkins. "In Canada, for example, fiscal transfers between federal and provincial governments geared to offsetting differences in provincial living standards are an important part of provincial budgets. Federal transfers can account for up to 40% of provincial revenues."
But the EU budget is much smaller than federal budgets in the US or Canada, and the stability pact is designed to keep EU members' fiscal deficits below 3% of GDP, so curtailing the ability of individual members to provide financial assistance to others. In addition, the Maastricht treaty contains a no bail-out clause, which states that "a member state shall not be liable for or assume the commitments of central governments, regional , local or other public bodies."
Yet the EU also has a greater divergence of GDP per capita than other unions. A full EU has a range of $25,000 (from $10,000 to just under $35,000), whereas Canada ranges over $10,000 and Australia over $8,000. Given this, and the restraint on fiscal transfers, the longer term outlook seems to be for a broader spread of EU government ratings.
One thing is certain: as Emu develops, more and more emphasis will be given to credit analysis.
Investors may be surprised to find that the rating agencies cannot even agree on the most fundamental question about Emu - whether the euro should be considered domestic or foreign currency for particpating countries - but the agencies' services will be in demand. "I know what I'd do if these rating agencies were listed on a stock exchange," says one head of syndicate. "I'd put as much money into them as I could - they're going to make a fortune." Antony Currie