Economist, New Zealand Council of Trade Unions Te Kauae Kaimahi

Two credit rating agencies – Standard and Poor’s and Fitch – downgraded New Zealand’s sovereign credit rating at the end of September 2011. Moody’s, the third major agency, left its rating of New Zealand unchanged in an announcement four weeks later. The Government had made New Zealand’s credit rating a touchstone of its competency in running the economy. It should stand accountable for the double downgrade. That is how it wants its economic management to be judged. But do we really want the country’s success to be judged by credit ratings?

Only Care About International Investors Getting Money Back

Let’s be clear what “sovereign credit ratings” mean. They are advice to international investors on how likely they are to get their money back if they lend it to the New Zealand government. The credit rating agencies don’t care about the effects of economic policies on fair distribution of income and wealth in society, people’s health and education or the environment, unless unpopular policies (like in Greece or Iceland) hurt people enough to get them out in the streets opposing debt repayment. The rating agencies only care about the priority given to investors getting their money back.

So credit ratings don’t rate how competent a Government is from a voter’s viewpoint. Nor are they a good guide as to the best long term policies a Government should be following. Judging a Government’s policies by credit ratings is like letting bankers run the Government. We should take notice of the ratings, but they are just one piece of a much bigger jigsaw. A progressive government that wants to improve the long term wellbeing of New Zealanders must look past the short term interests of financial markets. Just how badly financial markets can treat the long term interests of society is being amply demonstrated in the ongoing financial crisis. The credit rating agencies are acting for those markets. Their criteria consider not only the ability of a Government to repay but what they judge as the willingness of the Government to repay. That sets them off on inherently political judgements on the political system, political stability, whether there is widespread disagreement as to the policies a Government is following and how likely that is to be effective in changing policy, “labour flexibility” (how submissive working people are), and “respect for property rights”. They are interested in the Government’s ability to sell assets, cut spending or raise taxes.

While such criteria are blandly listed in a way that could be seen as neutral, in fact the judgements are not neutral in a social or political sense. They are intended to be interpreted in a way that asserts the interests of the financial markets. In 1988, for example, Moody’s supported the policies of the Lange/Douglas government which had introduced an extreme form of neo-liberalism into New Zealand, saying that the country had “realistic policies and successful micro-economic reforms and is improving its fiscal and external accounts”. They were wrong of course – the financial deregulation which was a fundamental part of these “realistic policies and successful micro-economic reforms” led to the build-up of huge international private debt which is now our biggest problem in the same credit rating agencies’ eyes (more of this below).

Just a year later, as that Government began to fall apart in the face of internal and external opposition to its policies, Standard and Poor’s was complaining about “policy drift”. In 1991, Standard and Poor’s approved the new National government’s “mother of all budgets”, which slashed Government spending, sending most welfare beneficiaries into poverty, as a move in the right direction. National’s unpopularity by 1993 led to Standard and Poor’s expressing concern about the Government’s “possible reaction to its weak standing in the opinion polls and the impact of the election later this year on policy direction”. Just before the 1993 election, both it and Moody’s expressed more concern at an indecisive result than a change of Government, saying that both Labour and National “have been largely moving in a similar direction”. A ratings upgrade came in 1996 despite continuing high levels of unemployment and poverty, and what a National Business Review columnist described as “piteous” returns on the Stock Market; “pathetic” export performance, and poor productivity1 .

Will Tolerate Political Change So Long As No Policy Change

In the recent downgrades, Prime Minister John Key tried to put words into Standard and Poor’s mouth, saying that a Labour victory would make a downgrade more likely. They denied it, saying “at no stage have we said that a rating downgrade was more likely if there were a change of Government”. The Dominion Post explained their position as follows: New Zealand had strong bipartisan political and community backing for conservative public finances, as well as stable political consensus on fiscal, monetary, and exchange rate policies. ‘‘We expect that this is unlikely to change whichever major party leads the Government. This remains a key factor supporting our credit ratings on sovereign’’.2 This makes their position clear: they will tolerate political change as long as it does not mean significant policy change.

This is crucial. What if a newly elected Government decided that it was more important to cut unemployment and stimulate the economy to prevent another recession, rather than have as its primary focus an aggressive programme to lower debt? Even the International Monetary Fund (IMF) – which, until recently, uncompromisingly advocated the policies the credit rating agencies find so attractive – is now recognising that it would be risking another world recession or worse if all countries cut back Government spending to reduce debt. What if a newly elected Government wanted to broaden the objectives of the Reserve Bank to include raising employment levels, economic growth and export performance? Or such a Government wanted to regulate financial movements between New Zealand and the rest of the world (such as by a financial transactions tax) to reduce our exposure to foreign debt and manage the exchange rate? Or strengthen collective bargaining to raise wages and provide more security of employment. These and many other policies are ones that a progressive Government may want to use to improve social conditions and rebalance the economy, but are likely to be criticised by the credit rating agencies. In the long run they would improve the economy and New Zealanders’ lives. In the short run, the credit rating agencies are likely to line up with those conservative forces in New Zealand business, which do not see progressive change as being in their interest. Very likely the rating agencies would be wrong. There are many Governments which follow such policies (in northern Europe and East Asia for example) and which are successful economically with high credit ratings. Social stability can be a strong basis for economic success. There are of course other Governments which are following policies they believe are in the interests of their people which have been downgraded by the rating agencies. A good rating is not a measure of a good Government as far as the population is concerned, or necessarily of the long term health of the economy.

The credit rating agencies mostly get it right in the sense of identifying repayment problems, but are by no means infallible. Moody’s continued Iceland’s top (AAA) rating in March 2008 (though with negative outlook – suggesting the possibility of a downgrade within the next two years), just six months before the country joined Moody’s list of the eleven biggest financial collapses in history 3 . All three major rating agencies had Greece on an A rating just a year before its crisis. A rating downgrade or upgrade of three or more notches within a 12 month period is regarded as a sign of rating agency failure according to the IMF. There were 17 such failures (all but two being downgrades) during the 1997-1998 Asian financial crisis, and 13 (all downgrades) during the 2007-10 global financial crisis, including Greece and Iceland. And looking beyond sovereign ratings to corporate and bond ratings, the rating agencies famously and comprehensively failed to accurately rate the complex “structured finance” products which triggered the global crisis. According to an IMF study published in October 2010, “over three-quarters of all private-label mortgage-backed securities issued in the US from 2005 to 2007 that were rated AAA by Standard and Poor’s are now rated below BBB-, that is, below investment grade.”4

Rate Countries Too High

It is sobering however that the mistakes largely rate countries too high. Failures almost all rate too high rather than too low. There are reasons why this is so. For corporate securities, the issuer pays the rating agency for the rating. There is therefore an incentive for agencies to rate higher to retain their business. That is constrained by their desire to retain a reputation for accuracy, but at the least it is logical that it introduces a bias. In the case of the “structured finance” products which they almost completely wrongly rated, the bias combined with inexperience with such products was fatal. For sovereign ratings, there are a number of reasons for an upward bias. There is a fear of an over-reaction from a downgrade. If the rating is at a point that triggers sell-offs by investors, then lowering it can lead to a “cliff” effect of a fall in investment and rise in interest rates much greater than justified. The reaction itself could lead to a further downgrade. For this and stability reasons, rating agencies tend to rate based on looking through an entire economic cycle, or (in the light of the financial crisis) looking at the potential effects of different crisis scenarios, rather than just the next few months. The effect may be to delay a downgrade. For such reasons, the IMF is recommending that policy makers reduce their reliance on ratings, remove references to ratings in laws, regulations and bank collateral policies, and increase the oversight of rating agencies.

On the whole, the rating agencies do accurately identify the countries close to default – but sometimes too late, and the resulting rapid downgrade can add to the severity of the consequences. It is clear that the credit rating agencies’ pronouncements are given too much importance. They reflect a narrow economic and political interest and their reliability cannot be taken for granted. The importance given to them reflects the excessive power of financial markets – something we should be weaning ourselves from, not slavishly obeying. Obedience means little possibility of real political change.

What could happen as a result of the downgrades that occurred in September? In 2009 the Prime Minister said that “If a downgrade were to happen, it would add 1-2 percent of interest on the amount the government borrows, which is around $600 million each year” 5 . First, that is greatly exaggerated. Treasury estimated the actual effect at 0.15 percent. That is barely detectable within the range of interest rates the Government pays. Second, the October 2010 International Monetary Fund analysis quoted above found that financial markets barely react to an actual downgrade. They do react significantly to warnings given by rating agencies of a future downgrade (negative “watch” or “review” means a downgrade is likely within 90 days; negative “outlook” means there is potential for one within two years). For an “advanced” economy like New Zealand’s, a negative warning on average meant a one percentage point increase in interest rates (1.6 percentage points for “emerging” economies). However, the increase is likely to be much higher for lower rated countries, so the increase for an AA rated country like New Zealand is likely to be significantly less than one percentage point – the 0.15 percent Treasury estimated is probably a good guideline. Not all downgrades are heralded by such warnings though (only 27% for Moody’s, 14% for Standard and Poor’s, and 8% for Fitch). Evidently, markets generally anticipate downgrades, so little changes once the downgrade occurs 6 .

The exception is if there is an unexpectedly steep downgrade (probably when the rating agency has failed to do its job) or if the downgrade takes the country below an investment-grade rating (below BBB- for Standard and Poor’s and Fitch; BAA3 for Moody’s). In that case, many institutional investors have internal rules that mean they have to sell, and the result can be a crash as investors flee, making the situation even worse. The IMF, describing this as going over a cliff, considers Governments should get rid of such rules.

Not A Reliable Judgement On Government

Clearly, New Zealand is a very long way from any of these situations. The Government is still rated AA for foreign currency borrowing by Standard and Poor’s and Fitch – their third-highest rating – and AAA by Moody’s – its highest rating. For domestic currency borrowing, the New Zealand government is rated AA+ and AAA respectively 7 . No country has ever defaulted (failed to repay) from a rating A- or above, which is four to six notches lower than New Zealand. Many financial commentators and most media greatly exaggerate the significance of a one notch change in rating at this level.

The New Zealand dollar appeared to drop following the downgrades. Again, it is hard to tell how much of that just continued the fall that had been happening over the previous month. From a peak on 31 August of US$0.85, the New Zealand dollar had fallen sharply to US$0.77 by the day before the downgrade, 29 September. It fell to US$0.76 by the following Wednesday, but was back up to US$0.82 by 28 October. If it had continued to depreciate, it would have been welcomed by exporters, but the effect of a downgrade on the exchange rate is ambiguous. Some investment funds may reconsider how much they would put into New Zealand Government bonds under their internal criteria following the downgrade. If some stop investing or withdraw, the dollar could fall. On the other hand, if interest rates rise as a result of the downgrade, more investors may be attracted to the bonds, and currency speculators might hasten the rise, betting on rising interest rates. In current circumstances, however, the truth is that compared to world markets, New Zealand looks pretty safe, partly because of the danger out there, and partly because, despite Government rhetoric (when it suits it), New Zealand’s Government debt is low and has been for the last decade. The downgrade is unlikely to have much effect.

Are there any lessons from the downgrades? The most important is that the rating agencies’ current concern is not about New Zealand’s Government debt. Net public debt at about 20% of Gross Domestic Product (GDP) is expected to peak around 30% of GDP compared to an Organisation for Economic Cooperation and Development (OECD) average already more than double that and likely to go much higher. The relatively low level is mainly due to the low debt handed over by the previous Government – under 6% of GDP.

Instead, the rating agencies are focusing on the increasing current account deficit – the difference between receipts and expenses from abroad. It is almost entirely due to the interest and dividends paid to overseas investors in companies and those owed New Zealand’s large international debt, built up over the last quarter century since financial deregulation. Overwhelmingly their loans are to the banks – almost 80% of New Zealand’s net international debt. The Government owes none of this debt. In net terms, its entire debt is to local investors.

The rating agencies are likely to worry that in another financial crisis the Government would have to bail out any banks which failed, at huge cost. The ensuing recession would also be very costly to the Government in lost revenue. Unfortunately another crisis is likely given that international financial markets have successfully resisted effective reform. The key issue is therefore not public debt, but New Zealand’s international liabilities and its exposure to the risk the financial markets present. The Government has done very little about these. Net international liabilities fell recently, but this was mainly due to earthquake reinsurance and statistical revisions, not Government actions. Treasury forecasts are that the current account deficit – which shows the rate at which international debt is accumulating – is going to rise steadily over its forecast period to 2016.

We need policies to reduce the banks’ excessive use of overseas funding and Government exposure to their failure, we must reduce our exposure to low quality and short term overseas investment, increase savings such as through KiwiSaver, direct those savings into more productive areas which could compete internationally through measures like a capital gains tax, support potential exporters, and increase firms’ productivity by improving management skills and employees’ skill and educational levels. Credit ratings make for simplistic headlines and fertile soil in which to create an artificial sense of crisis. They are not a reliable judgement on the quality of a Government or even its economic management. Their significance should be downgraded.

Endnotes

1. These examples come from “Reclaiming the Future”, by Jane Kelsey, Bridget Williams Books, 1999, p.77-83.

2. “Key tight-lipped about source of S&P remark”, by Vernon Small, Dominion Post, 11/10/11.

3. “Lessons from Iceland”, by Robert Wade and Silla Sigurgeirsdottir, New Left Review 65, September/October 2010; Moody’s Rating Action, “Moody’s changes outlook on HFF to negative; affirms Kaupthing, Glitnir and Landsbanki with stable outlook”, 5/3/08.

4. Data other than on Iceland is from “The uses and abuses of sovereign credit ratings”, Chapter 3, IMF Global Stability Report, October 2010.

5. See “PM not anticipating credit downgrade”, TVNZ, 25/5/09, http://tvnz.co.nz/content/2755701/2683454/article.html

6. “The uses and abuses of sovereign credit ratings”, Chapter 3, IMF Global Stability Report, October 2010.

7. See http://www.nzdmo.govt.nz/sovereigncreditratings.