Monday, March 30, 2009

Paradoxes of downgrading and simple accounting

One of the worst, most feared moments of the crisis for many ECE countries is the event of downgrading by a credit rating agency. It is usually accompanied by a sudden fall of the respective currency on the market (sometimes as a lasting effect, sometimes followed by a recovery soon), by the growing spreads of government bonds and by a wavering credibility in the country's public finances etc. Although it is far from being a case of normality, such downgradings and its opposites, upgradings occur regularly. The reactions, usually in line with the agnecy's direction, express the faith of the market actors in those institutions, the fact that they accept: the agency is capable to analyze possible outcomes of the present situation with mathematical models and judge whether a country among fixed circumstances can repay its debt or not. (In case of some factors they should rely on hypothesis or forecasts.)

The crisis shattered the credibility of such agencies as their mathmatical models readily accepted the fact that subprime mortgages can be "repacked" into extraordinarily secure assets and from the perspective of the crisis it was clearly not the case. However, this fact seemingly didn't affect their credibility as evaluators of sovereign debts (Paradox 1). (Who knows why? Incompetence remains incompetence even if it is used to assess a different type of loans and bonds...) But one can assume that rating agencies drew the consequences and they logical reaction is to be more cautious, that means to make downgradings easier and earlier. Not that in case of a crisis, when forecasts have to be revised in every month or week caution wouldn't be advisable, but acting instinctively is not in line with the perceived scientifically based approach. (Paradox 2) Anyway, the agencies are desperate not to make the same mistake, and in the future assess risks more precisely, what also means to be able to forecast problems (in case of countries: sovereign default) earlier. Downgrading is a sign of taking into account risks and warning the markets and the respective states. And if the worst happens notwithstanding the early notice, the credit rating agency can only gain in credibility and standing.

It is cerainly a sound approach in normal times, especially as markets can calm down after a downgrading, government should have time to prepare the necessary action. But there is a not easily dismissable possibility that in times of crisis the more severe judgment can turn out to be a self fulfilling prophecy in a way not strengthening, but weakening the much desired trust. The external factors, quite independently from the government action, can deteriorate in a very short time span once again forcing the agencies to downgrade a country's debt and leaving no time even to prepare the necessary measures as a reaction to the earlier one and portraying even the most able government as inapt. The deathly circle of downgrading and raising bond sperads leading to downgrading again and raising the bond spreads again can emerge too easily. As there is no way to know how a very alarmed and uncertain market will react, it is not easy to know when will this prophecy fulfill itself at the very moment of the downgrading. But if it would happen it won't be a sign of the wisdom and professional capability, quite the contrary. In this case, as it would be very similar to those derivatives from sub-prime mortgages, it would be inevitable to think that they once again missed their point, and miscalculated themselves. (Paradox 3)

But beyond some intriguing, rather theoretical considerations, sometimes the practical capacities of such institutions seems to be problematic as well. Today Standards and Poor downgraded Hungary's long term sovereign debt and issued a statement in which they calculated that the present 72-73% debt in ratio of GDP will reach a 82% level next year, after an estimated 6% contraction followed by a 1% in 2010 and after the country will be compelled to ask more loans from IMF. This is more or less in line with the ideas of "experts", but nothing else than a simple miscalulation, presuming that the present-day gross debt will eventually turn out to be a net one. But it is far from being certain, moreover, up to this point it didn't happened. The problem with this calculation - as the deputy general director of Hungary's national agency for sovereign debt explained in an interview last week - that although Hungary has drawn a substantial part of its IMF loan last year, it is now either a deposit in the Hungarian National Bank, or was lent to commercial banks with market conditions. In case of the latter there is a fair chance that it will be returned in time with due interests. The former either will be used to buy back outstanding state bonds or pay for bonds in due time, therefore not piling up additional sovereign debt, or simply paid back to the IMF without being used. As long as this is a reserve and not paid for running state costs or used up as a resource for pensions or similar expenses there is no reason to assume that it will raise the level of sovereign debt. But even if it would be the case the 82% ratio is highly unrealistic. The present debt is calculated by S&P as 73% of the GDP, and they estimate a 6% decline for this year and a 1% for the next. Together we can assume that they calculate the GDP level in 2010 as the 93% of 2008. Accordingly today's debt ratio would be compared with this lower level, yielding a 77,4% result as the level of sovereign debt. Even if they were not presuming any governemnt measure to control this years deficit (although it is not the case) 82% seems to be a bit exagerrated. But the problem is not this calculation, but the fact that the "experts" at S&P, although certainly very smart at making mathematical models, are not capable to make a simple accounting work. Well, I know that it is tought at another department...

Update: Two feloows from the National Agency for State Debt published today an analysis refuting the prevailing perception of the inevitable sovereign default, pointing out the huge mistake regarding the IMF loan. Unfortunately it is in Hungarian.

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