Debt Rating Agencies Sending Right Message...at Wrong Time

The heightened sense of scrutiny surrounding many heavily-indebted rich nations is sending the right message about fiscal discipline but is coming at the wrong point in the recovery cycle for many countries, and could do more harm than it's worth to the global economy.

That many countries need to lower outstanding debt and trim budget deficits for the long-term stability of their own economies is hardly disputable.

However, Japan, the United States, Britain and peripheral Europe still harbour economic problems that make drastic spending cuts difficult to stomach. Standard & Poor's downgrade of Japan last month raises questions about who will be next.

Moody's Investors Service is likely to provide a sobering assessment of the poor state of public finances in many countries at a briefing in Tokyo on Feb. 9, but no action on ratings is expected.

The United States and Europe are obvious places to look, and the slow pace of improvement in public finances could pave the way for a further rise in yields that condemns developed countries to another lacklustre year of growth and drives more money to emerging markets.

"It's going to be tough for the U.S. government to avoid some sort of ratings action," said Guy LeBas, chief fixed-income strategist at Philadelphia-based fund manager Janney Montgomery Scott, with $52 billion under management.

"The United States is the benchmark by which much of the rest the world's credit is measured. So when the benchmark gets hit you would think in theory everything else does."

HIGHER YIELDS COULD HOBBLE SLUGGISH ECONOMIES

Credit default swap (CDS) spreads for major economies have started to narrow again after Japan's downgrade sparked a widening in spreads, indicating a rise in the cost of protection from a sovereign debt default.

Yields in many countries have been on the rise as the global economic recovery improves. Some investors worry that if yields start rising further due to worries about fiscal discipline it will raise borrowing costs and slow growth for many debt-laden nations, making it harder to pay down debt.

Investors could price an additional 25 basis points into 10-year Treasury yields for a negative outlook on the United States, LeBas said. Yields in other developed countries, such as Germany and Scandinavia, could rise, while yields could weaken in emerging markets, he said.

Japan is in the worst shape by far, with outstanding debt twice the size of its $5 trillion economy, though a vast majority of its debt is held by local institutions, not foreign investors.

Greece and Ireland have ratios of debt to gross domestic product above 100%. Spain, Portugal, the United States and Britain aren't far behind.

Many market watchers still argue that a default by Greece could be preferable to a prolonged fiscal mess that would also weigh on its neighbours. There are also calls for Ireland to default.

This seems an unlikely outcome for Japan, the United States, Britain and smaller European countries, but another downgrade would be further evidence that government debt has lost its risk-free status.

Policymakers in many rich countries could not be blamed for wanting to buy time because, while the economic environment is improving, a rapid recovery is far from assured and rising commodity prices are fueling inflationary pressures, which could complicate an already messy situation.

Japan's government is propping up domestic demand with subsidies for durable goods, while nagging deflation increases the real cost of its debt.

In Britain, there is talk of stagflation, Spain is still restructuring its banking sector, and in the United States unemployment is too high and the housing market remains fragile after the bubble burst.

Ratings agencies' credibility is still tarnished by their handling of subprime mortgage derivatives and the collapse of Lehman Brothers in 2008, so some governments may look the other way if agencies get tougher on sovereign debt.

"Ratings agencies themselves have been blamed for late action, and they don't what to be blamed this time," said Akira Takei, general manager of international fixed-income investment at Mizuho Asset Management in Tokyo.

"But governments shouldn't respond to ratings agencies because they need to keep their economies healthy. Governments have to send messages about fiscal consolidation but they need to continue to pour money into their economies."

Takei added that he prefers to invest in super long-dated bonds from Britain and the United States as well as five-year debt from Australia and New Zealand.

For many of the world's sovereign debt hot spots, the political environment is also tenuous due to split parliaments, minority governments or low public approval ratings, making it all the more difficult for politicians to form a consensus for sound fiscal policy needed to ease investors' worries.